Money Demand, Equilibrium Interest Rate and Monetary Policy

 - B.Com (P), Principles of Macro Economics

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 Demand for Money
 It is how much money households and firms want to hold.

 The households have to decide how much of wealth to hold in the form of money and how
much in the form of bonds. We refer money as the currency in circulation and deposits which
pays no interest rate. However, bonds earn a positive interest rate.

 Holding wealth in the form of money is useful as it helps to buy things, i.e., transaction motive,
and it is convenient to hold wealth in the form of money.

 Holding wealth in the form of bonds is useful as it earns positive interest rate.
 Transaction Motive
 It is the main reason to hold money, i.e., to buy things.

 We assume the following –

1. The income for the typical household is “bunched up”, i.e., it arrives once a month and at
the beginning of each month
2. Spending is spread over the month and it occurs at a uniform rate throughout the month. It
means same amount is spend each day.
3. There is mismatch in the timings of earning income and the timings of outflow (spending),
known as Non-Synchronization of Income and Spending (Figure 1).
4. The spending for each month is exactly equal to the income for the that month.
 Transaction Motive

Figure1: Non-Synchronization of Income and Spending

 Money Management
 Using an example, we discuss how much of the income to hold as money and how much as
bonds.
 Say John earns Rupees 1200 per month and decides to deposit his entire earnings in the checking
account.
 At the beginning of each month, John account balance is Rupees 1200. During the month John
uses his balance, and withdraws cash to buy things. At the end of each month, John account
balance is zero. The next month, the same process continues. He earns and spends the entire
amount by the end of the month.
 Average Balance of John: -- As John spends at a constant rate of Rupees 40 per day (40 x 30
days = 1200). His average balance = (Starting balance + ending balance) / 2 = (1200 + 0)/2 =
600
 During the first half of the month, John has more than his average balance of Rupees 600 in his
checking account. For the second half of the month, John balance is less than average balance.
Money Management
 Possible strategies
 Is the current strategy good for John? : The answer is “No”. This is because John loses his
interest on his funds. As if John would have kept his wealth in the form of bonds, he could have
earned positive interest rate.
 The following strategies could be adopted by John –
• John could deposit half wealth in checking account and half wealth in the bonds. Say
John puts Rs. 600 in bonds and Rs. 600 in money (useful for 15 days of spending – with
average spending of Rs. 40 per day x 15 days = Rs. 600). After 15 days, John sells his bonds
and uses Rs. 600 for spending of rest of the month (figure 2)
Therefore, John average balance = Rs. 300
• John deposits Rs. 400 in checking account and buy two bonds of Rs. 400 each. The Rs.
400 last for 10 days and then after 10 days he sells one bond of Rs. 400 which last for another
10 days. After 20 days he sells his last bond.
Therefore, John average balance = Rs. 200
• Extreme case: keep all money in form of Bonds and nothing in the form of money.
Possible strategies

Figure 2: Strategy -- Rs. 600 in Bond and Rs. 600 in Money

 Possible strategies
 Tradeoff involved in holding wealth in the form of money and bonds

 Holding all wealth in the form of Bonds

• Earns positive interest
• Inconvenience and costly as each time individuals needs to visit/calls bank.
• Brokerage fees to sell bonds and time consuming (time spend at ATM/Bank)

 Holding all wealth in the form of Money

• Loose interest
• Convenient for daily transactions
• Lower management costs
 Optimal Balance
 The optimal balance of bonds and money which gives maximum profits, taking into account the
interest earned on bonds and costs paid for switching from bonds to money.
 The number of switches depends on the interest rate.
 The increase in interest rate means lower optimal money balance. Example
• If interest rate = 2% then keep more wealth in the form of the money and less in the form of
bonds
• If interest rate = 30% then keep most of the funds in the form of bonds and less in the form of
money.
 The interest rate is the opportunity costs of holding of money and not holding bonds.
 The higher interest rate, the higher is the opportunity costs of holding of money and therefore,
less people want to hold money. They want to hold more bonds due to high return.
Demand for Money
 Md = Y L(i)

 Increase in income implies higher

level of demand for money

 Increase in interest rate leads to

decrease in demand for money as
bonds are more attractive. Thus,
downward sloping demand curve

Figure 3: Demand for Money (for given income)

 Speculative Motive
 The household expectations and relationship of interest rates to bond values is useful to explain
why the quantity of money households desire to hold may rise when interest rate falls.

Interest Rate and Bond Value –

 If individual bought 8% bond a year ago for Rs. 1000. Suppose market interest rate rises to 10%.
 If individual sells that bond for Rs. 1000, no one will buy as the interest rate is 10% now. Instead
if I sell at lower price say Rs. 500, it is attractive to buyers.
 As Rs1000 bond at 8% pays Rs. 80 per year. If someone buys for Rs. 500, the return becomes
16%, i.e., 500 x 0.16 = Rs 80 per year
 Therefore, with increase in interest rate (8% to 10%) the bond values falls (Rs. 1000 to Rs.
500)
 Fall in interest rate leads to increase in bond value
 Speculative Motive
Household expectations

 If market interest rate is higher than normal :

• Individual expects interest rate to fall in future, and therefore expects bond value to rise
• Speculative motive of holding bonds, i.e., sell them in future when bond prices falls.

 If market interest rate is higher than normal :

• Individual expects interest rate to rise in future, and therefore expects bond value to fall
• Speculative motive of holding money instead of bonds