1.2 73The Money Market

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The Demand for Money

In Module 69 we learned about the various types of monetary aggregates: M1, the most commonly used definition of the money supply, consists of currency in circulation (cash), plus checkable bank deposits, plus traveler’s checks; and M2, a broader definition of the money supply, consists of M1 plus deposits that can easily be transferred into checkable deposits. 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.

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 because they don’t want to have to go 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.

There is a price to be paid for the convenience of holding money.

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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 might earn 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 73-1 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.

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Selected Interest Rates, June 2007

Table 73-1 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 73-2 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.

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Interest Rates and the Opportunity Cost of Holding Money

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.

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 73-2 shows, the opportunity cost of holding money fell. The last two rows of Table 73-2 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 73-2 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. 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.

Short-term interest rates tend to move together.

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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.

Table 73-2 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.

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 73-1, 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. (Recall that it is the nominal interest rate, not the real interest rate, that influences people’s money allocation decisions. Hence, r in Figure 73-1 and all subsequent figures is the nominal interest rate.)

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 relationship between the interest rate and the quantity of money demanded by the public is illustrated by the money demand curve, MD, in Figure 73-1. 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.

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 73-2 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.

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 LevelAmericans 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 73-2, 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 GDPHouseholds 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.

Credit cards allow people to hold less money to fund their purchases, decreasing the demand for money.

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Changes in Credit Markets and Banking TechnologyCredit cards are everywhere in American life 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 InstitutionsChanges 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.

A YEN FOR CASH

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 an economically and technologically advanced country and, according to some measures, ahead of the United States in the use of telecommunications and information technology.

No matter what they are shopping for, Japanese consumers tend to pay with cash rather than plastic.

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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 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 full of cash stolen. So why not hold cash?

Money and Interest Rates

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%.) Recall 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, a group called 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?

The Equilibrium Interest Rate

Remember that, for simplicity, we’re assuming 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 73-3, 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 73-3 combines the money demand curve, MD, with the money supply curve, MS, which shows how the quantity of money supplied by the Federal Reserve varies with the interest rate.

The money supply curve, MS, is vertical at the money supply chosen by the Federal Reserve, . The money market is in equilibrium at the interest rate r_E: the quantity of money demanded by the public is equal to , the quantity of money supplied.
At a point such as L, the interest rate, r_L, is below r_E and the corresponding quantity of money demanded, M_L, exceeds the money supply, . In an attempt to shift their wealth out of nonmoney interest-bearing financial assets and raise their money holdings, investors drive the interest rate up to r_E. At a point such as H, the interest rate r_H exceeds r_E and the corresponding quantity of money demanded, M_H, is less than the money supply, . In an attempt to shift out of money holdings into nonmoney interest-bearing financial assets, investors drive the interest rate down to r_E.

In the previous module we learned how 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 73-3, 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.

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 CDs 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 money 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, . 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 73-3, 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.

Two Models of Interest Rates?

You might have noticed that this is the second time we have discussed the determination of the interest rate. In an earlier module, we studied the loanable funds model of the interest rate; according to that model, the interest rate is determined by the equalization of the supply of funds from lenders and the demand for funds by borrowers in the market for loanable funds. But here we have described a seemingly different model in which the interest rate is determined by the equalization of the supply and demand for money in the money market.

Which of these models is correct? The answer is both, depending on context. The loanable funds model is focused on the interest rate in the long run. The money market model, however, focuses on the interest rate in the short run.

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Check Your Understanding

Draw a graph showing equilibrium in the money market. Select an interest rate below the equilibrium interest rate and explain what occurs in the market at that interest rate and how the market will eventually return to equilibrium.

Your graph should look like the following. At an interest rate below equilibrium, the quantity of money demanded exceeds the quantity of money supplied. People want to shift more of their wealth out of interest-bearing assets such as CDs and hold it as money instead. Because the quantity of interest-bearing nonmoney assets demanded is less than the quantity supplied, those trying to sell these assets will have to offer a higher interest rate to attract buyers. As the interest rate rises, the quantity of money demanded decreases. This process continues until the market returns to equilibrium.