Chapter 12

1. Chapter 12 The Demand for Real Money Balances and Market Equilibrium

2. The Demand for Real Money Balances • The interest rate, real income and real money balance • Additional Factors Affecting the Demand for Real Money Balances • Equilibrium in the Market for Real Money Balances

3. Where Is All the Money? • In August 2001, M1 = $1,277.8 billion • $646.2 billion was in currency • Given 107 million households, the average holdings of each household were $11,940 (in terms of M1) and $6,040 (in currency) • A large portion of checkable deposits are held by corporations • Estimates are that more than 50% of U.S. currency is held outside the U.S.

4. The Demand for RealMoney Balances • Wealth may be held in real assets or financial assets (including money) • when relative rates of return change, households adjust their portfolios • money also functions as a means of payment (medium of exchange)

5. The Demand for RealMoney Balances • The demand for money is actually a demand for real money balances • adjusted for changes in purchasing power • A real money balance can be defined as the nominal money supply (M) divided by the overall price level (P) • 实际货币余额：以实际数额表示的货币数量；名义货币供给M除以整体价格水平P。 real money balances = M/P

6. The Demand for RealMoney Balances • Since the demand for money is a demand for real money balances, nominal money demand is proportional to the overall level of prices • if the price level rises by 10%, nominal money demand rises by 10%

7. Households’ Demand for Real Money Balances • There are two motives behind households’ demand to hold real money balances • households need money to consummate transactions (transactions motive) 交易动机：处于交易需要而持有货币的动机。 • households try to hold some real money balances as a precaution against unforeseen developments (precautionary motive) 预防动机：为了防止意外事件发生而持有货币的动机。

8. Transactions Demand Transactions Demand Precautionary Demand Real Money Holdings by a Typical Household Average holdings of real money balances over the month $2,100 – $1,100 – $100 – Time (Months)

9. Households’ Demand for Real Money Balances • Real money balances yield a stream of services to households • benefits of holding real money balances • defined by the time and distress saved by having money on hand for immediate use • monetary (reduced transactions fees such as brokerage fees) • nonmonetary (reduced time and inconvenience) 持有实际货币余额的收益：持有一定数量的货币减少了个人需要使用货币的不便。

10. Households’ Demand for Real Money Balances • The cost of holding real money balancesis the additional foregone interest that holding nonmonetary financial assets would have yielded • even when money pays interest, the interest rate on real money balances is generally lower than what could be earned on less liquid financial assets 持有实际货币余额的成本：放弃持有非货币金融资产所损失的收益。

11. Households’ Demand for Real Money Balances • Ceteris paribus, the interest rate on nonmonetary assets and the quantity demanded of real money are inversely related • Ceteris paribus, the cost of transferring from nonmonetary assets to monetary assets and the quantity demanded of real money are directly related

12. Firms’ Demand for RealMoney Balances • Firms want real balances to consummate transactions • some payments will be regular and expected • other payments may be expected, but their timing may be uncertain • still other payments may be completely unexpected • Thus, firms have both transactions and precautionary motives

13. Firms’ Demand for RealMoney Balances • Firms experience two flows of real money balances • expenditures that generate outflows of funds • receipts that generate inflows of funds • The basic problem is that these flows are not synchronized • Thus, firms must consider the benefits and costs of holding real money balances

14. How Households and Firms Decide What Amount of Real Balances to Hold • Benefits of Holding Real Money Balances • Ability to provide a stream • of services because • money is available when • needed to make • payments, thus avoiding • the need to pay a • brokerage fee to get • money and the • inconvenience of waiting • for money to arrive • Interest earned on • checkable deposits (for • households) • Cost of Holding Real Money Balances • Forgone interest that • nonmonetary • balances would have • earned versus Decision Rule Hold real money balances as long as the benefits are greater than the costs

15. The Interest Rate, Real Income, and Real Money Balances • The opportunity cost of holding currency or checkable deposits is the foregone interest • as the interest rate rises, this opportunity cost increases • thus, at higher interest rates, households and firms will want to substitute into other less liquid assets that yield a higher return

16. The Interest Rate, Real Income, and Real Money Balances • There is an inverse relationship between the interest rate and the quantity demanded of real money balances Qd of real money balances = f(interest rate) • if the interest rate increases, the quantity demanded of real money balances falls • if the interest rate decreases, the quantity demanded of real money balances rises

17. A decline in the interest rate… …leads to an increase in the quantity demanded of real money balances A Demand Curve for RealMoney Balances Interest Rate (Percent) Demand Real Money Balances

18. The Interest Rate, Real Income, and Real Money Balances • The amount of nominal money demanded by a household is directly related to its income • The quantity demanded of real money balances will be directly related to real income • nominal income divided by a price index 实际收入：名义收入除以价格水平。

19. The Interest Rate, Real Income, and Real Money Balances • However, the relationship between household demand for real money balances and real income is not proportional • a doubling of real income will result in a less than proportional increase in the demand for real money balances

20. The Interest Rate, Real Income, and Real Money Balances • As firms expand production and sales, their transactions will also rise • another reason why an increase in real income will translate into an increase in the demand for real money balances

21. A decrease in real income leads to a decrease in demand An increase in real income leads to an increase in demand D' D'' The Demand for RealMoney Balances Interest Rate Demand Real Money Balances

22. Additional Factors Affecting the Demand for Real Money Balances • The demand for real money balances can also be affected by • wealth (as wealth increases, the demand for real money balances increases) • payment technologies • expected inflation • the risk and liquidity of other financial assets

23. Payment Technologies • The widespread availability of ATM machines allows funds to be easily transferred from savings accounts to checking accounts • This reduces the demand for real money balances • The availability of credit cards will have a similar effect on the demand for real money balances

24. Expected Inflation • Inflation reduces the value and purchasing power of money • The larger a household’s money balances, the greater the risk of losses if inflation should occur • Expectations of higher inflation reduce the demand for real money balances

25. Liquidity of Other Financial Assets • If the liquidity of other financial assets increases, they are better substitutes for real money balances • This should reduce the demand for real money balances

26. Risk of Other Financial Assets • If the risk of other financial assets increases, the demand for real money balances should rise

27. Factors that Affect the Demand for Real Money Balances

28. Equilibrium in the Market for Real Money Balances • The Fed exerts a great deal of control over the supply of nominal money • Since real money balances are nominal balances divided by a price index, the Fed must also have a great deal of control over the supply of real money balances • The supply of real money balances will be a vertical line

29. Equilibrium in the Market for Real Money Balances • Equilibrium occurs where the quantity demanded of real money balances is equal to the quantity supplied of real money balances

30. A 6 Equilibrium in the Market for Real Money Balances Interest Rate (Percent) Supply At an interest rate higher than 6%, there would be a surplus of funds At an interest rate lower than 6%, there would be a shortage of funds Demand Real Money Balances

31. Changes in the Supply of Real Money Balances • Open market operations lead to changes in reserves that lead to changes in the nominal money supply • if prices remain constant, then the real supply of money balances will change

32. Changes in the Supply of Real Money Balances • Changes in prices are correlated with past changes in the money supply • the immediate response to an increase in the growth rate is a less than proportional increase in the price level • because price changes lag, the supply of real money balances will be affected by changes in the nominal money supply

33. MS” MS' When the Fed increases reserves, the supply of real money balances increases When the Fed decreases reserves, the supply of real money balances decreases A Change in the Supply ofReal Balances MS Interest Rate (Percent) Real Money Balances

34. An Increase in the Supply of Real Money Balances • Suppose the Fed decides to use open market purchases to increase reserves • the supply of real money balances rises • if the demand for real money balances is unchanged, the interest rate will fall

35. MS' B A Change in the Supply ofReal Balances MS Interest Rate (Percent) A Demand Real Money Balances

36. An Increase in the Supply of Real Money Balances • Suppose the increase in the money supply achieve its desired results • real income increases • firms see increases in sales • This will lead to a rise in the demand for real money balances

37. D’ A Change in the Supply ofReal Balances MS' MS Interest Rate (Percent) The net effect on the interest rate depends on the relative magnitudes of the shifts D Real Money Balances

38. A Change in the Demand for Real Money Balances • The demand for real money balances can change for a variety of reasons • Assuming that the supply of real money balances does not change • an increase in demand will lead to a higher interest rate • a decrease in demand will lead to a lower interest rate

39. An increase in the demand for real money balances will lead to a higher interest rate DD’ Equilibrium in the Market for Real Money Balances Interest Rate (Percent) Supply A D Real Money Balances

40. A Final Note • This chapter develops a theory of interest rate determination based on the supply of and the demand for real money balances • real money balances are measured at a particular point in time (stock measures)

41. A Final Note • Earlier, we developed a theory of interest rate determination based on the supply of and the demand for loanable funds • the supply of and demand for loanable funds are measured through time (flow measures)

42. A Final Note • When there is a change in a stock measure, a flow has occurred • changes in the flow of loanable funds entail changes in the stocks of real money balances as measured at two different points in time