So far…Money supply

Now…Money demand

Equilibrium

Interest rate is determined

Future…interaction with real sector

• Road map of past, current and future classes

• Useful definitions- Monetary policy

- Interest and interest rate (r)

• Money demand- Transaction motive (Md is inversely related with r)

- Speculation motive (Md is inversely related with r)

- Transactions volume and price level (Md is positively related with Y and P)

• Equilibrium in the money market (equilibrium r)

- Effect of an increase in Ms

Useful definitions

• Monetary policy

-The behavior of the Central Bank concerning the money supply.

• Interest and interest rate

- Interest: The fee that borrowers pay to lenders for the use of their funds.

- Interest rate: The annual interest payment on a loan expressed as a percentage of the loan.

- Unit of account: a consistent way of quoting prices

Example: 100

loan theofamount

yearper receivedinterest rateInterest

Demand for Money

• We are concerned with how much of the financial assets people want to hold in the form of money, which does not earn interest, versus how much they want to hold in interest-bearing securities, such as bonds.

- Transaction Motive

The main reason that people hold money - to buy things.

- Assumptions:

- 2 kinds of assets: bonds and money.

- Household’s income arrives at the beginning of the month.

- Spending occurs at a completely uniform rate - the same amount is spent each day.

- Spending is exactly equal to income for the month.

- Nonsynchronization of income and spending (next figure).

- Instructive example:

Suppose Jim earns $1200 per month.

Strategy 1: Deposit entire paycheck ($1200) into checking account at the start of the month.

Main benefit: He does not spend time at the bank or with bond brokers!Main cost: He does not earn interest!

= (1200-0)/2 = 600

Strategy 2: Deposit one-half of his paycheck into his checking account and buy a bond with the other half at the start of the month. At midmonth, Jim would sell the bond and deposit the $600 into his checking account.

Main benefit compared with strategy 1: He does earn some interest!Main cost compared with strategy 1: He does spend some time at the bank

and/or with bond brokers!

= (600-0)/2 = 300

- The optimal average money balance considers the followingtrade-off:

- Having low level of money balances increases interest

(this effect is stronger the higher are interest rates).

- Having low level of money balances increases the time spent at the bank and/or with bond brokers.

Therefore…

- Speculation motive

One reason for holding bonds instead of money: Because the market value of bonds is inversely related to the interest rate, investors may wish to hold bonds (and not money) when interest rates are high with the hope of selling them when interest rates fall.

- Example: If someone buys a 10-year bond with a fixed rate of 10%, and anewly issued 10-year bond pays 12%, then the old bond paying10% will have fallen in value.

- This effect reinforce the transaction motive effect because:

When interest rates are high (low) and expected to fall (rise),demand for bonds is likely to be high (low) thus money demand is likely to be low (high).

- Transactions volume and price level

Another reason to hold money is related with dollar value of transactions made during a given period of time.

Total volume of trans. = number of trans. (Y) * average trans. amount (P)

Equilibrium in the money market (equilibrium interest rate)

- Effect of increase in money supply

- Terminology:

Tight monetary policy: Central Bank policies that contract Ms

Easy monetary policy: Central Bank policies that expand Ms