Chapter16Summary

Chapter16Summary - Chapter 16 Summary Tucker Macroeconomics for Today 5th Edn 1 Households and business firms do not have an"unlimited demand for

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Chapter 16 Summary Tucker , Macroeconomics for Today , 5th Edn. 1. Households and business firms do not have an "unlimited" demand for money. Rather, they choose to hold a portion of their wealth in the form of money because of a: (a) transactions demand; (b) precautionary demand; and (c) speculative demand. The transactions and precautionary demands for money depend (positively) on the level of nominal GDP (and the amount of disposable income related to it), and the speculative demand depends (negatively) on the rate of interest. Therefore, at any given GDP level, the total demand for money depends inversely on the rate of interest. 2. It is easy to understand why the transactions and precautionary demands for money are positively related to the level of nominal GDP. If the level of nominal GDP is higher, households and business firms are conducting more "transactions" and will want money in their checking accounts (or in currency) to conduct their day to day purchases of goods and services. Similarly, as the level of nominal GDP (and disposable income) increase, households are better able to set aside a portion of their wealth to handle "unexpected or unanticipated" transactions (e.g., paying for emergency medical care on a weekend because of an unanticipated medical problem). 3. The relationship between the speculative demand for money and the rate of interest is more complicated. Let us suppose the households and business firms have already set aside a portion of their wealth to meet their transactions and precautionary demands for money. Why should they hold any additional amounts of their wealth in the form of money? Even though checking accounts pay a positive rate of interest today, such interest rates are very low and certainly are not equal to the rates of return available on other financial assets (e.g., private or government-issued bonds). To understand this relationship you must recall the inverse relationship between bond prices and interest rates. Because bonds pay a rate of interest based upon the "par value" (maturity value) of the bond, day-to-day fluctuations in the actual market prices of these bonds (before they mature) will cause inverse movements of the rates of return on such bonds. Suppose, for example, that the government issues a 30 year bond that pays $60 per year to whoever owns the bond and that the bond is originally sold by the U.S. Treasury for a price of $1000. The individual who purchased that bond receives $60 per year on a $1000 purchase, or a 6% rate of return. The day-to- day price of 30 year government bonds in the New York bond market fluctuates, and so will the effective rates of return on these bonds. If the price falls to $500, the individual who receives $60 per year in interest on a bond purchased for $500 receives a 12% rate of return. Conversely, if the bond sells for $2000, the purchaser will receive $60 per year on a $2000 financial investment, or a 3% rate of return. Bond prices and bond yields move in opposite directions.
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4. As a result, because one component of the demand for money depends on the
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This note was uploaded on 04/02/2008 for the course ECN 211 taught by Professor Kingston during the Spring '08 term at ASU.

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Chapter16Summary - Chapter 16 Summary Tucker Macroeconomics for Today 5th Edn 1 Households and business firms do not have an"unlimited demand for

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