1. Chapter 19 The Demand for Real Money Balances and Market Equilibrium ©2000 South-Western College Publishing

2. 2 Real Money Balances The quantity of money expressed in real terms The nominal money supply, M, divided by overall price level, P, or M/P

3. 3 Transaction Motive A motive for holding money based on the need to make payments

4. 4 Precautionary Motive A motive for holding money based on a precaution against unforeseen developments

5. 5 Real Money Holdings by a Typical Household $100 $1,100 $2,100 Transactions Demand Precautionary Demand Average holdings of real money balances over the month Exhibit 19 - 1 Time

6. 6 Benefits of Holding Real Money Balances The stream of services that real balances yield defined as time and distress saved by having money on hand for immediate use

7. 7 How Households and Firms Decide What Amount of Real Balances to Hold The benefits of holding real money balances are: To fulfill a stream of services related to having money available when needed, including not having to pay a brokerage fee to get money and not having to wait to get money To be able to make payments when due Exhibit 19 - 2

8. 8 Costs of Holding Real Money Balances The additional foregone interest that holding nonmonetary financial assets would have yielded

9. 9 How Households and Firms Decide What Amount of Real Balances to Hold The costs of holding real money balances are: The foregone interest that the nonmonetary balances of households and firms would have earned Decision Rule: Hold real money balances as long as the benefits are greater than the costs Exhibit 19 - 2 cont.

10. 10 A Demand Curve for Real Money Balances Demand Real Money Balances Interest Rate (percent) Exhibit 19 - 3

11. 11 Liquidity Preference A theory of the demand for money developed by John Maynard Keynes that results in an inverse relationship between the quantity of money demanded and the interest rate

12. 12 Speculative Demand for Money The theory that individuals will demand to hold: money when interest rates are low (bond prices high) to avoid capital losses when interest rates rise, and bonds when interest rates are high (bond prices low) to capture capital gains when interest rates fall

13. 13 Liquidity Trap When interest rates are very low (bond prices very high), the demand for money becomes perfectly horizontal and the economy is in a liquidity trap; the Fed is unable to lower interest rates by increasing the supply of money

14. 14 A Demand Curve for Real Money Balances Liquidity trap Real Money Balances Interest Rate (percent) MS

15. 15 What is real income? Nominal income divided by a price index

16. 16 A Demand Curve for Real Money Balances D' Real Money Balances Interest Rate Exhibit 19 - 4 D D'' Decrease in Demand Increase in Demand

17. 17 Factors That Affect the Demand for Real Money Balances An increase in … Will cause the demand for money to... Income Increase Wealth Increase Payment Technologies Decrease Expected Inflation Decrease Risk of other Financial Assets Increase Liquidity of Other Financial Assets Decrease Exhibit 19 - 5

18. 18 Factors That Affect the Demand for Real Money Balances A decrease in … Will cause the demand for money to... Income Decrease Wealth Decrease Payment Technologies Increase Expected Inflation Increase Risk of other Financial Assets Decrease Liquidity of Other Financial Assets Increase Exhibit 19 - 5 cont.

19. 19 Market Equilibrium in the Market for Real Money Balances Demand Real Money Balances Interest Rate (percent) Exhibit 19 -6 Money Supply 6 A

20. 20 Market Equilibrium in the Market for Real Money Balances Real Money Balances Interest Rate (percent) Exhibit 19 - 7 MS MS' Increase Decrease

21. 21 Increases in the Supply of Real Balances Real Money Balances Interest Rate (percent) Exhibit 19 -8 MS MS' Demand A B

22. 22 Expansionary Open Market Operations May Eventually Lead to Increases in Demand Real Money Balances Interest Rate (percent) Exhibit 19 - 9 MS MS' D A B C D'

23. 23 Other Changes Can Also Shift the Demand for Real Balances Curve Real Money Balances Interest Rate (percent) Exhibit 19 - 10 MS D D'

24. 24 Monetarism The school of thought that emphasizes the importance of changes in the nominal money supply as a cause of fluctuations in prices, employment, and output

25. 25 Equation of Exchange M  V = GDP = P  Y

26. 26 Velocity The number of times the money supply turns over during a year to mediate all the purchases of goods and services comprising GDP

27. 27 Quantity Theory of Money The theory that velocity is stable or fixed and that changes in the money supply lead to proportional changes in GDP

28. 28 Average Daily Holding of Funds A household’s demand for real money balances during the month The amount of each withdrawal divided by two

29. 29 Income = $2,000 / month Price level = 1 0 Calls to Broker $1,000 $2,000 Number of Broker Calls per Month and the Average Holdings of Real Balances (Transactions Demand for Real Balances) Exhibit 19 - 11 30 Days Average Daily Holdings of Funds

30. 30 Income = $2,000 / month Price level = 1 1 Calls to Broker $500 $2,000 Number of Broker Calls per Month and the Average Holdings of Real Balances (Transactions Demand for Real Balances) Exhibit 19 - 11 cont. 30 Days Average Daily Holdings of Funds $1,000

31. 31 Income = $2,000 / month Price level = 1 2 Calls to Broker $333.33 $2,000 Number of Broker Calls per Month and the Average Holdings of Real Balances (Transactions Demand for Real Balances) Exhibit 19 -11 cont. 30 Days Average Daily Holdings of Funds $666.67

32. 32 Benefits and Costs of Additional Calls to the Broker (A) = Transactions demand for money if call not made (B) = Transactions demand for money if call made Benefit = Interest on Additional bonds held Call (A) (B) (A) - (B) Benefit 0 $1,000 ------ ------ 1 1,000 $500 $500 $2.50 2 500 333 167.83 3 333 250 83.43 4 250 200 50.25 Exhibit 19 - 14

33. 33 Benefits and Costs of Calls to Broker if the Interest Rate Increases to 1 % Per Month (A) = Transactions demand for money if call not made (B) = Transactions demand for money if call made Benefit = Interest on Additional bonds held Call (A) (B) (A) - (B) Benefit 0 $1,000 ------ ------ 1 1,000 $500 $500 $5.00 2 500 333 167 1.67 3 333 250 83.83 4 250 200 50.50 Exhibit 19 - 15