Remember that M1, the most commonly used definition of the money supply, consists of currency in circulation (cash), plus checkable bank deposits, plus traveler’s checks. M2, a broader definition of the money supply, consists of M1 plus deposits that can easily be transferred into checkable deposits. You also learned why people hold money—to make it easier to purchase goods and services. Now we’ll go deeper, examining what determines how much money individuals and firms want to hold at any given time.

Most economic decisions involve trade-offs at the margin. That is, individuals decide how much of a good to consume by determining whether the benefit they’d gain from consuming a bit more of that good is worth the cost. The same decision process is used when deciding how much money to hold.

Individuals and firms find it useful to hold some of their assets in the form of money because of the convenience money provides: money can be used to make purchases directly, while other assets can’t. But there is a price to be paid—an opportunity cost—for that convenience: money held in your wallet earns no interest.

As an example of how convenience makes it worth incurring some opportunity costs, consider the fact that even today—with the prevalence of credit cards, debit cards, and ATMs—people continue to keep cash in their wallets rather than leave the funds in an interest-bearing account. They do this because they don’t want to have to go to an ATM to withdraw money every time they want to make a small purchase. In other words, the convenience of keeping some cash in your wallet is more valuable than the interest you would earn by keeping that money in the bank.

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Even holding money in a checking account involves a trade-off between convenience and interest payments. That’s because you can earn a higher interest rate by putting your money in assets other than a checking account. For example, many banks offer certificates of deposit, or CDs, which pay a higher interest rate than ordinary bank accounts. But CDs also carry a penalty if you withdraw the funds before a certain amount of time—say, six months—has elapsed. An individual who keeps funds in a checking account is forgoing the higher interest rate those funds would have earned if placed in a CD in return for the convenience of having cash readily available when needed.

Table 28.1 illustrates the opportunity cost of holding money in a specific month. Because interest rates are currently at abnormally low levels, we refer back to June 2007. The first row shows the interest rate on one-month certificates of deposit—that is, the interest rate individuals could get if they were willing to tie their funds up for one month. In June 2007, one-month CDs yielded 5.30%. The second row shows the interest rate on interest-bearing bank accounts (specifically, those included in M1). Funds in these accounts were more accessible than those in CDs, but the price of that convenience was a much lower interest rate, only 2.30%. Finally, the last row shows the interest rate on currency—cash in your wallet—which, of course, was zero.

Table 28.1 shows the opportunity cost of holding money at one point in time, but the opportunity cost of holding money changes when the overall level of interest rates changes. Specifically, when the overall level of interest rates falls, the opportunity cost of holding money falls, too.

Table 28.2 illustrates this point by showing how selected interest rates changed between June 2007 and June 2008, a period when the Federal Reserve was slashing rates in an effort to fight off recession. Between June 2007 and June 2008, the federal funds rate, which is the rate the Fed controls most directly, fell by 3.25 percentage points. The interest rate on one-month CDs fell almost as much, 2.8 percentage points. That’s not an accident: all short-term interest rates—rates on financial assets that come due, or mature, within a year—tend to move together, with rare exceptions. The reason short-term interest rates tend to move together is that CDs and other short-term assets (like one-month and three-month U.S. Treasury bills) are in effect competing for the same business. Any short-term asset that offers a lower-than-average interest rate will be sold by investors, who will move their wealth into a higher-yielding short-term asset. The selling of the asset, in turn, forces its interest rate up because investors must be rewarded with a higher rate in order to induce them to buy it. Conversely, investors will move their wealth into any short-term financial asset that offers an above-average interest rate. The purchase of the asset drives its interest rate down when sellers find they can lower the rate of return on the asset and still find willing buyers. So interest rates on short-term financial assets tend to be roughly the same because no asset will consistently offer a higher-than-average or a lower-than-average interest rate.

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But as short-term interest rates fell between June 2007 and June 2008, the interest rates on money didn’t fall by the same amount. The interest rate on currency, of course, remained at zero. The interest rate paid on demand deposits did fall, but by much less than short-term interest rates. As a result, the opportunity cost of holding money fell. The last two rows of Table 28.2 show the differences between the interest rates on demand deposits and currency and the interest rate on CDs. These differences declined sharply between June 2007 and June 2008. This reflects a general result: the higher the short-term interest rate, the higher the opportunity cost of holding money; the lower the short-term interest rate, the lower the opportunity cost of holding money.

Table 28.2 contains only short-term interest rates. At any given moment, long-term interest rates—interest rates on financial assets that mature, or come due, a number of years in the future—may be different from short-term interest rates. The difference between short-term and long-term interest rates is sometimes important as a practical matter. Moreover, it’s short-term rates rather than long-term rates that affect money demand, because the decision to hold money involves trading off the convenience of holding cash versus the payoff from holding assets that mature in the short-term—a year or less. For our current purposes, however, it’s useful to ignore the distinction between short-term and long-term rates and assume that there is only one interest rate.

Because the overall level of interest rates affects the opportunity cost of holding money, the quantity of money individuals and firms want to hold, other things equal, is negatively related to the interest rate. In Figure 28.1, the horizontal axis shows the quantity of money demanded and the vertical axis shows the nominal interest rate, r, which you can think of as a representative short-term interest rate such as the rate on one-month CDs. Why do we place the nominal interest rate and not the real interest rate on the vertical axis? Because the opportunity cost of holding money includes both the real return that could be earned on a bank deposit and the erosion in purchasing power caused by inflation. The nominal interest rate includes both the forgone real return and the expected loss due to inflation. Hence, r in Figure 28.1 and all subsequent figures is the nominal interest rate.

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The relationship between the interest rate and the quantity of money demanded by the public is illustrated by the money demand curve, MD, in Figure 28.1. The money demand curve slopes downward because, other things equal, a higher interest rate increases the opportunity cost of holding money, leading the public to reduce the quantity of money it demands. For example, if the interest rate is very low—say, 0.15%, a common rate for one-month CDs in 2014—the interest forgone by holding money is relatively small. As a result, individuals and firms will tend to hold relatively large amounts of money to avoid the cost and nuisance of converting other assets into money when making purchases. By contrast, if the interest rate is relatively high—say, 15%, a level it reached in the United States in the early 1980s—the opportunity cost of holding money is high. People will respond by keeping only small amounts in cash and deposits, converting assets into money only when needed.

You might ask why we draw the money demand curve with the interest rate—as opposed to rates of return on other assets, such as stocks or real estate—on the vertical axis. The answer is that, for most people, the relevant question in deciding how much money to hold is whether to put the funds in the form of other assets that can be turned fairly quickly and easily into money. Stocks don’t fit that definition because there are significant broker’s fees when you sell stock (which is why stock market investors are advised not to buy and sell too often); selling real estate involves even larger fees and can take a long time as well. So the relevant comparison is with assets that are “close to” money—fairly liquid assets like CDs. And, as we’ve already seen, the interest rates on all these assets normally move closely together.

Like the demand curve for an ordinary good, the money demand curve can be shifted by a number of factors. Figure 28.2 shows shifts of the money demand curve: an increase in the demand for money corresponds to a rightward shift of the MD curve, raising the quantity of money demanded at any given interest rate; a fall in the demand for money corresponds to a leftward shift of the MD curve, reducing the quantity of money demanded at any given interest rate. The most important factors causing the money demand curve to shift are changes in the aggregate price level, changes in real GDP, changes in banking technology, and changes in banking institutions.

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Changes in the Aggregate Price Level Americans keep a lot more cash in their wallets and funds in their checking accounts today than they did in the 1950s. One reason is that they have to if they want to be able to buy anything: almost everything costs more now than it did when you could get a burger, fries, and a drink at McDonald’s for 45 cents and a gallon of gasoline for 29 cents. So higher prices increase the demand for money (a rightward shift of the MD curve), and lower prices decrease the demand for money (a leftward shift of the MD curve).

We can actually be more specific than this: other things equal, the demand for money is proportional to the price level. That is, if the aggregate price level rises by 20%, the quantity of money demanded at any given interest rate, such as r₁ in Figure 28.2, also rises by 20%—the movement from M₁ to M₂. Why? Because if the price of everything rises by 20%, it takes 20% more money to buy the same basket of goods and services. And if the aggregate price level falls by 20%, at any given interest rate the quantity of money demanded falls by 20%—shown by the movement from M₁ to M₃ at the interest rate r₁. As we’ll see later, the fact that money demand is proportional to the price level has important implications for the long-run effects of monetary policy.

Changes in Real GDP Households and firms hold money as a way to facilitate purchases of goods and services. The larger the quantity of goods and services they buy, the larger the quantity of money they will want to hold at any given interest rate. So an increase in real GDP—the total quantity of goods and services produced and sold in the economy—shifts the money demand curve rightward. A fall in real GDP shifts the money demand curve leftward.

Changes in Technology There was a time, not so long ago, when withdrawing cash from a bank account required a visit during the bank’s hours of operation. Since most people tried to do their banking during lunch hour, they often found themselves standing in line. So people limited the number of times they needed to withdraw funds by keeping substantial amounts of cash on hand. Not surprisingly, this tendency diminished greatly with the advent of ATMs in the 1970s. As a result, the demand for money fell and the money demand curve shifted leftward.

These events illustrate how changes in technology can affect the demand for money. In general, advances in information technology have tended to reduce the demand for money by making it easier for the public to make purchases without holding significant sums of money. ATMs are only one example of how changes in technology have altered the demand for money. The ability of stores to process credit card and debit card transactions via the Internet has widened their acceptance and similarly reduced the demand for cash.

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Changes in Institutions Changes in institutions can increase or decrease the demand for money. For example, until Regulation Q was eliminated in 1980, U.S. banks weren’t allowed to offer interest on checking accounts. So the interest you would forgo by holding funds in a checking account instead of an interest-bearing asset made the opportunity cost of holding funds in checking accounts very high. When banking regulations changed, allowing banks to pay interest on checking account funds, the demand for money rose and shifted the money demand curve to the right.

The Federal Open Market Committee decided today to lower its target for the federal funds rate 75 basis points to 2¼ percent.

Recent information indicates that the outlook for economic activity has weakened further. Growth in consumer spending has slowed and labor markets have softened. Financial markets remain under considerable stress, and the tightening of credit conditions and the deepening of the housing contraction are likely to weigh on economic growth over the next few quarters.

So read the beginning of a press release from the Federal Reserve issued on March 18, 2008. (A basis point is equal to 0.01 percentage point. So the statement implies that the Fed lowered the target from 3% to 2.25%.) Remember that the federal funds rate is the rate at which banks lend reserves to each other to meet the required reserve ratio. As the statement implies, at each of its eight-times-a-year meetings, the Federal Open Market Committee sets a target value for the federal funds rate. It’s then up to Fed officials to achieve that target. This is done by the Open Market Desk at the Federal Reserve Bank of New York, which buys and sells short-term U.S. government debt, known as Treasury bills, to achieve that target.

As we’ve already seen, other short-term interest rates, such as the rates on CDs, move with the federal funds rate. So when the Fed reduced its target for the federal funds rate from 3% to 2.25% in March 2008, many other short-term interest rates also fell by about three-quarters of a percentage point.

How does the Fed go about achieving a target federal funds rate? And more to the point, how is the Fed able to affect interest rates at all?

Recall that, for simplicity, we’ve assumed that there is only one interest rate paid on nonmonetary financial assets, both in the short run and in the long run. To understand how the interest rate is determined, consider Figure 28.3, which illustrates the liquidity preference model of the interest rate; this model says that the interest rate is determined by the supply and demand for money in the market for money. Figure 28.3 combines the money demand curve, MD, with the money supply curve, MS, which shows the relationship between the quantity of money supplied by the Federal Reserve and the interest rate.

The Federal Reserve can increase or decrease the money supply: it usually does this through open-market operations, buying or selling Treasury bills, but it can also lend via the discount window or change reserve requirements. Let’s assume for simplicity that the Fed, using one or more of these methods, simply chooses the level of the money supply that it believes will achieve its interest rate target. Then the money supply curve is a vertical line, MS in Figure 28.3, with a horizontal intercept corresponding to the money supply chosen by the Fed, . The money market equilibrium is at E, where MS and MD cross. At this point the quantity of money demanded equals the money supply, , leading to an equilibrium interest rate of r_E.

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To understand why r_E is the equilibrium interest rate, consider what happens if the money market is at a point like L, where the interest rate, r_L, is below r_E. At r_L the public wants to hold the quantity of money M_L, an amount larger than the actual money supply, . This means that at point L, the public wants to shift some of its wealth out of interest-bearing assets such as high-denomination CDs (which aren’t money) into money. This has two implications. One is that the quantity of money demanded is more than the quantity of money supplied. The other is that the quantity of interest-bearing nonmoney assets demanded is less than the quantity supplied. So those trying to sell nonmoney assets will find that they have to offer a higher interest rate to attract buyers. As a result, the interest rate will be driven up from r_L until the public wants to hold the quantity of money that is actually available, M. That is, the interest rate will rise until it is equal to r_E.

Now consider what happens if the money market is at a point such as H in Figure 28.3, where the interest rate r_H is above r_E. In that case the quantity of money demanded, M_H, is less than the quantity of money supplied, . Correspondingly, the quantity of interest-bearing nonmoney assets demanded is greater than the quantity supplied. Those trying to sell interest-bearing nonmoney assets will find that they can offer a lower interest rate and still find willing buyers. This leads to a fall in the interest rate from r_H. It falls until the public wants to hold the quantity of money that is actually available, . Again, the interest rate will end up at r_E.

Here we have developed the liquidity preference model of the interest rate. In this model, the equilibrium interest rate is the rate at which the quantity of money demanded equals the quantity of money supplied in the money market. This model is different from, but consistent with, another model known as the loanable funds model of the interest rate, which is developed in the next module. In the loanable funds model, we will see that the interest rate matches the quantity of loanable funds supplied by savers with the quantity of loanable funds demanded for investment spending.