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8/13/2019 principles of economics chapter 11
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2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
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Prepared by: Fernando Quijanoand Yvonn Quijano
Money Demand, theEquilibrium Interest Rate, and
Monetary Policy
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8/13/2019 principles of economics chapter 11
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2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
The Demand for Money
The main concern in the study of thedemand for money is:
How much of your financial assets you
want to hold in the form of money, whichdoes not earn interest, versus how muchyou want to hold in interest-bearingsecurities.
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2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
The Transactions Motive
There is a trade-off between the liquidity ofmoney and the interest income offered byother kinds of assets.
The t ransact ions mot iveis the mainreason that people hold moneyto buythings.
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2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
The Transactions Motive
Simplifying assumptions in the study of thedemand for money:
There are only two kinds of assets available tohouseholds: 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.
Spending is exactly equal to income for themonth.
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2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
The Nonsynchronization ofIncome and Spending
The mismatch between thetiming of money inflow andthe timing of money outflowis called thenons ynchron izat ion of
incom e and spend ing.
Income arrives only once a month, butspending takes place continuously.
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2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
Money Management
Jim could decide todeposit his entirepaycheck ($1,200) into hischecking account at the
start of the month and runhis balance down to zeroby the end of the month.
In this case, his average
money holdings would be$600.
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7/21 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
Money Management
Jim could decide todeposit half of hispaycheck ($1,200) into hischecking account, and buy
a $600 bond with the otherhalf. At mid-month, hecould sell the bond anddeposit the $600 into his
checking account. Month over month, his
average money holdingswould be $300.
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8/13/2019 principles of economics chapter 11
8/21 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
The Optimal Balance
There is a level of average money holdingsthat earns Jim the most profit, taking intoaccount both the interest earned on bonds
and the cost paid for switching from bondsto money. This level is his optimal balance.
An increase in the interest rate lowers the
optimal money balance. People want totake advantage of the high return on bonds,so they choose to hold very little money.
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8/13/2019 principles of economics chapter 11
9/21 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
The Speculation Motive
The speculation mo tiveisone reason for holdingbonds instead of money:Because the market value
of interest-bearing bonds isinversely related to theinterest rate, investors maywish to hold bonds when
interest rates are high withthe hope of selling themwhen interest rates fall.
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10/21 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
The Speculation Motive
If someone buys a 10-year bond with a fixedrate of 10%, and a newly issued 10-yearbond 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) andexpected to fall (rise), demand for bonds islikely to be high (low) and money demand islikely to be low (high).
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11/21 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
The Total Demand for Money
The total quantity of money demanded in theeconomy is the sum of the demand forchecking account balances and cash by both
households and firms. The quantity of money demanded at any
moment depends on the opportunity cost of
holding money, a cost determined by theinterest rate. A higher interest rate raises theopportunity cost of holding money and thusreduces the demand for money.
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12/21 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
The Determinants of Money Demand
The total demand for money in theeconomy depends on the total dollarvolume of transactions made.
The total dollar volume of transactions, inturn, depends on the totalnumber oftransactions, and the averagetransaction
amount.
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8/13/2019 principles of economics chapter 11
13/21 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
Transactions Volume andthe Level of Output
When output (income)rises, the totalnumberof transactions rises,
and the demand formoney curve shifts tothe right.
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Transactions Volume andthe Price Level
When the price levelrises, the averagedollar amount of each
transaction rises; thus,the quantity of moneyneeded to engage intransactions rises, and
the demand for moneycurve shifts to the right.
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15/21 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
The Determinants of Money Demand
Money demand is not a flow measure.Rather it is a stock variable, measured at agiven point in time.
Money demand answers the question: How much money do firms and households
desire to hold at a specific point in time, given thecurrent interest rate, volume of economic activity,
and price level? How much of its assets a household holds in
the form of money is different from howmuch of its income it spends during the year.
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16/21 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
The Equilibrium Interest Rate
The point at which thequantity of moneydemanded equals the
quantity of moneysupplied determinesthe equilibrium interestrate in the economy.
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17/21 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
The Equilibrium Interest Rate
At r1, amount of moneyin circulation is higherthan households and
firms want to hold.They will attempt toreduce their moneyholdings by buying
bonds.
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18/21 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
The Equilibrium Interest Rate
At r2, households donthave enough money tofacilitate ordinary
transactions. They willshift assets out ofbonds and into theirchecking accounts.
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2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
Changing the Money Supplyto Affect the Interest Rate
An increase in the supplyof money lowers the rateof interest.
To expand the moneysupply the fed can reducethe reserve requirement,cut the discount rate, orbuy U.S. government
securities in the openmarket.
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2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
Increases in Yand Shifts inthe Money Demand Curve
An increase in aggregateoutput (income) shifts themoney demand curve,which raises the
equilibrium interest ratefrom 7 percent to 14percent.
An increase in the price
level has the same effect.
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2002 Prentice Hall Business Publishing Principles of Economics 6/e Karl Case Ray Fair
The Federal Reserve andMonetary Policy
Tight monetary pol icyrefers to Fedpolicies that contract the moneysupply in an effort to restrain the
economy. Easy monetary pol icyrefers to Fed
policies that expand the moneysupply in an effort to stimulate theeconomy.