So interest rates on short term financial assets tend

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Unformatted text preview: ing 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. But the interest rates on money don’t rise by the same amount. The interest rate on currency remains at zero. The interest rate on zero-maturity bank deposits rises, but by much less than short-term interest rates. As a result, the opportunity cost of holding money increases. This reflects a general result: the higher the short-term interest rate, the higher the opportunity cost of holding money. So the quantity of money the public wants to hold—the quantity of money demanded—depends negatively on the interest rate. Table 14-1 contains only short-term interest rates. At any given moment, longterm 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 UNCORRECTED Preliminary Edition CHAPTER 14 M O N E TA R Y P O L I C Y 345 as a practical matter. For our current purposes, however, it’s useful to ignore the distinction between short-term and long-term rates and assume that there is only one interest rate. The Money Demand Curve The relationship between the interest rate and the quantity of money demanded by the public is illustrated by the money demand curve, MD, in Figure 14-1. This curve slopes downward because, other things equal, a higher interest rate increases the opportunity cost of holding money, leading the public to reduce the quantity of money it demands. For example, if the interest rate is very low—say, 1%—the interest forgone by holding money is relatively small. As a result, people will tend to hold relatively large amounts of money to avoid the cost and nuisance of converting other assets into money when making purchases. By contrast, if the interest rate is relatively high—say, 15%, a value it reached in the United States in the early 1980s—the opportunity cost of holding money is high. People will respond by keeping only small amounts in cash and deposits, converting funds into money only when needed. Figure The money demand curve shows the relationship between the quantity of money demanded and the interest rate. 14-1 The Liquidity Preference Model of the Interest Rate Interest rate, r The money demand curve illustrates the relationship between the interest rate and the nominal quantity of money demanded. It slopes downward: a higher interest rate leads to a higher opportunity cost of holding money and reduces the quantity of money demanded. Money demand curve, MD Nominal quantity of money, M You might ask why we draw the money demand curve with the interest rate—as opposed to rates of return on other assets, such as stocks or real estate—on the vertical axis. As we noted earlier, for most people the relevant question in deciding how much money to hold is whether to put the funds in the form of other assets that can be turned fairly quickly in...
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