CHAPTER 11

Money Demand,
the Equilibrium Interest
Rate, and Monetary Policy
Appendix A and Appendix B

Prepared by: Fernando Quijano

and Yvonn Quijano

2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair
 Monetary Policy and Interest
C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and

Monetary policy is the behavior of the

Federal Reserve concerning the money
supply.
Interest is the fee that borrowers pay to
lenders for the use of their funds.
Interest rate is the annual interest
payment on a loan expressed as a
percentage of the loan.
Monetary Policy

interest received per year

Interest rate x100
amount of the loan

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 The Demand for Money
C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and

The main concern in the study of the

demand for money is:
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.
Monetary Policy

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 The Transaction Motive
C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and

There is a trade-off between the

liquidity of money and the interest
income offered by other kinds of
assets.

The transaction motive is the main

reason that people hold moneyto
buy things.
Monetary Policy

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 The Transaction Motive
C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and

Simplifying assumptions in the study of the

demand for money:
There are only two kinds of assets available
to households: bonds and money.
The typical households income arrives
once a month, at the beginning of the
month.
Spending occurs at a completely uniform
ratethe same amount is spent each day.
Monetary Policy

Spending is exactly equal to income for the

month.

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 The Nonsynchronization
of Income and Spending
C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and

The mismatch between

the timing of money
inflow to the household
and the timing of money
outflow for household
expenses is called the
nonsynchronization of
income and spending.
Income arrives only once a month, but
Monetary Policy

spending takes place continuously.

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 Money Management
C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and

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 money holdings

Monetary Policy

would be $600.

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 Money Management
C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and

Jim could decide to

deposit half of his
paycheck ($1,200) into
his checking account,
and buy a $600 bond
with the other half. At
mid-month, he could
sell the bond and
deposit the $600 into
his checking account.
Monetary Policy

Month over month, his average money

holdings would be $300.
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 The Optimal Balance
C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and

There is a level of average money holdings

that earns Jim the most profit, taking into
account both the interest earned on bonds
and the cost paid for switching from bonds
to money. This level is his optimal balance.
An increase in the interest rate lowers the
optimal money balance. People want to take
advantage of the high return on bonds, so they
choose to hold very little money.
Monetary Policy

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 The Speculation Motive
C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and

The speculation motive:

Because the market value
of interest-bearing bonds is
inversely related to the
interest rate, investors may
wish to hold bonds when
interest rates are high with
the hope of selling them
when interest rates fall.
Monetary Policy

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 The Speculation Motive
C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and

If someone buys a 10-year bond with a

fixed rate of 10%, and a newly issued 10-
year bond pays 12%, then the old bond
paying 10% will have fallen in value.

Higher bond prices mean that the interest a

buyer is willing to accept is lower than
before.

When interest rates are high (low) and

Monetary Policy

expected to fall (rise), demand for bonds is

likely to be high (low) thus money demand
is likely to be low (high).
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 The Total Demand for Money
C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and

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.
Monetary Policy

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 The Total Demand for Money
C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and

The quantity of money demanded at

any moment depends on the
opportunity cost of holding money, a
cost determined by the interest rate.
A higher interest rate raises the
opportunity cost of holding money and
thus reduces the quantity of money
demanded.
Monetary Policy

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 Transactions Volume
and the Price Level
C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and

The total demand for money in the

economy depends on the total dollar
volume of transactions made.

The total dollar volume of

transactions, in turn, depends on the
total number of transactions, and the
average transaction amount.
Monetary Policy

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 Transactions Volume
and the Price Level
C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and

When output
(income) rises, the
total number of
transactions rises,
and the demand for
money curve shifts
to the right.
Monetary Policy

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 Transactions Volume
and the Price Level
C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and

When the price level rises, the

average dollar amount of each
transaction rises; thus, the quantity
of money needed to engage in
transactions rises, and the demand
for money curve shifts to the right.
Monetary Policy

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 The Determinants of
Money Demand: Review
C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and

Determinants of Money Demand

1. The interest rate: r (negative effect)
2. The dollar volume of transactions (positive effect)
a. Aggregate output (income): Y (positive effect)
b. The price level: P (positive effect)

Money demand is a stock variable,

measured at a given point in time.
Monetary Policy

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 The Determinants of
Money Demand: Review
C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and

Money demand answers the

question:
How much money do firms and
households desire to hold at a specific
point in time, given the current interest
rate, volume of economic activity, and
price level?
Monetary Policy

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 The Equilibrium Interest Rate
C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and

The point at which

the quantity of
money demanded
equals the quantity
of money supplied
determines the
equilibrium interest
rate in the economy.
Monetary Policy

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 The Equilibrium Interest Rate
C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and

At r1, the amount of

money in circulation is
higher than
households and firms
wish to hold. They
will attempt to reduce
their money holdings
by buying bonds.
Monetary Policy

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 The Equilibrium Interest Rate
C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and

At r2, households
dont have enough
money to facilitate
ordinary transactions.
They will shift assets
out of bonds and into
their checking
accounts.
Monetary Policy

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 Changing the Money
Supply to Affect the Interest Rate
C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and

An increase in the
supply of money
lowers the rate of
interest.
Monetary Policy

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 Increases in Y and Shifts
in the Money Demand Curve
C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and

An increase in
aggregate output
(income) shifts the
money demand curve,
which raises the
equilibrium interest rate.

An increase in the price

level has the same
effect.
Monetary Policy

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 Looking Ahead: The Federal
Reserve and Monetary Policy
C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and

Tight monetary policy refers to Fed

policies that contract the money
supply in an effort to restrain the
economy.

Easy monetary policy refers to Fed

policies that expand the money
supply in an effort to stimulate the
economy.
Monetary Policy

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 Review Terms and Concepts
C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and

easy monetary policy

interest
interest rate
monetary policy
nonsynchronization of income
and spending
speculation motive
tight monetary policy
transaction motive
Monetary Policy

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 Appendix A: The Various
Interest Rates in the U.S. Economy
C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and

The Term Structure of Interest Rates:

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 future short-
Monetary Policy

term interest rates are reflected in

current long-term interest rates.

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 Appendix A: The Various
Interest Rates in the U.S. Economy
C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and

Types of Interest Rates:

Three-Month Treasury Bill Rate

Government Bond Rate

Federal Funds Rate
Commercial Paper Rate
Prime Rate
Monetary Policy

AAA Corporate Bond Rate

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 Appendix B: The Demand for
Money: A Numerical Example
C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and

The optimal average level of money

holdings is the amount that
maximizes the profits from money
management.

The cost per switch multiplied by the

number of switches must be
subtracted from interest revenue to
obtain the net profit from money
Monetary Policy

management.

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 Appendix B: The Demand for
Money: A Numerical Example
C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and

1 2 3 4 5 6
NUMBER OF AVERAGE MONEY AVERAGE BOND INTEREST COST OF NET
SWITCHESa HOLDINGSb HOLDINGSc EARNEDd SWITCHINGe PROFITf
r = 5 percent
0 $600.00 $ 0.00 $ 0.00 $0.00 $ 0.00
1 300.00 300.00 15.00 2.00 13.00
2 200.00 400.00 20.00 4.00 16.00
3 150.00* 450.00 22.50 6.00 16.50
4 120.00 480.00 24.00 8.00 16.00
Assumptions: Interest rate r = 0.05. Cost of switching from bonds into money equals $2 per transaction.
r = 3 percent
0 $600.00 $ 0.00 $ 0.00 $0.00 $ 0.00
1 300.00 300.00 9.00 2.00 7.00
2 200.00* 400.00 12.00 4.00 8.00
Monetary Policy

3 150.00 450.00 13.50 6.00 7.50

4 120.00 480.00 14.40 8.00 6.40
Assumptions: Interest rate r = 0.05. Cost of switching from bonds into money equals $2 per transaction.
*Optimum money holdings. aThat is, the number of times you sell a bond. bCalculated as 600/(col.1+ 1). cCalculated as 600 col.2.
dCalculated as r x col.3, where r is the interest rate. eCalculated as t x col.1, where t is the cost per switch ($2). fCalculated as col.4 col.5.

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