1. Chapter 20: Monetary Policy

2. The Demand for Money Disadvantage of holding money? – Opportunity Cost Motives for holding money? – Keynes gave three…

3. Money Demand Transactions demand for money: money people hold to pay everyday expenses. – “walking around money” Precautionary demand for money: money people hold to pay unpredictable expenses. – “rainy day money” These tend to depend on variables that aren’t in our model.

4. Money Demand Speculative demand for money: money people hold to take advantage of expected changes in non-money financial assets. – Also, think of this as the demand for money as an asset. – If the interest rate increases, should I increase or decrease my speculative demand for money?

5. Money Demand If the interest rate increases, should I increase or decrease my speculative demand for money? Decrease because the opportunity cost has increased – money is “more expensive.” Example: checking account vs. bonds There is an inverse relationship between the demand for money and the interest rate.

6. Downward-sloping due to speculative demand. Equilibrium interest rate.

7. Bond prices and interest rates The interest rate (annual yield) on a bond depends on its market price and its annual interest payment. Example: Suppose a 20-year government bond pays $50 annually and is currently selling for $1000. Then, interest rate = $50/$1000 = 5%

8. Bond prices and interest rates Now, suppose that an decrease in the demand for bonds drops the price of the bond to $500. interest rate = $50/$500 = 10% When the bond price fell, the interest rate rose. There is an inverse relationship between bond prices and interest rates.

12. Interest rates and Investment Demand