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PART
III
The
Core
of
Macroeconomic
Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
CASE  FAIR  OSTER
PRINCIPLES OF
ECONOMICS
ELEVENTH EDITION
PEARSON
Prepared by: Fernando Quijano w/Shelly Tefft

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CHAPTER OUTLINE
26
Money Demand and
the Equilibrium
Interest Rate
Interest Rates and Bond Prices
The Demand for Money
The Transaction Motive
The Speculation Motive
The Total Demand for Money
The Effect of Nominal Income 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 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

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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.
Bonds are issued with a face value, typically in denominations of $1,000. They
come with a maturity date—or the date when the face value of the bond is paid
out, and they offer a fixed yearly payment, known as a coupon.
A key relationship that we will use in this chapter is that market-determined
prices of existing bonds and interest rates are inversely related.
Given a bond’s market-determined price, its face value, its maturity, and its
coupon, the interest rate, or yield, on that bond can be calculated. Interest rates
are thus indirectly determined by the bond market.

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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…
If an investor in Russia can earn 5 percent on these securities, why 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.
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
THINKING PRACTICALLY
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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transaction motive The main reason that people hold money—to buy things.
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 26.1 The Nonsynchronization of Income and Spending
The Transaction Motive

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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 26.2 Jim’s Monthly Checking Account Balances: Strategy 1

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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 26.3 Jim’s Monthly Checking Account Balances: Strategy 2
There is a level of average money balances that earns Jim the most profit, taking into
account both the interest earned on bonds and the costs paid for switching from bonds to
money. This level is his optimal balance.

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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 26.4 The Demand Curve for Money Balances

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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 Speculation Motive

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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 Total Demand for Money

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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
THINKING PRACTICALLY
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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 FIGURE 26.5 An Increase in Nominal Aggregate Output
(Income) (P •Y) Shifts the Money Demand Curve to the Right
The Effect of Nominal Income on the Demand for Money

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TABLE 26.1 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 depends negatively on the interest rate, r, and
positively on real income, Y, and the price level, P.

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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 26.6 Adjustments in the
Money Market
Supply and Demand in the Money Market

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 FIGURE 26.7 The Effect of an
Increase in the Supply of Money on
the Interest Rate
An increase in the supply of
money from MS
0 to MS
1 lowers the
rate of interest from 7 percent to 4
percent.
Changing the Money Supply to Affect the Interest Rate

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 FIGURE 26.8 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
Md
0 to Md
1, which raises the
equilibrium interest rate from 4
percent to 7 percent.
Increases in P • Y and Shifts in the Money Demand Curve

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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 time of this writing (March
2013).
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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Looking Ahead
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.
We have not yet discussed, however, why the Fed might want to change the
interest rate. We have also not considered the determination of the aggregate
price level. We discuss both of these issues in the next chapter. It is the key
chapter regarding the core of macro theory.

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easy monetary policy
interest
nonsynchronization of income and spending
speculation motive
tight monetary policy
transaction motive
R E V I E W T E R M S A N D C O N C E P T S

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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-year rate expected a year from now.
Fed behavior may directly affect people’s expectations of the future short-term
rates, which will then affect long-term rates.
CHAPTER 26 APPENDIX A
The Various Interest Rates in the U.S. Economy
The Term Structure of Interest Rates

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Three-Month Treasury Bill Rate Probably the most widely followed short-term
interest rate.
Government Bond Rate There are 1-year bonds, 2-year bonds, and so on, up to 30-
year bonds. Bonds of different terms have different interest rates.
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
operations.
Commercial Paper Rate Short-term corporate IOUs that offer a designated rate of
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
customers depending on the cost of funds to the bank; it moves up and down with
changes in the 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.
The Various Interest Rates in the U.S. Economy
Types of Interest Rates

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TABLE 26B.1 Optimum Money Holdings
1
Number of
Switchesa
2
Average Money
Holdingsb
3
Average Bond
Holdingsc
4
Interest
Earnedd
5
Cost of
Switchinge
6
Net
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.
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.
The Demand For Money: A Numerical Example
CHAPTER 26 APPENDIX B