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MacroLecture8
Money demand, the equilibrium
interest rate, and monetary policy
Lecture Highlights
The demand for money
Supply and demand in the money
market
Changing the money supply to affect
the interest rate
Increases in real GDP and shifts in
the money demand curve
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MacroLecture8
Money demand, the equilibrium
interest rate, and monetary policy
To understand central banks short-run
influence on the interest rate, we must
understand what determines the
demand for money, the supply of
money, and the forces that bring
equilibrium in the money market.
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The demand for money
The amount of money that households
and firms choose to hold is the
quantity of money demanded.
What determines the quantity of money
demanded?
It depends on a benefit-opportunity cost
calculation.
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Benefit of holding money
Money is the means of payment and that it
serves as a medium of exchange, unit of
account, and store of value.
You dont need any money to use it as a unit
of account. You dont need any money to
store your wealth you can store it in the
form of bonds, stocks.
The more money you hold, the easier it is for
you to make payment and transactions.
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Opportunity cost of holding
money
The opportunity cost of holding money
is the interest foregone on an
alternative assets.
e.g. If you can earn 8% a year, then
holding an additional $100 in money
costs you $8 a year.
Your opportunity cost of holding $100 in
money is the goods and services
worth $8 that you must forgo.
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Three motives for holding
money
Transaction demand for money
Individuals hold money for use in
transactions. The amount of money held for
transactions would vary positively with the
volume of transactions.
Income is a good measure of this volume of
transactions the transaction demand for
money is assumed to depend positively on
the level of income.
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Contd.
Precautionary demand for money
Apart from money held for planned
transactions, additional money
balances were held in case of
unexpected expenditures such as
medical or repair bills.
The amount held for this purpose
depends positively on income.
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Contd.
Speculative demand for money
Because of the uncertainty about future
interest rates and the relationship between
changes in the interest rate and the price of
bonds additional demand for money will
exist.
The opportunity cost of holding money is
the interest rate foregone on an alternative
assets (e.g. bonds)
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Contd.
If you can earn 8% a year on a mutual fund
account. Holding an additional $100 in
money costs you $8 a year.
Your opportunity cost of holding $100 in
money is the goods and services worth $8
that you must forego.
The opportunity cost of holding money =
nominal interest rate
nominal interest rate = real interest rate +
inflation rate
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The demand for money
curve
The demand for money (Md) is the
relationship between the quantity of
money demanded and the nominal
interest rate, when all other influences
on the amount of money that people
wish to hold remain the same.
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Contd.
Md
Qty of money
Nominal
interest
rate (i)
A rise in
the interest
rate
A fall in the
interest rate
When the interest rate
rises (other factors
remaining the same),
the opportunity cost
of holding money
rises qty. of money
demanded decreases.
When the interest rate
falls (other factors
remaining the same),
the opportunity cost
of holding money ,
qty of money
demanded
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Changes in the Md
A change in any other influence on
money holding changes Md.
3 main influences on Md
(i) The price level
(ii) Real GDP (income)
(iii) Financial technology
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Contd.
(i) The price level
Md is proportional to the price level. This is because we
hold money to make payments.
If P Md curve shifts rightward
If P Md curve shifts leftward

(ii) Real GDP
Md increases as real GDP increases. Expenditures and
incomes increase when real GDP increases.
If Y Md curve shifts rightward
If Y Md curve shifts leftward
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Contd.
(iii) Financial technology
Changes in financial technology change Md.
Daily interest checking deposits and automatic transfers
between checking and saving deposits enable people
to earn interest on money
Lower the opportunity cost of holding money
Increase Md
Automatic Teller Machine (ATM), debit cards
Have made money easier to obtain and use.
Have increased Md (i.e. Md curve shifts to the right)
Credit cards have made it easier for people to buy goods
and services on credit
This has decreased Md (Md curve shifts leftward)
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Money market equilibrium
The quantity of money supplied (Ms) is
determined by the actions of the
banking system and the central bank.
The supply of money the relationship
between the quantity of money
supplied and the nominal interest.
Equilibrium in the money market occurs
when Md = Ms.
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Contd.
Ms
Md
Nominal
interest rate
ie
i
1
i
2
Excess Ms. People
buy bonds & the
interest rate
Excess Md.
People sell
bonds & the
interest rate
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Changing the interest rate

Mso
Md
Nominal
interest rate
io
i
1
i
2
Ms1
Ms2
Qty of money
To change the interest
rate, CB changes the
qty of money.
CB qty of money, Ms
curve shifts right from
Mso to Ms
1
, interest
rate from io to i
1
.
CB qty of money, Ms
curve shifts left from
Mso to Ms
2
, interest
rate from io to i
2
.