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Interest Rates and Bond Prices

Money Demand and
the Equilibrium 26 interest The fee that borrowers pay to lenders for the use of their funds.
Interest Rate
CHAPTER OUTLINE Firms and governments borrow funds by issuing bonds, and they pay interest
Interest Rates and Bond Prices tto th
the llenders
d th
thatt purchase
h th
the b
bonds.
d
The Demand for Money
The Transaction Motive
The Speculation Motive
Bonds are issued with a face value, typically in denominations of $1,000. They
The Total Demand for Money come with a maturity date—or the date when the face value of the bond is paid
The Effect of Nominal Income on the Demand for Money out, and they offer a fixed yearly payment, known as a coupon.
The Equilibrium Interest Rate
Supply and Demand in the Money Market
Changing the Money Supply to Affect the Interest Rate A key relationship that we will use in this chapter is that market-determined
Increases in P • Y and Shifts in the Money Demand Curve
Z
Zero Interest
I t t Rate
R t Bound
B d
p
prices of existing
g bonds and interest rates are inversely y related.
Looking Ahead: The Federal Reserve and Monetary
Policy Given a bond’s market-determined price, its face value, its maturity, and its
Appendix A: The Various Interest Rates in the U.S. coupon, the interest rate, or yield, on that bond can be calculated. Interest rates
Economy are thus indirectly determined by the bond market.
Appendix B: The Demand for Money: A Numerical
Example

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EC O N O M I C S IN PRACTI C E The Demand for Money

Professor Serebryakov Makes an Economic Error

In Chekhov’s play Uncle Vanya, Alexander When we speak of the demand for money, we are concerned with how much of
Vladimirovitch Serebryakov, a retired your financial assets you want to hold in the form of money, which does not
professor, but apparently not of economics, earn interest, versus how much you want to hold in interest-bearing securities
calls his household together to propose the such as bonds
bonds.
following:
…Our estate yields on an average not more
than two per cent, on its capital value. I propose The Transaction Motive
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… transaction motive The main reason that people hold money—to buy things.

If an investor in Russia can earn 5 p

percent on these securities,, whyy would he or she
buy an estate earning only 2 percent? The price of the estate would have to fall until the
return to the investor was 5 percent. nonsynchronization of income and spending The mismatch between the
timing of money inflow to the household and the timing of money outflow for
THINKING PRACTICALLY household expenses.
1. What would happen to the value of the estate if the interest rate on the securities that
Professor Serebryakov is talking about fell?

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The Transaction Motive

c FIGURE 26.2 Jim’s Monthly Checking Account Balances: Strategy 1

c FIGURE 26.1 The Nonsynchronization of Income and Spending
Income arrives only once a month, but spending takes place
continuously.
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.

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d FIGURE 26.3 Jim’s Monthly Checking Account Balances: Strategy 2

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.

c FIGURE 26.4 The Demand Curve for Money Balances

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,
There is a level of average money balances that earns Jim the most profit, taking into increases in the interest rate reduce the quantity of money that firms and households
account both the interest earned on bonds and the costs paid for switching from bonds to want to hold and decreases in the interest rate increase the quantity of money that
money. This level is his optimal balance. firms and households want to hold.
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The Speculation Motive The Total Demand for Money

The total quantity of money demanded in the economy is the sum of the
demand for checking g account balances and cash byy both households and
firms.

speculation motive One reason for holding bonds instead of money: Because At any given moment, there is a demand for money—for cash and checking
the market price of interest-bearing bonds is inversely related to the interest account balances. Although households and firms need to hold balances for
rate, investors may want to hold bonds when interest rates are high with the everyday transactions, their demand has a limit.
hope of selling them when interest rates fall.
For both households and firms, the quantity of money demanded at any
moment depends on the opportunity cost of holding money, a cost determined
b th
by the iinterest
t t rate.
t

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EC O N O M I C S IN PRACTI C E The Effect of Nominal Income on the Demand for Money

ATMs and the Demand for Money

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 p
pay
y 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.

c FIGURE 26.5 An Increase in Nominal Aggregate Output

THINKING PRACTICALLY (Income) (P •Y) Shifts the Money Demand Curve to the Right
1. Suppose most or all ATM machines increased the fee they charged per transaction.
What would this do to the transaction demand for money?

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The Equilibrium Interest Rate

The demand for money depends negatively on the interest rate, r, and
positively on real income, Y, and the price level, P.
We are now in a position to consider one of the key questions in
macroeconomics: How is the interest rate determined in the economy?
TABLE 26.1 Determinants of Money Demand
1 The interest rate: r (The quantity of money demanded is a negative
1.
function of the interest rate.)
The point at which the quantity of money demanded equals the quantity of
2. Aggregate nominal output (income) P • Y
money supplied determines the equilibrium interest rate in the economy.
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.)

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

f FIGURE 26.6 Adjustments in the

Money Market f FIGURE 26.7 The Effect of an
Increase in the Supply of Money on
Equilibrium exists in the money th Interest
the I t t Rate
R t
market when the supply of money An increase in the supply of
is equal to the demand for money money from MS0 to MS1 lowers the
and thus when the supply of rate of interest from 7 percent to 4
bonds is equal to the demand for percent.
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).

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Increases in P • Y and Shifts in the Money Demand Curve Zero Interest Rate Bound

f FIGURE 26.8 The Effect of an Increase By the middle of 2008 the Fed had driven the short-term interest rate close to
in Nominal Income (P • Y) on the Interest
R t
Rate
zero, and it remained at essentially zero through the time of this writing (March
2013).
An increase in nominal income (P • Y)
shifts the money demand curve from
Md0 to Md1, which raises the The Fed does this, of course, by increasing the money supply until the
equilibrium interest rate from 4 intersection of the money supply at the demand for money curve is at an
percent to 7 percent. interest rate of roughly zero.

The Fed cannot drive the interest rate lower than zero, preventing it from
stimulating
ti l ti th the economy ffurther.
th

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Looking Ahead REVIEW TERMS AND CONCEPTS

One of the main aims of this chapter and the last one has been to explain how
the Fed can change the interest rate and the money supply through open
market operations.
easy monetary policy

We have not yet discussed,

discussed however
however, why the Fed might want to change the
interest rate. We have also not considered the determination of the aggregate interest
price level. We discuss both of these issues in the next chapter. It is the key
chapter regarding the core of macro theory. nonsynchronization of income and spending

speculation motive

tight monetary policy

transaction motive

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CHAPTER 11 APPENDIX A The Various Interest Rates in the U.S. Economy

The Various Interest Rates in the U.S. Economy Types of Interest Rates

Three-Month Treasury Bill Rate Probably the most widely followed short-term
The Term Structure of Interest Rates
interest rate.
The term structure of interest rates is the relationship among the interest rates Government Bond Rate There are 1-year bonds, 2-year bonds, and so on, up to 30-
year bonds
bonds. Bonds of different terms have different interest rates
rates.
offered
ff d on securities
i i off diff
different maturities.
ii
Federal Funds Rate The rate banks are charged to borrow reserves from other banks.
Generally a 1-day rate on which the Fed has the most effect through its open market
According to a theory called the expectations theory of the term structure of operations.
interest rates, the 2-year rate is equal to the average of the current 1-year rate Commercial Paper Rate Short-term corporate IOUs that offer a designated rate of
and the 1-year rate expected a year from now. interest depending on the financial condition of the firm and the maturity date of the
IOU.
Prime Rate A benchmark that banks often use in quoting interest rates to their
Fed behavior may directly affect people’s expectations of the future short-term customers depending on the cost of funds to the bank; it moves up and down with
rates, which
hi h will
ill then
h affect
ff llong-term rates. changes in the economy
economy.
AAA Corporate Bond Rate Classified by various bond dealers according to their risk.
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.

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CHAPTER 11 APPENDIX B
The Demand For Money: A Numerical Example
TABLE 11B.1 Optimum Money Holdings
1 2 3 4 5 6
Number of Average Money Average Bond Interest Cost of Net
Switchesa g b
Holdings g c
Holdings Earnedd ge
Switching 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 to money equals $2 per transaction.
r = 3 percent
0 $600 00
$600.00 $ 0
0.00
00 $ 0
0.00
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
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 = 0.03. 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.
dCalculated as r × col. 3, where r is the interest rate.eCalculated as t × col. 1, where t is the cost per switch ($2).fCalculated as col. 4 − col. 5.

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