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.

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 15-1 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 15-1 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 15-2 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.

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 15-2 shows, the opportunity cost of holding money fell. The last two rows of Table 15-2 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 15-2 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.

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 15-2 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.