The Demand For Money| CBCS

Interest Rates and Bond Prices 

Interest Rates and Bond Prices Interest is the fee that borrowers pay to lenders for the use of their funds. . Firms and governments borrow funds by issuing bonds, and they pay interest to the lenders that purchase the bonds. Households also borrow, either directly from banks and finance companies or by taking out mortgages. 

Some loans are very simple. You might borrow $1,000 from a bank to be paid back a year from the date you borrowed the funds. If the bank charged you, say, $100 for doing this, the interest rate on the loan would be 10 percent. You would receive $1,000 now and pay back $1,100 at the end of the year—the original $1,000 plus the interest of $100. In this simple case the interest rate is just the interest payment divided by the amount of the loan, namely 10 percent. 

Bonds are more complicated loans. Bonds have several properties. First, they are issued with a face value, typically in denominations of $1,000. Second, they come with a maturity date, which is the date the borrower agrees to pay the lender the face value of the bond. Third, there is a fixed payment of a specified amount that is paid to the bondholder each year. This payment is known as a coupon.

Say that company XYZ on January 2, 2011, issued a 15-year bond that had a face value of $1,000 and paid a coupon of $100 per year. On this date the company sold the bond in the bond market. The price at which the bond sold would be whatever price the market determined it to be. Say that the market-determined price was in fact $1,000. The lender would give XYZ a check for $1,000 and every January for the next 14 years XYZ would send the lender a check for $100. Then on January 2, 2026, XYZ would send the lender a check for the face value of the bond—$1,000—plus the last coupon payment—$100— and that would square all accounts. In this example the interest rate that the lender receives each year on his or her $1,000 investment is 10 percent. If, on the other hand, the market-determined price of the XYZ bond at the time of issue were only $900, then the interest rate that the lender receives would be larger than 10 percent. The lender pays $900 and receives $100 each year. This is an interest rate of roughly 11.1 percent.

The Demand for Money 

The factors and forces determining the demand for money are central issues in macroeconomics. As we shall see, the interest rate and nominal income influence how much money households and firms choose to hold.

The Transaction Motive

The main reason for holding money instead of interest bearing assets is that money is useful for buying things. Economists call this the transaction motive. 

First, we assume that there are only two kinds of assets available to households: bonds and money. By “bonds” we mean interest-bearing securities of all kinds. We are assuming that there is only one type of bond and only one market-determined interest rate. By “money” we mean currency in circulation and deposits in checking accounts that do not pay interest.

Second, we assume that income for the typical household is “bunched up.” It arrives once a month at the beginning of the month. Spending, by contrast, is spread out over time; we assume that spending occurs at a completely uniform rate throughout the month—that is, that the same amount is spent each day. The mismatch between the timing of money inflow and the timing of money outflow is sometimes called the nonsynchronization of income and spending.

Finally, we assume that spending for the month is equal to income for the month. Because we are focusing on the transactions demand for money and not on its use as a store of value, this assumption is perfectly reasonable.

Income arrives only once a month, but spending takes place continuously

Suppose Jim decides to deposit his entire paycheck in his checking account. Let us say that Jim earns $1,200 per month. The pattern of Jim’s bank account balance is illustrated in Figure. At the beginning of the month, Jim’s balance is $1,200. As the month rolls by, Jim draws down his balance, writing checks or withdrawing cash to pay for the things he buys. At the end of the month, Jim’s bank account balance is down to zero. Just in time, he receives his next month’s paycheck, deposits it, and the process begins again.

Strategy 1 Jim could decide to deposit his entire paycheck ($1,200) into his checking account at the start of the month and run his balance down to zero by the end of the month. In this case, his average balance would be $600

One useful statistic we need to calculate is the average balance in Jim’s account. Jim spends his money at a constant $40 per day ($40 per day times 30 days per month = $1,200). His average balance is just his starting balance ($1,200) plus his ending balance (0) divided by 2, or ($1,200 + 0)/2 = $600. For the first half of the month, Jim has more than his average of $600 on deposit, and for the second half of the month, he has less than his average.

Strategy 2 Jim could also choose to put half of his paycheck into his checking account and buy a bond with the other half of his income. At mid month, Jim would sell the bond and deposit the $600 into his checking account to pay the second half of the month’s bills. Following this strategy, Jim’s average money holdings would be $300.

Jim’s money holdings (checking account balances) if he follows this strategy are shown in Figure. When he follows the buy-a-$600-bond strategy, Jim reduces the average amount of money in his checking account. Comparing the dashed green lines (old strategy) with the solid green lines (buy-$600-bond strategy), his average bank balance is exactly half of what it was with the first strategy. The buy-a-$600-bond strategy seems sensible. The object of this strategy was to keep some funds in bonds, where they could earn interest, instead of being “idle” money. 

Another possibility would be for Jim to put only $400 into his checking account on the first of the month and buy two $400 bonds. The $400 in his account will last only 10 days if he spends $40 per day, so after 10 days he must sell one of the bonds and deposit the $400 from the sale in his checking account. This will last through the 20th of the month, at which point he must sell the second bond and deposit the other $400. This strategy lowers Jim’s average money holding (checking account balance) even further, reducing his money holdings to an average of only $200 per month, with correspondingly higher average holdings of interest-earning bonds.

The Speculation Motive

One reason for holding bonds instead of money: Because the market price of interest-bearing bonds is inversely related to the interest rate, investors may want to hold bonds when interest rates are high with the hope of selling them when interest rates fall. Consider your desire to hold money balances instead of bonds. If market interest rates are higher than normal, you may expect them to come down in the future. If and when interest rates fall, the bonds that you bought when interest rates were high will increase in price.

Similarly, when market interest rates are lower than normal, you may expect them to rise in the future. Rising interest rates will bring about a decline in the price of existing bonds. Thus, when interest rates are low, it is a good time to be holding money and not bonds. When interest rates are low, not only is the opportunity cost of holding cash balances low, but also there is a speculative motive for holding a larger amount of money.

The Total Demand for Money

The total quantity of money demanded in the economy is the sum of the demand for checking account balances and cash by both households and firms. The trade-off for firms is the same as it was for Jim. Like households, firms must manage their money. They have payrolls to meet and purchases to make, they receive cash and checks from sales, and many firms that deal with the public must make change—they need cash in the cash register. Thus, just like Jim, firms need money to engage in ordinary transactions. However, firms as well as households can hold their assets in interest-earning form. Firms manage their assets the same way households do, keeping some in cash, some in their checking accounts, and some in bonds. A higher interest rate raises the opportunity cost of money for firms as well as for households and thus reduces the demand for money.

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