Chapter 12

The Demand for Real Money Balances and Market Equilibrium

2

The Demand for Real Money Balances The interest rate, real income and real mone

y balance Additional Factors Affecting the Demand for

Real Money Balances Equilibrium in the Market for Real Money Ba

lances

3

Where Is All the Money?

In August 2001, M1 = $1,277.8 billion$646.2 billion was in currencyGiven 107 million households, the average

holdings of each household were $11,940 (in terms of M1) and $6,040 (in currency)

A large portion of checkable deposits are held by corporations

Estimates are that more than 50% of U.S. currency is held outside the U.S.

4

The Demand for RealMoney Balances

Wealth may be held in real assets or financial assets (including money)when relative rates of return change,

households adjust their portfoliosmoney also functions as a means of payment

(medium of exchange)

5

The Demand for RealMoney Balances

The demand for money is actually a demand for real money balancesadjusted for changes in purchasing power

A real money balance can be defined as the nominal money supply (M) divided by the overall price level (P)

实际货币余额：以实际数额表示的货币数量；名义货币供给 M 除以整体价格水平 P 。

real money balances = M/P

6

The Demand for RealMoney Balances

Since the demand for money is a demand for real money balances, nominal money demand is proportional to the overall level of pricesif the price level rises by 10%, nominal money

demand rises by 10%

7

Households’ Demand for Real Money Balances

There are two motives behind households’ demand to hold real money balanceshouseholds need money to consummate

transactions (transactions motive) 交易动机：处于交易需要而持有货币的动机。households try to hold some real money

balances as a precaution against unforeseen developments (precautionary motive)

预防动机：为了防止意外事件发生而持有货币的动机。

8

Real Money Holdings by a Typical Household

Average holdings of real money balances over the month

Time (Months)

$2,100 –

$1,100 –

$100 – Precautionary Demand

Transactions Demand

Transactions Demand

9

Households’ Demand for Real Money Balances

Real money balances yield a stream of services to householdsbenefits of holding real money balancesdefined by the time and distress saved by

having money on hand for immediate usemonetary (reduced transactions fees such as

brokerage fees)nonmonetary (reduced time and inconvenience)持有实际货币余额的收益：持有一定数量的货币减少了

个人需要使用货币的不便。

10

Households’ Demand for Real Money Balances

The cost of holding real money balances is the additional foregone interest that holding nonmonetary financial assets would have yieldedeven when money pays interest, the interest

rate on real money balances is generally lower than what could be earned on less liquid financial assets

持有实际货币余额的成本：放弃持有非货币金融资产所损失的收益。

11

Households’ Demand for Real Money Balances

Ceteris paribus, the interest rate on nonmonetary assets and the quantity demanded of real money are inversely related

Ceteris paribus, the cost of transferring from nonmonetary assets to monetary assets and the quantity demanded of real money are directly related

12

Firms’ Demand for RealMoney Balances

Firms want real balances to consummate transactionssome payments will be regular and expectedother payments may be expected, but their

timing may be uncertainstill other payments may be completely

unexpected

Thus, firms have both transactions and precautionary motives

13

Firms’ Demand for RealMoney Balances

Firms experience two flows of real money balancesexpenditures that generate outflows of fundsreceipts that generate inflows of funds

The basic problem is that these flows are not synchronized

Thus, firms must consider the benefits and costs of holding real money balances

14

How Households and Firms Decide What Amount of Real Balances to Hold

Benefits of Holding Real Money Balances

• Ability to provide a stream of services because money is available when needed to make payments, thus avoiding the need to pay a brokerage fee to get money and the inconvenience of waiting for money to arrive

• Interest earned on checkable deposits (for households)

Cost of Holding Real Money Balances

• Forgone interest that nonmonetary balances would have earned

Decision Rule

Hold real money balances as long as the benefits are greater than the costs

versus

15

The Interest Rate, Real Income, and Real Money Balances

The opportunity cost of holding currency or checkable deposits is the foregone interestas the interest rate rises, this opportunity cost

increasesthus, at higher interest rates, households and

firms will want to substitute into other less liquid assets that yield a higher return

16

The Interest Rate, Real Income, and Real Money Balances

There is an inverse relationship between the interest rate and the quantity demanded of real money balances

Qd of real money balances = f (interest rate)

if the interest rate increases, the quantity demanded of real money balances falls

if the interest rate decreases, the quantity demanded of real money balances rises

17

A Demand Curve for RealMoney Balances

Interest Rate (Percent)

Real Money Balances

Demand

A decline in the interest rate…

…leads to an increase in the quantity demanded of real money balances

18

The Interest Rate, Real Income, and Real Money Balances

The amount of nominal money demanded by a household is directly related to its income

The quantity demanded of real money balances will be directly related to real incomenominal income divided by a price index

实际收入：名义收入除以价格水平。

19

The Interest Rate, Real Income, and Real Money Balances

However, the relationship between household demand for real money balances and real income is not proportionala doubling of real income will result in a less

than proportional increase in the demand for real money balances

20

The Interest Rate, Real Income, and Real Money Balances

As firms expand production and sales, their transactions will also riseanother reason why an increase in real income

will translate into an increase in the demand for real money balances

21

The Demand for RealMoney Balances

Interest Rate

Real Money Balances

Demand

An increase in real income leads to an increase in demand

D'

D''

A decrease in real income leads to a decrease in demand

22

Additional Factors Affecting the Demand for Real Money Balances

The demand for real money balances can also be affected bywealth (as wealth increases, the demand for

real money balances increases)payment technologiesexpected inflationthe risk and liquidity of other financial assets

23

Payment Technologies

The widespread availability of ATM machines allows funds to be easily transferred from savings accounts to checking accounts

This reduces the demand for real money balances

The availability of credit cards will have a similar effect on the demand for real money balances

24

Expected Inflation

Inflation reduces the value and purchasing power of money

The larger a household’s money balances, the greater the risk of losses if inflation should occur

Expectations of higher inflation reduce the demand for real money balances

25

Liquidity of Other Financial Assets

If the liquidity of other financial assets increases, they are better substitutes for real money balances

This should reduce the demand for real money balances

26

Risk of Other Financial Assets

If the risk of other financial assets increases, the demand for real money balances should rise

27

Factors that Affect the Demand for Real Money Balances

28

Equilibrium in the Market for Real Money Balances

The Fed exerts a great deal of control over the supply of nominal money

Since real money balances are nominal balances divided by a price index, the Fed must also have a great deal of control over the supply of real money balances

The supply of real money balances will be a vertical line

29

Equilibrium in the Market for Real Money Balances

Equilibrium occurs where the quantity demanded of real money balances is equal to the quantity supplied of real money balances

30

Equilibrium in the Market for Real Money Balances

Interest Rate (Percent)

Real Money Balances

Demand

SupplyAt an interest rate higher than 6%, there would be a surplus of funds

At an interest rate lower than 6%, there would be a shortage of funds

6 A

31

Changes in the Supply of Real Money Balances

Open market operations lead to changes in reserves that lead to changes in the nominal money supplyif prices remain constant, then the real supply of

money balances will change

32

Changes in the Supply of Real Money Balances

Changes in prices are correlated with past changes in the money supplythe immediate response to an increase in the

growth rate is a less than proportional increase in the price level

because price changes lag, the supply of real money balances will be affected by changes in the nominal money supply

33

A Change in the Supply ofReal Balances

Interest Rate (Percent)

Real Money Balances

MS MS'

When the Fed increases reserves, the supply of real money balances increases

MS”

When the Fed decreases reserves, the supply of real money balances decreases

34

An Increase in the Supply of Real Money Balances

Suppose the Fed decides to use open market purchases to increase reservesthe supply of real money balances risesif the demand for real money balances is

unchanged, the interest rate will fall

35

A Change in the Supply ofReal Balances

Interest Rate (Percent)

Real Money Balances

MS MS'

Demand

A

B

36

An Increase in the Supply of Real Money Balances

Suppose the increase in the money supply achieve its desired resultsreal income increasesfirms see increases in sales

This will lead to a rise in the demand for real money balances

37

A Change in the Supply ofReal Balances

Interest Rate (Percent)

Real Money Balances

MS MS'

D

D’

The net effect on the interest rate depends on the relative magnitudes of the shifts

38

A Change in the Demand for Real Money Balances

The demand for real money balances can change for a variety of reasons

Assuming that the supply of real money balances does not changean increase in demand will lead to a higher

interest ratea decrease in demand will lead to a lower

interest rate

39

Equilibrium in the Market for Real Money Balances

Interest Rate (Percent)

Real Money Balances

D

Supply

A

An increase in the demand for real money balances will lead to a higher interest rate

DD’

40

A Final Note

This chapter develops a theory of interest rate determination based on the supply of and the demand for real money balancesreal money balances are measured at a

particular point in time (stock measures)

41

A Final Note

Earlier, we developed a theory of interest rate determination based on the supply of and the demand for loanable fundsthe supply of and demand for loanable funds

are measured through time (flow measures)

42

A Final Note

When there is a change in a stock measure, a flow has occurredchanges in the flow of loanable funds entail

changes in the stocks of real money balances as measured at two different points in time