11 Macroeconomics

CHAPTER 11 Money Demand and the Equilibrium Interest Rate
PowerPoint Lectures for

Principles of
Macroeconomics, 9e
; ; By
Karl E. Case,
Ray C. Fair &
Sharon M. Oster
© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 1 of 23
PART III THE CORE OF MACROECONOMIC THEORY
Money Demand
and
11
the Equilibrium
Interest Rate
Prepared by:
Fernando & Yvonn Quijano
© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster
PART III THE CORE OF MACROECONOMIC THEORY
Money Demand
and
11
the Equilibrium
Interest Rate CHAPTER

OUTLINE
Interest Rates and Bond Prices
The Demand for Money
The Transaction Motive
The Speculation Motive
The Total Demand for Money
The Effects of Income and the Price
Level on the Demand for Money
The Equilibrium Interest Rate
Supply and Demand in the Money Market
Changing the Money Supply to Affect the
Interest Rate
Increases in Y and Shifts in the Money
Demand Curve
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.
Professor Serebryakov
Makes an Economic
Error
Uncle Vanya
by Anton Chekhov
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.
transaction motive The main reason that people

hold money—to buy things.
 FIGURE 11.1 The Nonsynchronization of Income and Spending
Income arrives only once a month, but spending takes place continuously.
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.
 FIGURE 11.2 Jim’s Monthly Checking Account Balances: Strategy 1
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 11.3 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.
 FIGURE 11.4 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, 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.
The Speculation Motive
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 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.
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 pay interest is cash.
In other words, in Italy there is an
interest cost to carrying cash instead
of depositing the cash in a checking
account.
Orazio Attansio, Luigi Guiso, and Tullio Jappelli, “The Demand for Money, Financial
Innovation and the Welfare Costs of Inflation: An Analysis with Household Data,” Journal
of Political Economy, April 2002.
The Effects of Income and the Price Level on the Demand for Money
 FIGURE 11.5 An Increase in Aggregate Output (Income) (Y) Will Shift the Money Demand Curve
to the Right
An increase in Y means that there is more economic activity. Firms are producing and selling more, and
households are earning more income and buying more. There are more transactions, for which money is
needed. As a result, both firms and households are likely to increase their holdings of money balances at a
given interest rate.
The Effects of Income and the Price Level on the Demand for Money
The amount of money needed by firms and

households to facilitate their day-to-day

transactions also depends on the average dollar
amount of each transaction. In turn, the average
amount of each transaction depends on prices, or
instead, on the price level.
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. The dollar volume of transactions
a. Aggregate output (income): Y (An increase in Y shifts the money demand curve to
the right.)
b. The price level: P (An increase in P shifts the money demand curve to the right.)
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.
Supply and Demand in the Money Market
 FIGURE 11.6 Adjustments

in the Money Market
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), and at r1 the price of bonds
would be bid down (and thus the
interest rate up).
Changing the Money Supply to Affect the Interest Rate
 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 to lowers the rate of
interest from 7 percent to 4
percent.
Increases in Y and Shifts in the Money Demand Curve
 FIGURE 11.8 The Effect of

an Increase in Income on the
Interest Rate
An increase in aggregate output

(income) shifts the money demand
curve from to , which raises
the equilibrium interest rate from 4
percent to 7 percent.
Looking Ahead: The Federal Reserve and Monetary Policy
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.
REVIEW TERMS AND CONCEPTS
easy monetary policy

interest
nonsynchronization of income
and spending
speculation motive
tight monetary policy
transaction motive
APPENDIX A
THE VARIOUS INTEREST RATES IN THE U.S. ECONOMY
THE TERM STRUCTURE OF INTEREST RATES
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-year rate expected a year from
now.
People’s expectations of higher future short-term

interest rates are likely to increase. These
expectations will then be reflected in current long-
term interest rates.
APPENDIX A
THE VARIOUS INTEREST RATES IN THE U.S. ECONOMY
TYPES OF INTEREST RATES
Three-Month Treasury Bill Rate
Government Bond Rate
Federal Funds Rate
Commercial Paper Rate
Prime Rate
AAA Corporate Bond Rate
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
Switches a
Holdings b
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 to 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
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.
d
Calculated 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

11 Macroeconomics

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11 Macroeconomics

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CHAPTER 11 Money Demand and the Equilibrium Interest Rate

PowerPoint Lectures for

Interest Rate CHAPTER

Interest The fee that borrowers pay to lenders for

the use of their funds.

When we speak of the demand for money, we are

you want to hold in the form of money, which does

The Transaction Motive

transaction motive The main reason that people

 FIGURE 11.1 The Nonsynchronization of Income and Spending

nonsynchronization of income and spending

 FIGURE 11.2 Jim’s Monthly Checking Account Balances: Strategy 1

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

 FIGURE 11.4 The Demand Curve for Money Balances

speculation motive One reason for holding

The total quantity of money demanded in the

At any given moment, there is a demand for

ATMs and the Demand

The amount of money needed by firms and

households to facilitate their day-to-day

TABLE 11.1 Determinants of Money Demand

We are now in a position to consider one of the

key questions in macroeconomics: How is the

The point at which the quantity of money

 FIGURE 11.6 Adjustments

 FIGURE 11.7 The Effect of

An increase in the supply of money

 FIGURE 11.8 The Effect of

An increase in aggregate output

tight monetary policy Fed policies that contract

easy monetary policy Fed policies that expand

easy monetary policy

The term structure of interest rates is the

According to a theory called the expectations

People’s expectations of higher future short-term

Three-Month Treasury Bill Rate

Government Bond Rate

Federal Funds Rate

Commercial Paper Rate

AAA Corporate Bond Rate

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