No Such Thing as a Free Lunch: Principles of Economics (Part 126)

Money is our madness, our vast collective madness.

D. H. Lawrence

Money Demand, the Equilibrium Interest Rate, and Monetary Policy

(Part B)

by

Charles Lamson

The Speculation Motive

A number of theories have been offered to explain why the quantity of money households desire to hold may rise when interest rates fall, and fall when interest rates rise. One involves household expectations and the relationship of interest rates to bond values.

To understand this theory, you need to realize that the market value of most interest-bearing bonds is inversely related to the interest rate. Suppose I bought an 8 percent bond a year ago for $1,000. Now suppose the market interest rate rises to 10 percent. If I offered to sell my bond for $1,000, no one would buy it because anyone can buy a new bond and earn 10 percent in the market instead of 8 percent of my bond. However, at some lower selling price, my bond becomes attractive to buyers. This is because a lower price increases the actual yield to the buyer of my bond. Suppose I sell you my bond for $500. Because the bond is paying 8 percent annually on the original $1,000---that is, $80 per year---it is actually paying you an annual amount that comes to 16 percent of your investment in the bond ($500 X .16 = $80). If you bought that same bond from me for about $800, it would effectively pay you 10 percent interest ($800 * 10 = $80). The point here is simple:

When market interest rates fall, bond values rise; when market interest rates rise, bond values fall.

Now consider my desire to hold money balances instead of bonds. If market interest rates are higher than normal, I may expect them to come down in the future. If and when interest rates fall, the bonds that I bought when they were high will increase in value. When interest rates are high, the opportunity cost of holding cash balances is high and there is a speculation motive for holding bonds in lieu of cash. I am "speculating" that interest rates will fall in the future.

Similarly, when market interest rates are lower than normal, I may expect them to rise in the future. Rising interest rates will bring about a decline in the value of bonds. Thus, when interest rates are low, it is a good time to be holding money and not bonds. When interest rates are low, not only is the the opportunity cost of holding cash balances low, but also there is a speculative motive for holding a larger amount of money. Why should I put money into bonds now when I expect interest rates to rise in the future?

The Total Demand for Money

So far we have talked only about household demand for checking account balances. However, 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. 

The trade-off for firms is the same as it was for Jim from last post. Like households, firms must manage their money. They have payrolls to meet and purchases to make; they receive cash and checks from sales; and many firms that deal with the public must make change---they need cash in the cash register. Thus, just like Jim, firms need money to engage in ordinary transactions.

However, firms as well as households can hold their assets in interest earning form. Firms manage their assets just as households do, keeping some in cash, some in their checking accounts, and some in bonds. A higher interest rate rises the opportunity cost of money for firms as well as for households and thus reduces the demand for money.

The same trade-offs hold for cash. We walk around with some money in our pockets, but not thousands of dollars, for routine transactions. We carry, on average, about what we think we will need, not more, because there are costs---risks of being robbed and a foregone interest.

At any given moment, there is a demand for money or 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.

Transactions Volume and the Price Level

The money demand curve in Figure 4 (from last post and reintroduced below) is a function of the interest rate. There are other factors besides the interest rate that influence total desired money holdings. One is the dollar value of transactions made during a given period of time.

Suppose Jim's income were to increase. Instead of making $1,200 in purchases each month, he will now spend more. He just needs to hold more money. The reason is simple: To buy more things, he needs more money.

What is true for Jim is true for the economy as a whole. The total demand for money in the economy depends on the total dollar volume of transactions made. The total dollar volume of transactions in the economy, in turn, depends on two things: the total number of transactions and the average transaction amount. Although there are no data on the actual number of transactions in the economy, a reasonable indicator is likely to be aggregate output (income) (Y). A rise in aggregate output---real gross domestic product (GDP)---means there is more economic activity. Firms are producing and selling more output, more people are on payroll, and household incomes are higher. In short, there are more transactions, and firms and households together will hold more money when they are engaging in more transactions. Thus, an increase in aggregate output (income) will increase the demand for money.

Figure 5 shows a shift of the money demand curve resulting from an increase in Y:

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 change depends on prices, or instead, on the price level. If all prices, including the price of labor (the wage rate) were to double, firms and households would need more money balances to carry out their day-to-day transactions---each transaction would require twice as much money. If the price of your lunch increases from $3.50 to $7.00, you will begin carrying more cash. If your end of the month bills are twice as high as they used to be, you will keep more money in your checking account.

Increases in the price level shift the money demand curve to the right, and decreases in the price level shift the money demand curve to the left. Even though the number of transactions may not have changed the quantity of money needed to engage in them has.

The Determinants of Money Demand: Review

Table 1 summarizes everything we have said about the demand for money. First, because the interest rate (r) is the opportunity cost of holding money balances for both firms and households: increases in the interest rate are likely to decrease the quantity of money demanded; decreases in the interest rate will increase the quantity of money demanded. Thus, the quantity of money demanded is a negative function of the interest rate.

The demand for money also depends on the dollar volume of transactions in a given period. The dollar volume of transactions depends on both aggregate output (income), Y, and the price level, P. The relationship of money demand to Y and the relationship of money demand to P are both positive. Increases in Y or in P will shift the money demand curve to the right; decreases in Y or P will shift the money demand curve to the left.

Some Common Pitfalls We need to consider several pitfalls in thinking about money demand. First, when we spoke in earlier posts about the demand for goods and services, we were speaking of demand as a flow variable---something measured over a period of time. If you say your demand for coffee is three cups, you need to specify whether you are talking about three cups per hour, three cups per day, or three cups per week. In macroeconomics, consumption and saving are flow variables. We consume and save continuously, but we express consumption and saving in time-period terms, such as $600 per month.

Money demand is not a flow measure. Instead, it is a stock variable, measured at a given point in time. It answers the question: How much money do firms and households desire to hold at a specific point in time, given the current interest rate, volume of economic activity, and price level?

Second, many people think of money demand and saving as roughly the same---they are not. Suppose that in a given year a household had income of $50,000 and expenses of $47,000. It saved $3,000 during the year. At the beginning of the year the household had no debt and $100,000 in assets. Because the household saved $3,000 during the year, it has $103,000 in assets at the end of the year. Some of the $103,000 is held in stock, some in bonds, some in other forms of securities, and some in money. How much the household chooses to hold in the form of money is its demand for money. Depending on the interest rate and the household transactions, the amount of the $103,000 that it chooses to hold in the form of money could be anywhere from a few hundred dollars to many thousands. How much of its assets a household retains in the form of money is different from how much of its income it spends during the year.

Finally, recall the difference between a shift in a demand curve and a movement along the curve. The money demand curve in Figure 4 shows optimal money balances as a function of the interest rate ceteris paribus, all else equal. Changes in the interest rate cause movement along the curve---changes in the quantity of money demanded. Changes in Real GDP (Y) or in the price level (P) cause shifts of the curve as shown in Figure 5---changes in demand. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 503-506*

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