ECON 1nd Edition Lecture 22 Outline of Current Lecture I. Demand of Money II. Money Demand Curve Current LectureModule 28 I. Demand for Money - Opportunity cost of holding money?o There is a price to be paid for the convenience of holding money. o We all carry some cash around for the convenience. When we do, we give up interest income we’d collect if that spending power were in an interest-bearing asset like a bond o The higher the interest rate, the higher the opportunity cost of holding moneyo People lower money demand when there are high interest rates - What happens to the opportunity cost of holding cash if…o Merchants charge 1% fee on debit/credit card transactions for purchases of less than $50?  say interest rate is 5%, opportunity cost will go down 1% so opportunity cost will be 4%o Banks raise the interest paid on saving accounts?  opportunity cost is higher when interest rates rise o Real estate prices fall significantly?  opportunity cost of holding cash, not much impact because 2 markets are not strongly correlated o What happens to the opportunity cost of holding money if the banks start offering interests on checking account holdings?  rate on savings is 4% and rate on checking is 5%, opportunity cost of holding money 4%-1%= 3% so it goes down. - A trade-off - Hold cash get zero nominal interest- Hold non-monetary asset, earn some interest- Selected interes rates of 2007 These notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.-- real return on holding cash is always negative - As a rule, most short-term rates tend to move in the same direction.- We assume that there is just one interest rate in the economy in the shortrun. We use r to represent that short term interest rate.- Short-term interest rates: the interest rates on financial assets that mature within six months or less.- Long-term interest rates: interest rates on financial assets that mature a number of years in the future.- Question: What is the correlation between interest rate and the money demand?II. Money Demand Curve - The money demand curve shows the relationship between the quantity of money demanded and the interest rate.- At higher interest rates, the cost of holding money is ________, so less quantity is demanded (countries like Venezuela with r=17 %)- At lower interest rates, the cost of holding money is ______, so a higher quantity is demanded (countries like Japan with r=0 %)- Keeping all other things constant, o changes in aggregate price level Higher prices mean we need more _money_____ for transactions (and vice versa).o changes in real GDP (changes in income) The more money peoplemake (the higher the real GDP), the __more ___ they purchase (and vice versa).o changes in technology The ease of credit card payments ___lower____ the need for cash.o changes in institutions After 1980 banks were allowed to offer interest on checking accounts. This decreased the cost of holding money, and money demand ___________.- A fall in money demand shifts the money demand curve to the left.- A rise in money demand shifts the money demand curve to the right.- What happens to demand curve if o Short term interest rates rise from 5% to 30%? no change o All prices fall by 10%?  shift to the lefto New wireless technology automatically charges the supermarket purchases to credit cards, eliminating the need to stop at the cash register?  shift to the left o In order to avoid paying taxes, a vast underground economy develops in which workers are paid their wages in cash rather than with checks?  - The higher the interest rate, the higher the opportunity cost of holding money. - The lower the interest rate, the lower the opportunity cost of holding money.- But, what determines the interest rate?o The money market - We need to understand how interest rates are determined in the market.- The liquidity preference model of the interest rate asserts that the interest rate is determined by the supply and demand for money in the money market.- In the money market, we have o Money demando Money supply o Interest rate (price of the money)- Price of an asset and the return on an assets are negatively correlated. - Think of a $100 worth of T-bills (matures in a year) with a 2% coupon offerings:o If the price of the T-bills now is $100, the nominal return on the asset is 2%.o If the price of the T-bills now is $90, the nominal return on the asset is higher than 2%.o If the price of the T-bills now is $110, the nominal return on the asset is less than 2%.- At rH, interest rates are high. MS > MD, and a surplus of money means there is a shortage of other assets like bonds. - At rL , interest rates are low. MD > MS, and a shortage of money means there is a surplus of other assets like