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40 Chapter 11 - Money Demand (MD), the Equilibrium Interest Rate (r) Interest and “the” interest rate (r) – Distinguish between interest and “the” interest rate (r). Interest is the fee that a borrower pays a lender for the use of the latter’s funds. The interest rate (r) is the periodic, viz., annual, interest payment on a loan expressed as a percentage of the loan. We will discuss “the” interest rate even though there is more than one interest rate. All interest rates are related, with the differences between them being due to risk, viz., default risk (risk of non-payment), and maturity (the date on which the loan must be repaid). Inflation will reduce the purchasing power of the principal and interest payments. Money demand (MD)- MD is the amount of their financial wealth that individuals would like to hold as money, not how much money they would like to have (most people would prefer more money as opposed to less money). By definition, all money is held. However, it may be that MD the money supply, i.e., the amount of their financial wealth that individuals actually hold as money (MS) may differ from the amount of their financial wealth that they would like to hold as money (MD). Motives for holding money - 1) Transactions motive - Perhaps the major reason for holding money as opposed to interest-earning assets is that money is the most liquid financial asset, i.e., it is extremely useful for buying things. Money is held to finance transactions because of the non- synchronization of income and spending, i.e., the times at which money is received as income payments do not necessarily coincide with the times at which monetary payments are made. Ceteris paribus, the transactions motive is inversely or negatively related to the interest rate (r), as the interest rate represents the opportunity cost of holding money as financial wealth. The transactions motive is also directly or positively related to the value of transactions. - Transactions MD = f(r) (ceteris paribus, viz., holding the value of transactions constant) (Notice the negative sign above r.) Using calculus, <0 <0 41 2) Precautionary motive - Some money is held as a precaution for emergencies. “Lump” this motive in with the transactions motive. It is not that important currently due to insurance, lines of credit, etc. Thus, precautionary motive is directly related to the value of transactions and inversely related to the interest rate. The inverse (negative) relationship between the market price of a bond and the yield on the bond (the interest rate) - Suppose that I buy a bond with a face, par or maturity value of $2,000 paying 10% simple interest (coupon rate). The annual interest payment is $200 (0.10*2000). Suppose that I sell the bond for $1,500 (at a discount from par). The yield on the bond (the interest rate) rises to 13.3% [ = ( )*100]. Suppose that I sell the bond for $2,500 (at a premium above par). The yield (the interest rate) falls to 8% [ = ( )*100)]. Bond prices change to ensure that yields on similar bonds (bonds having the same default risk) are equivalent. Therefore, bond prices and interest rates are inversely or negatively related. 3) Speculation motive - If actual interest rates > (<) expected interest rates, individuals may expect interest rates to fall (rise). If interest rates fall (rise), bond prices will rise (fall). In the first case (the actual interest rate > the expected interest rate and the actual bond price < the expected bond price), the individual would hold more bonds (less money) in anticipation of rising bond prices, with the possibility of receiving a capital gain by selling bonds. In the second case (the actual interest rate < the expected rate and the actual bond price > the expected bond price), the individual would hold less bonds (more money) in anticipation of falling bond prices. Moving funds out of bonds and into money reduces the possibility of incurring a capital loss. Thus, the speculation MD is inversely related to the interest rate or - Speculation MD = f(r) (Notice the negative sign above r.) Using calculus, <0 42 Total MD - Defined as the sum of HH’s’ and firms’ MD. r MD 0 M Other determinants of MD - Dollar value of transactions = (number of transactions)*(average transactions amount or average dollar amount of each transaction) 1) Number of transactions – A proxy is real income (aggregate output or income). Ceteris paribus, expect a positive or direct relationship between transactions MD and real income. Using calculus, >0 43 The effect on MD of a change in income, ceteris paribus – An increase (decrease) in real income leads to a rightward (leftward) shift in MD. r MD2 (Y=Y2>Y1) &/or (P=P2>P1) MD1 (Y=Y1) &/or (P=P1) 0 2) Average dollar amount of each transaction – A proxy is the average price level. Effect on MD of a change in the average price level – A rise (fall) in average price level leads to a rightward (leftward) shift in MD. Using calculus, >0 44 The equilibrium interest rate - The equilibrium rate is that interest rate at which MD = MS. Remember that, by definition, all money is held. However, the amount of their financial wealth that individuals want to hold as money (MD) may differ from the amount of their financial wealth that they actually hold as money (MS). r MS r1 r r2 MD 0 If r = r1 > equilibrium r, MD < MS. I.e., people are holding more of their financial wealth as money than they would like to hold. They buy bonds, causing bond prices to rise and the interest rate to fall. With a fall in the interest rate, people are more willing to hold money. If r = r2 < equilibrium r, MD > MS. I.e., people are holding less of their financial wealth as money than they would like to hold. They sell bonds, causing bond prices to fall and the interest rate to rise. With a rise in the interest rate, people are less willing to hold money. 45 Fed action to change the interest rate - The Fed can increase (reduce) the interest rate by reducing (increasing) the MS.- With an increase (reduction) in the MS, given no change in the MD, the interest rate falls (rises). r MS1 MS2 r1 r2 MD 0 Appendix A Term structure of interest rates - The term structure of interest rates shows the relationship between interest rates (yields) on comparable (having the same default risk) securities of different maturities. Some “important” interest rates – 1) Treasury or T-bill rate – The interest rates on US government securities that mature in < 1 year 2) Government bond rate – The interest rate on US government bonds with terms of maturity of 1 year or more. 3) Federal funds rate – The interest rates that banks charge each other on loans, i.e., the interbank lending rate The Federal funds rate is the interest rate that the FOMC now “targets.” 4) Commercial paper rate – Large firms borrow directly from the public by selling or issuing commercial paper, viz., short-term corporate IOU’s that offer a designated rate of interest. The interest rate or yield depends on the financial condition of the issuing firm and the maturity date. 46 5) Prime rate – The interest rates that banks charge their most “creditworthy” borrowers 6) AAA corporate bond rate – The interest rate that the “least risky” firms pay on the bonds that they issue