1. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 1 of 37 PowerPoint Lectures for Principles of Economics, 9e By Karl E. Case, Ray C. Fair & Sharon M. Oster ; ;

2. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 2 of 37

3. © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster PART V THE CORE OF MACROECONOMIC THEORY 26 Money Demand and the Equilibrium Interest Rate Fernando & Yvonn Quijano Prepared by:

4. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 4 of 37 Interest Rates and Bond PricesThe Demand for MoneyThe Transaction MotiveThe Speculation MotiveThe Total Demand for MoneyThe Effects of Income and the Price Level on the Demand for Money The Equilibrium Interest RateSupply and Demand in the Money MarketChanging the Money Supply to Affect the Interest Rate Increases in Y and Shifts in the Money Demand Curve Looking Ahead: The Federal Reserve and Monetary Policy Appendix A: The Various Interest Rates in the U.S. Economy Appendix B: The Demand for Money: A Numerical Example CHAPTER OUTLINE Money Demand and the Equilibrium Interest Rate PART V THE CORE OF MACROECONOMIC THEORY 26

5. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 5 of 37 Interest Rates and Bond Prices Interest The fee that borrowers pay to lenders for the use of their funds. Professor SerebryakovMakes an EconomicError Uncle Vanya by Anton Chekhov

6. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 6 of 37 The Demand for Money transaction motive The main reason that people hold moneyto buy things. The Transaction Motive When we speak of the demand for money, we are concerned with how much of your financial assets you want to hold in the form of money, which does not earn interest, versus how much you want to hold in interest-bearing securities, such as bonds.

7. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 7 of 37 The Demand for Money The Transaction Motive Income arrives only once a month, but spending takes place continuously. FIGURE 26.1 The Nonsynchronization of Income and Spending

8. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 8 of 37 The Demand for Money nonsynchronization of income and spending The mismatch between the timing of money inflow to the household and the timing of money outflow for household expenses. The Transaction Motive

9. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 9 of 37 The Demand for Money The Transaction Motive Jim could decide to deposit his entire paycheck ($1,200) into his checking account at the start of the month and run his balance down to zero by the end of the month. In this case, his average balance would be $600. FIGURE 26.2 Jims Monthly Checking Account Balances: Strategy 1

10. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 10 of 37 Jim receives $1,200 per month (30 days) and spends $40 each day. What is his average money balance? a.$40. b.$30. c.$600. d.$1,200.

11. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 11 of 37 Jim receives $1,200 per month (30 days) and spends $40 each day. What is his average money balance? a.$40. b.$30. c.$600. d.$1,200.

12. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 12 of 37 The Demand for Money The Transaction Motive Jim could also choose to put half of his paycheck into his checking account and buy a bond with the other half of his income. At midmonth, Jim would sell the bond and deposit the $600 into his checking account to pay the second half of the months bills. Following this strategy, Jims average money holdings would be $300. FIGURE 26.3 Jims Monthly Checking Account Balances: Strategy 2

13. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 13 of 37 The Demand for Money The Transaction Motive The quantity of money demanded (the amount of money households and firms want to hold) is a function of the interest rate. Because the interest rate is the opportunity cost of holding money balances, increases in the interest rate reduce the quantity of money that firms and households want to hold and decreases in the interest rate increase the quantity of money that firms and households want to hold. FIGURE 26.4 The Demand Curve for Money Balances

14. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 14 of 37 Assume that there are no management costs associated with buying and selling bonds. What is the impact of an increase in the interest rate on money holdings and interest revenue? a.Both money holdings and interest revenue would rise. b.Both money holdings and interest revenue would decline. c.Money holdings would rise and interest revenue would decline. d.Money holdings would decline, and interest revenue would rise.

15. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 15 of 37 Assume that there are no management costs associated with buying and selling bonds. What is the impact of an increase in the interest rate on money holdings and interest revenue? a.Both money holdings and interest revenue would rise. b.Both money holdings and interest revenue would decline. c.Money holdings would rise and interest revenue would decline. d.Money holdings would decline, and interest revenue would rise.

16. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 16 of 37 The Demand for Money The Speculation Motive speculation motive One reason for holding bonds instead of money: Because the market price of interest-bearing bonds is inversely related to the interest rate, investors may want to hold bonds when interest rates are high with the hope of selling them when interest rates fall.

17. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 17 of 37 The Demand for Money The Total Demand for Money The total quantity of money demanded in the economy is the sum of the demand for checking account balances and cash by both households and firms. At any given moment, there is a demand for moneyfor cash and checking account balances. Although households and firms need to hold balances for everyday transactions, their demand has a limit. For both households and firms, the quantity of money demanded at any moment depends on the opportunity cost of holding money, a cost determined by the interest rate.

18. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 18 of 37 Which of the following is a better measure of the opportunity cost of holding money balances? a.The demand for money curve. b.The interest rate. c.The transactions motive. d.The optimal money balance.

19. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 19 of 37 Which of the following is a better measure of the opportunity cost of holding money balances? a.The demand for money curve. b.The interest rate. c.The transactions motive. d.The optimal money balance.

20. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 20 of 37 The Demand for Money The Total Demand for Money ATMs and the Demandfor Money Italy makes a great case study of the effects of the spread of ATMs on the demand for money. In Italy, virtually all checking accounts pay interest. What doesnt pay interest is cash. In other words, in Italy there is an interest cost to carrying cash instead of depositing the cash in a checking account. Orazio Attansio, Luigi Guiso, and Tullio Jappelli, The Demand for Money, Financial Innovation and the Welfare Costs of Inflation: An Analysis with Household Data, Journal of Political Economy, April 2002.

21. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 21 of 37 The Demand for Money The Effects of Income and the Price Level on the Demand for Money An increase in Y means that there is more economic activity. Firms are producing and selling more, and households are earning more income and buying more. There are more transactions, for which money is needed. As a result, both firms and households are likely to increase their holdings of money balances at a given interest rate. FIGURE 26.5 An Increase in Aggregate Output (Income) (Y) Will Shift the Money Demand Curve to the Right

22. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 22 of 37 The Demand for Money The Effects of Income and the Price Level on the Demand for Money TABLE 26.1 Determinants of Money Demand 1.The interest rate: r (The quantity of money demanded is a negative function of the interest rate.) 2.The dollar volume of transactions a. Aggregate output (income): Y (An increase in Y shifts the money demand curve to the right.) b. The price level: P (An increase in P shifts the money demand curve to the right.) The amount of money needed by firms and households to facilitate their day-to-day transactions also depends on the average dollar amount of each transaction. In turn, the average amount of each transaction depends on prices, or instead, on the price level.

23. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 23 of 37 The demand for money increases when: a.Both the dollar volume of transactions and the average transaction amount increase. b.Both the dollar volume of transactions and the average transaction amount decrease. c.The dollar volume of transactions increases and the average transaction amount decreases. d.The dollar volume of transactions decreases and the average transaction amount increases.

24. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 24 of 37 The demand for money increases when: a.Both the dollar volume of transactions and the average transaction amount increase. b.Both the dollar volume of transactions and the average transaction amount decrease. c.The dollar volume of transactions increases and the average transaction amount decreases. d.The dollar volume of transactions decreases and the average transaction amount increases.

25. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 25 of 37 The Equilibrium Interest Rate We are now in a position to consider one of the key questions in macroeconomics: How is the interest rate determined in the economy? The point at which the quantity of money demanded equals the quantity of money supplied determines the equilibrium interest rate in the economy.

26. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 26 of 37 The Equilibrium Interest Rate Supply and Demand in the Money Market Equilibrium exists in the money market when the supply of money is equal to the demand for money and thus when the supply of bonds is equal to the demand for bonds. At r 0 the price of bonds would be bid up (and thus the interest rate down), and at r 1 the price of bonds would be bid down (and thus the interest rate up). FIGURE 26.6 Adjustments in the Money Market

27. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 27 of 37 When the interest rate is above the equilibrium interest rate: a.People will move out of bonds and into moneyhold larger cash balances. b.The quantity of money demanded is too high to achieve equilibrium. c.The quantity of money demanded is greater than the quantity of money supplied. d.There is more money in circulation than households and firms want to hold.

28. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 28 of 37 When the interest rate is above the equilibrium interest rate: a.People will move out of bonds and into moneyhold larger cash balances. b.The quantity of money demanded is too high to achieve equilibrium. c.The quantity of money demanded is greater than the quantity of money supplied. d.There is more money in circulation than households and firms want to hold.

29. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 29 of 37 The Equilibrium Interest Rate Changing the Money Supply to Affect the Interest Rate FIGURE 26.7 The Effect of an Increase in the Supply of Money on the Interest Rate An increase in the supply of money from to lowers the rate of interest from 7 percent to 4 percent.

30. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 30 of 37 An increase in the money supply, without a change in the demand for money will: a.Increase the equilibrium interest rate. b.Decrease the equilibrium interest rate. c.Result in an excess demand for money. d.Decrease the quantity of money demanded.

31. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 31 of 37 An increase in the money supply, without a change in the demand for money will: a.Increase the equilibrium interest rate. b.Decrease the equilibrium interest rate. c.Result in an excess demand for money. d.Decrease the quantity of money demanded.

32. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 32 of 37 The Equilibrium Interest Rate Increases in Y and Shifts in the Money Demand Curve FIGURE 26.8 The Effect of an Increase in Income on the Interest Rate An increase in aggregate output (income) shifts the money demand curve from to, which raises the equilibrium interest rate from 4 percent to 7 percent.

33. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 33 of 37 Looking Ahead: The Federal Reserve and Monetary Policy tight monetary policy Fed policies that contract the money supply and thus raise interest rates in an effort to restrain the economy. easy monetary policy Fed policies that expand the money supply and thus lower interest rates in an effort to stimulate the economy.

34. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 34 of 37 If the Fed wants to maintain the interest rate constant, it will have to: a.Increase the money supply when the demand for money increases. b.Increase the money supply when the demand for money decreases. c.Leave the money supply unchanged regardless of changes in the demand for money. d.Decrease the reserve requirement when the demand for money shifts to the left.

35. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 35 of 37 If the Fed wants to maintain the interest rate constant, it will have to: a.Increase the money supply when the demand for money increases. b.Increase the money supply when the demand for money decreases. c.Leave the money supply unchanged regardless of changes in the demand for money. d.Decrease the reserve requirement when the demand for money shifts to the left.

36. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 36 of 37 easy monetary policy interest nonsynchronization of income and spending speculation motive tight monetary policy transaction motive REVIEW TERMS AND CONCEPTS

37. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 37 of 37 THE VARIOUS INTEREST RATES IN THE U.S. ECONOMY A P P E N D I X A THE TERM STRUCTURE OF INTEREST RATES The term structure of interest rates is the relationship among the interest rates offered on securities of different maturities. According to a theory called the expectations theory of the term structure of interest rates, the 2- year rate is equal to the average of the current 1- year rate and the 1-year rate expected a year from now. Peoples expectations of higher future short-term interest rates are likely to increase. These expectations will then be reflected in current long- term interest rates.

38. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 38 of 37 THE VARIOUS INTEREST RATES IN THE U.S. ECONOMY A P P E N D I X A TYPES OF INTEREST RATES Three-Month Treasury Bill Rate Government Bond Rate Federal Funds Rate Commercial Paper Rate Prime Rate AAA Corporate Bond Rate

39. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 39 of 37 THE DEMAND FOR MONEY: A NUMERICAL EXAMPLE A P P E N D I X B TABLE 26B.1 Optimum Money Holdings 1 Number of Switches a 2 Average Money Holdings b 3 Average Bond Holdings c 4 Interest Earned d 5 Cost of Switching e 6 Net Profit f r = 5 percent 0$600.00$ 0.00 1300.00 15.002.0013.00 2200.00400.0020.004.0016.00 3150.00*450.0022.506.0016.50 4120.00480.0024.008.0016.00 Assumptions: Interest rate r = 0.05. Cost of switching from bonds to money equals $2 per transaction. r = 3 percent 0$600.00$ 0.00 1300.00 9.002.007.00 2200.00*400.0012.004.008.00 3150.00450.0013.506.007.50 4120.00480.0014.408.006.40 Assumptions: Interest rate r = 0.03. Cost of switching from bonds to money equals $2 per transaction. *Optimum money holdings. a That is, the number of times you sell a bond. b Calculated as 600/(col. 1 + 1). c Calculated as 600 col. 2. d Calculated as r × col. 3, where r is the interest rate. e Calculated as t × col. 1, where t is the cost per switch ($2). f Calculated as col. 4 col. 5