1. Money Demand and Interest Rates

2. Money Demand and Interest Rates interest The reward 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. When interest rates rise, the prices of existing bonds fall.

3. The Demand for Money 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 Transaction Motive transaction motive The main reason that people hold money—to buy things. nonsynchronization of income and spending motive The mismatch between the timing of money inflow to the household and the timing of money outflow for household expenses.

4. The Demand for Money The Transaction Motive The Nonsynchronization of Income and Spending Income arrives only once a month, but spending takes place continuously

5. The Demand for Money The Transaction Motive Jim’s Monthly Account Balances Jim could decide to deposit his entire paycheck (£1,200) into his 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. £

6. The Demand for Money The Transaction Motive The Demand Curve for Money Balances 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.

7. The Demand for Money The Speculative Motive speculative 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.

8. The Demand for Money The Total Demand for Money 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.

9. The Demand for Money The Effect of Nominal Income on the Demand for Money An Increase in Nominal Aggregate Output (Income) (P •Y) Shifts the Money Demand Curve to the Right

10. The Demand for Money The Effect of Nominal Income on the Demand for Money The demand for money depends negatively on the interest rate, r, and positively on real income, Y, and the price level, P. 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 x 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.)

11. The Equilibrium Interest Rate Supply and Demand in the Money Market Adjustments in the Money Market 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).

12. The Equilibrium Interest Rate Changing the Money Supply to Affect the Interest Rate The Effect of an Increase in the Supply of Money on the Interest Rate An increase in the supply of money from MS0 to MS1 lowers the rate of interest from 7 percent to 4 percent.

13. The Equilibrium Interest Rate Increases in P x Y and Shifts in the Money Demand Curve 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 Md0 to Md1, which raises the equilibrium interest rate from 4 percent to 7 percent.

14. The Equilibrium Interest Rate Zero Interest Rate Bound By the middle of 2008 the Bank had driven the short-term interest rate close to zero, and it remained at essentially zero until 2015. The Bank does this 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 Bank cannot drive the interest rate lower than zero, preventing it from stimulating the economy further.

15. Looking Ahead: The Bank and Monetary Policy Zero Interest Rate Bound tight monetary policy Bank of England policies that contract the money supply and thus raise interest rates in an effort to restrain the economy. easy monetary policy Bank policies that expand the money supply and thus lower interest rates in an effort to stimulate the economy.

16. Key terms • monetary policy easing • Interest rate • nonsynchronization of income and spending • speculative motive • tight monetary policy • transaction motive (or transactions demand for money)

17. The Various Interest Rates in the UK Economy The Term Structure of Interest Rates 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. Bank behaviour may directly affect people’s expectations of the future short-term rates, which will then affect long-term rates. Different interest rates can be noted in the financial press.

18. The Various Interest Rates in the UK Economy Types of Interest Rates 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. Interbank Rate The rate banks are charged to borrow reserves from other banks. Generally a 1-day rate on which the Bank 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. Base 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 and is fixed by the Monetary Policy Committee. 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.