macsg11 - 11[26 Money Demand and the Equilibrium Interest...

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269 11 [26] Money Demand and the Equilibrium Interest Rate C hapter objectives: 1. Define the interest rate. 2. Describe the trade-off facing households when choosing the quantity of money balances to hold for transactions. 3. Distinguish between the transaction motive and the speculation motive for holding money. 4. List the variables that influence the demand for money and indicate in which direction the demand for money will be affected by a change in each of them. 5. Draw a supply and demand diagram of the money market and describe how equilibrium is reached following a demand or supply curve shift. 6. Discuss the reasoning behind, and the conclusions of, the expectations theory of the term structure of interest rates. BRAIN TEASER: Can there be too much money supplied—that is, more money in circulation than households and firms wish to hold? What does it mean when the actual interest rate is higher than the equilibrium interest rate? If the stock of money is fixed, how can an excess supply of money be eliminated? How would the behavior of participants in the market cause the market to reach a new equilibrium? OBJECTIVE 1: Define the interest rate. The interest rate is the annual interest payment expressed as a percentage of the loan (as opposed to interest , which is the charge imposed by a lender on a borrower for the use of funds). (page 203 [515]) For simplicity, the text assumes that there is only one interest rate and that money earns no interest. Historically, the assumption that money earns no interest was accurate—currency doesn’t, and, in previous decades, checking accounts earned no interest. ECONOMICS IN PRACTICE: On page 204 [516], the textbook considers the economic basis of Chekhov’s play “Uncle Vanya.” Securities yield a return of about 5 percent while Serebryakov’s estate yields a
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270 Study Guide to Principles of Macroeconomics return of only 2 percent. Serebryakov proposes to sell his estate and buy securities. Your text asks “If an investor…can earn 5 percent on these securities, why…buy an estate earning only 2 percent?” Can you find an economic reason why the low-yielding estate might still be an attractive option? Do you engage in such behavior? ANSWER: A key principle in investing is diversification, i.e., not putting all of one’s eggs in one basket. In investment strategy, variety is often the spice of life. By holding a range of assets (not just bonds; not just real estate), one spreads one’s risk. If, personally, you own stock, you most probably own stock in a range of companies, rather than one. Perhaps you’ve spread the risk by investing in a mutual fund. Some stock will offer higher returns than others but, even if all returns were equal, it is still wise to diversify. Also, you may wish to have a spectrum of assets with differing yields, risks and maturities. Liquidity may
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macsg11 - 11[26 Money Demand and the Equilibrium Interest...

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