KRUGMAN_WELLS_MACRO_CHAPTER14

The next to last row in table 14 1 shows the

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Unformatted text preview: t row in Table 14-1 shows the difference between the interest rate on one-month Treasury bills and the interest rate on zero-maturity 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 bills; by March 2005 that difference had risen to 1.31 percentage points. The comparison between one-month Treasury bills and currency is even worse: in May 2004 holding currency meant forgoing 0.91 percentage points at an annual rate; by March 2005 that difference had widened to 2.36 percentage points. As this example shows, people pay a cost for holding wealth in the form of money as opposed to nonmonetary assets such as Treasury bills. Why, then, does the public hold money? Money provides convenience and reduces the costs of transactions because it can be used immediately for spending, which other assets can’t. As an example of how convenience makes it worth incurring some opportunity costs, consider the fact that even today—with the prevalence of credit cards, debit cards, and ATMs—people continue to keep cash in their wallets rather than leave the funds in an interest-bearing account. They don’t want to have to go to the bank to withdraw money every time they want to buy lunch from a place that doesn’t accept credit cards at all or won’t accept them for small amounts because of the processing fee. The convenience of keeping some cash in your wallet is more valuable than the interest you would earn by keeping that money in the bank. So how much of your wealth should you hold in the form of money on any given day? Choosing the optimal quantity of money to hold requires a trade-off between the extra convenience of an additional dollar in your wallet against the higher return from keeping it in other financial assets. The terms of this trade-off change when interest rates change. Look again at Table 14-1. Between May 2004 and March 2005, the federal funds rate rose by about 1.5 percentage points. The interest rate on onemonth Treasury bills rose by about the same amount. That’s not an accident: all short-term interest rates—rates on financial assets that come due, or mature, within six months or less—tend to move together. This occurs because Treasury bills, one-month bonds, three-month bonds, and so on are in effect competing for the same business. Why? Investors will move their wealth out of any short-term financial asset that offers a lower-than-average interest rate. The selling of the asset forces the interest rate on that asset up because new buyers must be rewarded with a higher rate in order to induce them to buy it. Conversely, investors will move their wealth into any short-term financial asset that offers an above-average interest rate. The purchase of the asset drives its interest rate down when sellers find they can lower the rate of return on the asset and still find will...
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This note was uploaded on 09/09/2009 for the course ECON 701 taught by Professor Charlie during the Spring '09 term at École Normale Supérieure.

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