KW_Macro_Ch_14_Sec_01_The_Demand_for_Money

KW_Macro_Ch_14_Sec_01_The_Demand_for_Money - chapter 14...

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>> Monetary Policy Section 1: The Demand for Money chapter 14 In Chapter 13 we saw that M1, the most commonly used definition of the money supply, consists of currency in circulation (cash) plus checkable bank deposits plus traveler’s checks. M2, a broader definition of the money supply, consists of M1 plus deposits that can easily be transferred into checkable deposits. We also saw why peo- ple hold money—to make it easier to purchase goods and services. Now we’ll go deep- er, examining what determines how much money individuals and firms want to hold at any given time. The Opportunity Cost of Holding Money Individuals and firms hold some of their assets in the form of money because only money can be used to make purchases directly. But there is a price to be paid for hold- ing money: it normally yields a lower rate of return than nonmonetary assets. For most individuals and firms, the relevant choice is between money and less liquid assets, such as short-term bonds, that can be converted fairly quickly into money but
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2 CHAPTER 14 SECTION 1: THE DEMAND FOR MONEY yield higher interest rates than money. The rate-of-return disadvantage of money is obvious in the case of currency, which pays no interest. Most checkable bank deposits pay interest, but the rate is lower than that on other, less convenient assets. Table 14-1 shows a selection of average interest rates prevailing in two months, May 2004 and March 2005. The top row shows the federal funds rate. The next row shows the rate on one-month Treasury bills, a bond issued by the U.S. government that is paid off in one month. The next row shows the interest rate on interest-bearing zero-matu- rity (checkable) bank deposits. These are deposits, including checking account deposits, from which funds can be withdrawn at any time without penalty. The fourth row shows the interest rate on currency, which is, of course, zero. TABLE 14-1 Selected Interest Rates May 2004 March 2005 Federal funds rate 1.00% 2.63% One-month Treasury bill 0.91 2.36 Interest-bearing bank deposits* 0.54 1.05 Currency 0.00 0.00 Treasury bill rate minus rate on deposits 0.37 1.31 Treasury bill rate minus rate on currency 0.91 2.36 *Average on all zero-maturity deposits (deposits that can be withdrawn at any time) Source: Federal Reserve Bank of St. Louis.
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As you can see, in both months people received a higher rate of interest on one- month U.S. Treasury bills than they did on either currency or zero-maturity deposits. There is an opportunity cost to holding money, which we can measure by the differ- ence between the interest rate on assets that aren’t money and the interest rate on assets that are money. The next-to-last row in Table 14-1 shows the difference between the interest rate on one-month Treasury bills and the interest rate on zero- maturity bank deposits. The last row shows the difference between the interest rate on one-month Treasury bills and the interest rate on currency. In May 2004 zero- maturity deposits yielded 0.37 percentage points less at an annual rate than Treasury
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KW_Macro_Ch_14_Sec_01_The_Demand_for_Money - chapter 14...

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