19.2 The Demand for Money

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In the previous chapter we learned about the various types of monetary aggregates:

We 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.

The Opportunity Cost of Holding Money

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 any given good is worth the cost. The same decision process is used when deciding how much money to hold.

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There is a price to be paid for the convenience of holding money.
Big Cheese Photo/SuperStock

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, but other assets can’t. But there is a price to be paid for that convenience: money normally yields a lower rate of return than nonmonetary assets.

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 to avoid going to an ATM to withdraw money every time they want to buy lunch from a place that doesn’t accept credit cards or won’t accept them for small amounts because of the processing fee. 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.

Even holding money in a checking account involves a trade-off between convenience and earning interest. 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.

So making sense of the demand for money is about understanding how individuals and firms trade off the benefit of holding cash—that provides convenience but no interest—versus the benefit of holding interest-bearing nonmonetary assets—that provide interest but not convenience. And that trade-off is affected by the interest rate. (As before, when we say the interest rate it is with the understanding that we mean a nominal interest rate—that is, it’s unadjusted for inflation.) Next, we’ll examine how that trade-off changed dramatically from June 2007 to June 2008, when there was a big fall in interest rates.

Table 19-1 illustrates the opportunity cost of holding money in a specific month, 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 demand deposits (specifically, those included in M2, minus small time deposits). 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 was, of course, zero.

Table : TABLE 19-1 Selected Interest Rates, June 2007
One-month certificates of deposit (CDs) 5.30%
Interest-bearing demand deposits 2.30%
Currency 0

Data from: Federal Reserve Bank of St. Louis.

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Table 19-1 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.

Short-term interest rates are the interest rates on financial assets that mature within less than a year.

Table 19-2 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 (unsuccessful) effort to fight off a rapidly worsening recession. A comparison between interest rates in June 2007 and June 2008 illustrates what happens when the opportunity cost of holding money falls sharply. 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. These interest rates are short-term interest rates—rates on financial assets that come due, or mature, within less than a year.

Table : TABLE 19-2 Interest Rates and the Opportunity Cost of Holding Money
June 2007 June 2008
Federal funds rate 5.25% 2.00%
One-month certificates of deposit (CDs) 5.30% 2.50%
Interest-bearing demand deposits 2.30% 1.24%
Currency 0 0
CDs minus interest-bearing demand deposits (percentage points) 3.00 1.26
CDs minus currency (percentage points) 5.30 2.50

Data from: Federal Reserve Bank of St. Louis.

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 comparison of the two columns of Table 19-2 shows, the opportunity cost of holding money fell. The last two rows of Table 19-2 summarize this comparison: they give the differences between the interest rates on demand deposits and on currency and the interest rate on CDs.

These differences—the opportunity cost of holding money rather than interest-bearing assets—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.

The fact that the federal funds rate in Table 19-2 and the interest rate on one-month CDs fell by almost the same percentage is not an accident: all short-term interest rates tend to move together, with rare exceptions because 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.

Long-term interest rates are interest rates on financial assets that mature a number of years in the future.

Table 19-2 contains only short-term interest rates. At any given moment, long-term interest rates—rates of interest on financial assets that mature, or come due, a number of years into 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 the moment, however, let’s ignore the distinction between short-term and long-term rates and assume that there is only one interest rate.

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The Money Demand Curve

Because the overall level of interest rates affects the opportunity cost of holding money, the quantity of money individuals and firms want to hold is, other things equal, negatively related to the interest rate. In Figure 19-1, the horizontal axis shows the quantity of money demanded and the vertical axis shows the interest rate, r, which you can think of as a representative short-term interest rate such as the rate on one-month CDs.

Figure 19.1: FIGURE 19-1 The Money Demand Curve
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Figure 19.1: The money demand curve illustrates the relationship between the interest rate and the quantity of money demanded. It slopes downward: a higher interest rate leads to a higher opportunity cost of holding money and reduces the quantity of money demanded. Correspondingly, a lower interest rate reduces the opportunity cost of holding money and increases the quantity of money demanded.

The money demand curve shows the relationship between the interest rate and the quantity of money demanded.

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 19-1. 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, 1%—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 transaction fees when you sell stock (which is why stock market investors are advised not to buy and sell too often). Real estate doesn’t fit the definition either because 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.

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Shifts of the Money Demand Curve

A number of factors other than the interest rate affect the demand for money. When one of these factors changes, the money demand curve shifts. Figure 19-2 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 decrease 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.

Figure 19.2: FIGURE 19-2 Increases and Decreases in the Demand for Money
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Figure 19.2: The demand curve for money shifts when non-interest rate factors that affect the demand for money change. An increase in money demand shifts the money demand curve to the right, from MD1 to MD2, and the quantity of money demanded rises at any given interest rate. A decrease in money demand shifts the money demand curve to the left, from MD1 to MD3, and the quantity of money demanded falls 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 credit markets and banking technology, and changes in institutions.

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, other things equal, 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 19-2, 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, the fact that money demand is proportional to the price level has important implications for the long-run effects of monetary policy.

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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 Credit Markets and Banking Technology Credit cards are used everywhere in America today, but it wasn’t always so. The first credit card that allowed customers to carry a balance from month to month (called a revolving balance) was issued in 1959. Before then, people had to either pay for purchases in cash or pay off their balance every month. The invention of revolving-balance credit cards allowed people to hold less money in order to fund their purchases and decreased the demand for money. In addition, changes in banking technology that made credit cards widely available and widely accepted magnified the effect, making it easier for people to make purchases without having to convert funds from their interest-bearing assets, further reducing the demand for money.

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.

ECONOMICSin Actionimage

A Yen for Cash

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No matter what they are shopping for, Japanese consumers tend to pay with cash rather than plastic.
Akio Kon/Bloomberg via Getty Images

Japan, say financial experts, is still a “cash society.” Visitors from the United States or Europe are surprised at how little use the Japanese make of credit cards and how much cash they carry around in their wallets. Yet Japan is one of the most economically and technologically advanced countries, and superior to the United States in some areas such as transportation. So why do the citizens of this economic powerhouse still do business the way Americans and Europeans did a generation ago? The answer highlights the factors affecting the demand for money.

One reason the Japanese use cash so much is that their institutions never made the switch to heavy reliance on plastic. For complex reasons, Japan’s retail sector is still dominated by small mom-and-pop stores, which are reluctant to invest in credit card technology. Japan’s banks have also been slow about pushing transaction technology; visitors are often surprised to find that ATMs outside of major metropolitan areas close early in the evening rather than staying open all night.

But there’s another reason the Japanese hold so much cash: there’s little opportunity cost to doing so. Short-term interest rates in Japan have been below 1% since the mid-1990s. It also helps that the Japanese crime rate is quite low, so you are unlikely to have your wallet stolen. So why not hold cash?

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Quick Review

  • Money offers a lower rate of return than other financial assets. We usually compare the rate of return on money with short-term, not long-term, interest rates.

  • Holding money provides liquidity but incurs an opportunity cost that rises with the interest rate, leading to the downward slope of the money demand curve.

  • Changes in the aggregate price level, real GDP, credit markets and banking technology, and institutions shift the money demand curve. An increase in the demand for money shifts the money demand curve rightward; a decrease in the demand for money shifts the money demand curve leftward.

Check Your Understanding19-1

Question 19.1

1. Explain how each of the following would affect the quantity of money demanded. Does the change cause a movement along the money demand curve or a shift of the money demand curve?

  1. Short-term interest rates rise from 5% to 30%.

    By increasing the opportunity cost of holding money, a high interest rate reduces the quantity of money demanded. This is a movement up and to the left along the money demand curve.

  2. All prices fall by 10%.

    A 10% fall in prices reduces the quantity of money demanded at any given interest rate, shifting the money demand curve leftward.

  3. New wireless technology automatically charges supermarket purchases to credit cards, eliminating the need to stop at the cash register.

    This technological change reduces the quantity of money demanded at any given interest rate. So it shifts the money demand curve leftward.

  4. In order to avoid paying a sharp increase in taxes, residents of Laguria shift their assets into overseas bank accounts. These accounts are harder for tax authorities to trace but also harder for their owners to tap and convert funds into cash.

    This will increase the demand for money at any given interest rate. With more of the economy’s assets in overseas bank accounts that are difficult to access, people will want to hold more cash to finance purchases.

Question 19.2

2. Which of the following will increase the opportunity cost of holding cash? Reduce it? Have no effect? Explain.

  1. Merchants charge a 1% fee on debit/credit card transactions for purchases of less than $50.

    A 1% processing fee on debit/credit card transactions for purchases less than $50 reduces the opportunity cost of holding cash because consumers will save money by paying with cash.

  2. To attract more deposits, banks raise the interest paid on six-month CDs.

    An increase in the interest paid on six-month CDs raises the opportunity cost of holding cash because holding cash requires forgoing the higher interest paid.

  3. It’s the holiday shopping season and retailers have temporarily slashed prices to unexpectedly low levels.

    This reduces the opportunity cost of holding cash because it can now be used to fund purchases at very low prices, compensating its owner for any interest forgone by holding cash.

  4. The cost of food rises significantly.

    Because many purchases of food are made in cash, a significant increase in the cost of food reduces the opportunity cost of holding cash.

Solutions appear at back of book.