## :+:CHAPTER 6 Money demand, The equilibrium interest rate and Monetary policy

posted on 15 Feb 2011 16:17 by marry-dodo

CHAPTER 6

Money demand, The equilibrium interest rate and Monetary policy

What is “the Demand for Money?”

How much money would you like to have? A billion or two? Of course, that is not what we mean by your demand for money! What we do mean by your demand for money is this: how much of your wealth do you wish to keep in the form of money, that is, currency and bank deposits? For example, suppose that the Joneses have \$50,000 in financial assets which they divide between investment in bonds and holding money. How are they going to decide how much of their \$50,000 to invest in bonds and how much to hold in the form of money, including currency and the balance in their checking account? An investment in bonds pays interest, but currency pays none and the Joneses receive no interest from their bank on their checking account.

Clearly, the opportunity cost of holding money is the rate of interest. If the Joneses keep \$1,000, on average, in currency and in their checking account during the year and bonds yield 10%, then it costs the Joneses \$100 in foregone interest to hold that \$1,000. Why, then, should the Joneses hold any money at all instead of putting all of their wealth into bonds and other assets that will earn a return? For that matter, why does anyone hold any money?

Economists have identified three primary motives for holding money:

• To settle transactions, since money is the medium of exchange.

• As a precautionary store of liquidity, in the event of unexpected need.

• To reduce the riskiness of a portfolio of assets by including some money in the portfolio, since the value of money is very stable compared with that of stocks, bonds, or real estate.

These three motives for holding money are often referred to as the transactions motive, the precautionary motive, and the portfolio motive respectively. Together they provide good reasons for the Joneses to hold some money in their portfolio in spite of the opportunity cost of foregone interest.

Now suppose, hypothetically, that with the interest rate at 20% the Joneses choose to hold \$1,000 of their \$50,000 in the form of money. What will they do if the interest rate now drops to 5%? With the opportunity cost of holding money reduced, they will very likely choose to increase their money holdings by reducing their bond holdings. After all, it now costs the Jones only 5 cents per year to hold an extra dollar instead of 20 cents, while adding to their holdings of money will give them more of the services that holding money provides. The more currency in your wallet the less frequently you need to stand in line at a cash machine or teller's window. The larger your checking account balance the more readily you can meet unexpected payments, such as buying that suit that is on sale even though your credit card is up to its limit. The larger your cash position, the less worrisome is a fall in the stock market.

As a result of the interest rate falling from 20% to 5% the Joneses might well decide to increase their money holdings, say from \$1,000 to \$1,500. They would accomplish that increase in their money holdings by selling bonds worth \$500 and keeping the money they would be paid. The amount of money demanded by the Joneses would change if their income increased. They would demand more money (at a given level of interest rates) primarily because their transactions and precautionary demands would increase at their new higher level of spending. An increase in their wealth would increase their portfolio demand for money. Even a change of jobs could affect their demand for money. Someone who travels a great deal in a sales position will have a greater precautionary demand for money than someone who stays in town.

We see, then, that a households' demand for money depends on the interest rate, their income, and wealth, among perhaps many other variables. Firms are also holders of money, in their cash registers and bank accounts, for essentially the same basic reasons as households. When we add up the demand for money by all households and firms we have the total demand for money in the economy and that demand will be most importantly a function of the interest rate, income, and wealth in the economy.

The demand for any good or service is usually pictured in economics as a function of its price, holding income and other factors constant. In the case of holding money, the "price" is the opportunity cost of holding one dollar for one year, the interest rate. When we plot the quantity of money demanded on the horizontal axis and the interest rate on the vertical axis, just as we would the quantity of oranges demanded and the price of oranges, we will have a demand curve like the one pictured in Figure 7.1.

Note that the quantity of money demanded is higher when the interest rate is lower, just as the quantity of oranges demanded is higher when the price of oranges is lower. As this hypothetical demand for money has been drawn, the demand for money is \$600 billion when the interest rate is 5%, but only \$150 billion when it is 20%. This inverse relationship between the interest rate and the demand for money just reflects the fact that when the opportunity cost of holding money is low, people will want to hold more of it, and when it is high people will want to hold less of it.

Notice, too, that at very low levels of the interest rate in Figure 7.1, the quantity of money demanded increases dramatically, meaning that people would then want to hold a very great amount of their wealth in the form of money. And why not hold money instead of bonds when the reward to holding bonds is very, very small? After all, money is more liquid than bonds, and bonds are subject to the risk of price fluctuation that we discussed in Chapter 3.

In contrast, even when the interest rate is very, very high, people will still want to hold some money. Even if it costs 30 cents per year to hold a dollar, we will still hold some dollars because it is even more costly to revert to barter in making transactions. How will the demand for money change when the income and wealth increases? Imagine that over the next decade the economy grows in real terms by 3% per year while inflation averages 4%, so nominal income roughly doubles (Remember how to compute doubling time?). Clearly the quantity of money demanded will rise. Sales at the supermarket will have doubled, reflecting both the greater quantity of goods and higher prices, so the transactions demand for money must roughly double.

Further, it is likely that rising wealth will also contribute to higher demand for money holdings through the portfolio motive. Indeed, it seems likely that wealth would also roughly double in nominal terms over a decade in which nominal income had doubled. Overall, the quantity of money demanded at any given interest rate will be much higher a decade later under our assumptions, probably about twice its level a decade earlier. We depict this change in the demand for money by shifting the demand curve to the right. In Figure 7.2, the doubling of nominal incomes and wealth doubles the demand for money at any given interest rate. For example, at an interest rate of 5%, the quantity of money demanded is \$1,200 billion at the end of the decade, while it was only \$600 billion at the beginning of the decade ago when nominal income and wealth were half as great.

Overall, the quantity of money demanded at any given interest rate will be much higher a decade later under our assumptions, probably about twice its level a decade earlier. We depict this change in the demand for money by shifting the demand curve to the right. In Figure 7.2, the doubling of nominal incomes and wealth doubles the demand for money at any given interest rate. For example, at an interest rate of 5%, the quantity of money demanded is \$1,200 billion at the end of the decade, while it was only \$600 billion at the beginning of the decade ago when nominal income and wealth were half as great.

Demand for Money Wrap Up

The demand for money is not at all constant. There are quite a few factors which influence the demand for money.

Factors Which Increase the Demand for Money

1. A reduction in the interest rate.
2. A rise in the demand for consumer spending.
3. A rise in uncertainty about the future and future opportunities.
4. A rise in transaction costs to buy and sell stocks and bonds.
5. A rise in inflation causes a rise in the nominal money demand but real money demand stays constant.
6. A rise in the demand for a country's goods abroad.
7. A rise in the demand for domestic investment by foreigners.
8. A rise in the belief of the future value of the currency.
9. A rise in the demand for a currency by central banks (both domestic and foreign).

# Effects of Expansionary Monetary Policy on Interest Rates

Expansionary monetary policy refers to any policy initiative by a country's central bank to raise, or expand, its money supply. This can be accomplished with open market purchases of government bonds, with a decrease in the reserve requirement or with an announced decrease in the discount rate. In most growing economies the money supply is expanded regularly to keep up with the expansion of GDP. In this dynamic context, expansionary monetary policy can mean an increase in the rate of growth of the money supply, rather than a mere increase in money. However, the money market model is a non-dynamic (or static) model, so we cannot easily incorporate money supply growth rates. Nonetheless, we can project the results from this static model to the dynamic world without much loss of relevance. (In contrast, any decrease in the money supply, or decrease in the growth rate of the money supply, is referred to as contractionary monetary policy.)

Suppose the money market is originally in equilibrium in the adjoining diagram at point A with real money supply MS'/P\$ and interest rate i\$' when the money supply increases, ceteris paribus. The ceteris paribus assumption means that we assume all other exogenous variables in the model remain fixed at their original levels. In this exercise it means that real GDP (Y\$) and the price level (P\$) remain fixed. An increase in the money supply (MS) causes an increase in the real money supply (MS/P\$) since P\$ remains constant. In the diagram this is shown as a rightward shift from MS'/P\$ to MS"/P\$ . At the original interest rate, real money supply has risen to level 2 along the horizontal axis while real money demand remains at level 1. This means that money supply exceeds money demand and the actual interest rate is higher than the equilibrium rate. Adjustment to the lower interest rate will follow the "interest rate too high" equilibrium story.

The final equilibrium will occur at point B on the diagram. The real money supply will have risen from level 1 to 2 while the equilibrium interest rate has fallen from i\$' to i\$". Thus, expansionary monetary policy (i.e., an increase in the money supply) will cause a decrease in average interest rates in an economy. In contrast, contractionary monetary policy (a decrease in the money supply) will cause an increase in average interest rates in an economy.

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