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Unformatted text preview: Chapter 11 outline 1. Introduction a. Monetary Policy- The behavior of the federal reserve concerning the money supply b. Interest- the fee that borrowers pay to lenders for the use of their funds. c. Firms and the government borrow funds by issuing bonds, and they pay interest to the firms and households(the lenders) that purchase those bonds. d. Interest rate- the annual interest payment on a loan expressed as a percentage of the loan. Equal to the amount of interest received per year divided by the amount of the loan. 2. The Demand for Money a. The interest rate and the level of national income(Y) influence how much money households and firms wish to hold. b. We are concerned with how much your financial assets you want to hold in the form of money, which does not earn interest. c. The Transaction Motive i. Transaction motive-the main reason that people hold moneyto buy things. ii. Assumptions 1. We assume there are only two kinds of assets available to households: bonds and money. a. bonds- we mean interest-bearing securities of all kinds. b. money- we mean currency in circulation and in deposits, neither of which is assumed to pay interest. 2. We assume that income for the typical household is bunched up (arrives once a month) 3. Nonsynchronization of income and spending- the mismatch between the timing of money inflow to the household and the timing of money outflow for household expenses. 4. We assume that spending for the month is exactly equal to income for the month. d. Money Management and the Optimal Balance i. Average balance= starting balance + ending balance / 2 ii. Less switching means more interest revenue lost(because average money holdings are higher) but lower money management costs(fewer purchases and sales of bonds, less time spent waiting in bank lines, fewer trips to the bank, and so on). iii. The optimal Balance- the level of average money balances that earns the most profit 1. An increase in the interest rate lowers the optimal money balance 2. The interest rate represents the opportunity cost of holding money(and therefore not holding bonds, which pay interest). 3. The higher the interest rate is, the higher the opportunity cost of holding money, and the less money people will want to hold. 4. When interest rates are high, people want to take advantage of the high return on bonds, so they choose to hold very little money. 5. At a higher interest rate, bonds are much more attractive than money, so people hold less money because they must make a larger sacrifice in interest for each dollar of money they hold. 6. There is an inverse relationship between interest rate and the quantity of money demanded....
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