Principles of macroeconomics 10e by case fair oster ch11

The Equilibrium Interest RateSupply and Demand in the Money Market Changing the Money Supply to Affect the Interest Rate Increases in P • Y and Shifts in the Money Demand Curve Zero Inte

The Equilibrium Interest Rate

Supply and Demand in the Money Market Changing the Money Supply to Affect the Interest Rate

Increases in P • Y and Shifts in the Money Demand Curve

Zero Interest Rate Bound

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

Interest Rates and Bond Prices

interest The fee that borrowers pay to lenders for the use of their funds

Firms and governments borrow funds by issuing bonds, and they pay interest to the lenders that purchase the bonds

When interest rates rise, the prices of existing bonds fall

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In Chekhov’s play Uncle

Vanya, Alexander

Vladimirovitch Serebryakov, a

retired professor, but

apparently not of economics,

calls his household together

to propose the following:

…Our estate yields on an

average not more than two

per cent, on its capital value I

propose to sell it If we invest

the money in suitable securities, we should get from four to five per cent, and I

think we might even have a few thousand roubles to spare…

Uncle Vanya tried to kill Professor Serebryakov for this idea, but no one

pointed out that this was bad economics and not a scheme

Perhaps had Uncle Vanya taken an introductory economics course and

known this, he would have been less agitated

Professor Serebryakov Makes an Economic Error

E C O N O M I C S I N P R A C T I C E

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

The Demand for Money

The Transaction Motive

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

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Income arrives only once a month, but spending takes place continuously.

 FIGURE 11.1 The Nonsynchronization of Income and Spending

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 11.2 Jim’s Monthly Checking Account Balances: Strategy 1

The Demand for Money

The Transaction Motive

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Jim receives $1,200 per month (30 days) and spends $40 each day What is his average money balance?

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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 month ’s bills Following this strategy, Jim ’s average money holdings would be

$300

 FIGURE 11.3 Jim’s Monthly Checking Account Balances: Strategy 2

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 11.4 The Demand Curve for Money Balances

The Demand for Money

The Transaction Motive

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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

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.

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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

The Demand for Money

The Speculation Motive

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 money—for 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

The Demand for Money

The Total Demand for Money

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Which of the following is a better measure of the opportunity cost

of holding money balances?

Which of the following is a better measure of the opportunity cost

of holding money balances?

b The interest rate.

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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

doesn’t pay interest is cash

The study found that the demand for

cash responds to changes in the

interest rate paid on checking

accounts The higher the interest rate,

the less cash held

In other words, when the interest rate

on checking accounts rises, people go

to ATM machines more often and take

out less in cash each time, thereby

keeping, on average, more in checking

accounts earning the higher interest

rate

E C O N O M I C S I N P R A C T I C E

ATMs and the Demand for Money

 FIGURE 11.5 An Increase in Nominal Aggregate Output

(Income) (P •Y) Shifts the Money Demand Curve to the Right

The Demand for Money

The Effect of Nominal Income on the Demand for Money

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TABLE 11.1 Determinants of Money Demand

1 The interest rate: r (The quantity of money demanded is a negative

function of the interest rate.)

2 Aggregate nominal output (income) P • Y

a Real aggregate output (income): Y (An increase in Y shifts the

money demand curve to the right.)

b The aggregate price level: P (An increase in P shifts the money

demand curve to the right.)

The Demand for Money

The Effect of Nominal Income on the Demand for Money

The demand for money depends negatively on the interest rate, r, and positively on real income, Y, and the price level, P.

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

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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

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

The Equilibrium Interest Rate

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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 r0 the price of bonds would be bid

up (and thus the interest rate down).

At r1 the price of bonds would be bid

down (and thus the interest rate up)

 FIGURE 11.6 Adjustments in the Money

Market

The Equilibrium Interest Rate

Supply and Demand in the Money Market

When the interest rate is above the equilibrium interest rate:

a People will move out of bonds and into money—hold larger

d There is more money in circulation than households and

firms want to hold

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When the interest rate is above the equilibrium interest rate:

a People will move out of bonds and into money—hold larger

d There is more money in circulation than households and

firms want to hold.

 FIGURE 11.7 The Effect of an Increase in

the Supply of Money on the Interest Rate

An increase in the supply of money

from M S

0 to M S

1 lowers the rate of interest from 7 percent to 4 percent.

The Equilibrium Interest Rate

Changing the Money Supply to Affect the Interest Rate

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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

a Increase the equilibrium interest rate.

b Decrease the equilibrium interest rate.

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 FIGURE 11.8 The Effect of an Increase in

Nominal Income (P • Y) on the Interest Rate

An increase in nominal income (P • Y)

shifts the money demand curve from M d

0

to M d

1 , which raises the equilibrium interest rate from 4 percent to 7 percent.

The Equilibrium Interest Rate

Increases in P • Y and Shifts in the Money Demand Curve

The Equilibrium Interest Rate

Zero Interest Rate Bound

By the middle of 2008 the Fed had driven the short-term interest rate close to zero, and it remained at essentially zero through the middle of

2010

The Fed does this, of course, by increasing the money supply until the intersection of the money supply at the demand for money curve is at

an interest rate of roughly zero

The Fed cannot drive the interest rate lower than zero, preventing it from stimulating the economy further

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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

Looking Ahead: The Federal Reserve and Monetary Policy

changes in the demand for money.

money shifts to the left

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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.

decreases

changes in the demand for money

money shifts to the left

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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 1-1-year rate expected a 1-year from now

Fed behavior may directly affect people’s expectations of the future

short-term rates, which will then affect long-short-term rates

CHAPTER 11 APPENDIX A

The Various Interest Rates in the U.S Economy

The Term Structure of Interest Rates

30-year bonds Bonds of different terms have different interest rates.

Generally a 1-day rate on which the Fed has the most effect through its open market

operations.

interest depending on the financial condition of the firm and the maturity date of the

IOU

customers depending on the cost of funds to the bank; it moves up and down with

changes in the economy.

Bonds have a longer maturity than commercial paper The interest rate on bonds rated

AAA is the triple A corporate bond rate, the rate that the least risky firms pay on the

bonds that they issue.

CHAPTER 11 APPENDIX A

The Various Interest Rates in the U.S Economy

Types of Interest Rates

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TABLE 11B.1 Optimum Money Holdings

1 Number of

2 Average Money

3 Average Bond

4 Interest

5 Cost of

6 Net Profitf

Assumptions: Interest rate r  0.03 Cost of switching from bonds to 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

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) fCalculated as col 4  col 5.

CHAPTER 11 APPENDIX B

The Demand For Money: A Numerical Example