We have already gone over how money, as macroeconomists use the term, means something different from "income" or "wealth." Money is defined as anything that is generally accepted as payment or, in a word, as liquidity. Since having liquidity is a much smaller priority for most people than earning a high income or becoming wealthy is, we need to figure out what it is that money is good for. Economists have identified three main functions of money: 1. Medium of exchange - money "greases the wheels of commerce," by making it much easier for people to exchange the goods and services they produce for the goods and services that they want.Having a generally accepted currency eliminates the need for barter (trading), and makes the volume of transactions a lot larger than it would otherwise be. 2. Unit of account - having a standard monetary unit, like the dollar, allows us to price individual goods and services, putting a single price on each item instead of having to compute a different exchange price for every different pair of commodities (e.g., 1 cup of coffee = 2 newspapers = 6 minutes of office work as a temp = 3 minutes of my teaching services). 3. Store of value - money has some use as an asset, because it holds its nominal value over time and, unlike stocks or bonds, its value does not fluctuate from day to day. Unlike stocks or bonds, there is no risk that dollars will suddenly become worthless. In sum, money is a virtually riskless asset. It is also a very liquid (convertible into cash; spendable) asset, which is another desirable quality.
II. MONEY SUPPLY, MONEY DEMAND, AND THE EQUILIBRIUM INTEREST RATE
Defn. INTEREST RATE -- the annual interest payment on a loan expressed as a % of the loan. It is equal to the amount of interest received per year divided by the amount of the loan. It is the "price" of money, or rather the price of borrowing someone else's money. -- Ex.: If you borrow $100 and must pay $105, int. rate = (5%). (We don't count the repayment of the original $100, which is called the principal on the loan. The interest rate is the net payment you make; we say that the gross interest rate = 105%, but that usage is uncommon.) -- Which interest rate are we talking about here? There are many interest rates in the economy or even at a single bank. But, they do tend to move together and, for the sake of simplicity, we will talk as if there is only one interest rate ("the interest rate").
One of the best ways to understand movements in interest rates is through the money market - a representation of the supply and demand of money and the resulting equilibrium point. So the money market is just another supply-and-demand diagram, with the price of money on the vertical axis, the quantity of money on the horizontal axis, and a downward-sloping money-demand curve. - [Refer to Figure 13-2, panel (c), on p. 273 of McConnell's textbook.] - The only variations on the usual supply-and-diagram are that:
the supply curve of money is perfectly vertical, instead of upward-sloping, because the supply of money is fixed by the Fed without regard to the interest rate;
the "price of money" is not a dollar amount but rather is the interest rate. The interest rate is the opportunity cost of holding money, since money pays no interest and alternative assets like bonds, savings accounts, and CD's do pay interest. When you hold money, you are giving up the interest that you could be receiving if that money were in a bond or savings account or CD. The higher the interest rate, the more interest you lose out on by holding money, so you'll carry less money and keep more in the bank. Likewise, when the interest rate is very low, you don't lose much by carrying a lot of money, so you will carry (or demand) more money. The quantity of money demanded is a negative function of the interest rate (i); the money demand curve slopes downward. Q: Considering that money earns a lower rate of return (0%) than virtually every other asset there is, why hold money at all? Even when i is low, as long as it's greater than 0, holding money means that you are losing out on the interest that you could be earning on bonds, CDs (certificates of deposit), or savings accounts, not to mention the positive returns you could be earning on things like stocks or real estate.
A: There are at least four good MOTIVES FOR HOLDING MONEY. They are:
(1.) Transactions demand (the most obvious motive) -- We need it to buy things, since money is the universal medium of exchange. -- Corollary: the more you earn, the more money you'll demand.
-After a Mets game in the mid-1980s, it was reported that pitcher Ron Darling's wife lost purse at the game, and that the Darlings were upset because the purse had over $400 of cash in it. Why would she have been carrying so much money in the first place? (Probably because her husband was a multimillionaire...) -- The greater your income and wealth, the greater your consumption will be, hence the greater your transactions demand for money will be.
(2.) Precautionary demand ("save it for a rainy day") -- Ex.: Say I normally spend ~$20/day --> then if I go to the bank every 5 days, I should withdraw $100 every time, right? Not necessarily -- even though $100 is what I'd need on average, I might have some abnormal expenses -- unexpected emergencies, bills, great sales, etc. So I might withdraw more than $100. -- Money is the most liquid of assets, thus you might want to set some aside to be ready for any emergencies that might arise.
(3.) Avoid transactions costs of bank trips (ATM fees, time and inconvenience of trips to the bank). Because of those costs, it is often desirable to make very large withdrawals of cash when you visit the bank, so that you won't have to visit the bank again for a long while. The larger your average bank withdrawal, the greater your money demand. Putting those two observations together, money demand will be greater when the transactions costs of bank trips are high.
(4.) Asset demand - money is a riskless asset and is extremely liquid. Thus, money is somewhat useful as a store of value.
Despite all of these good reasons to hold money, it's still true that money earns a lower rate of return than bonds and other interest-bearing assets, so people will try to economize on their holdings of money somewhat, by keeping only small amounts of money as cash or in their checking accounts, while keeping the rest of their unspent income in bonds or other assets that earn competitive rates of interest. People will hold even less money when the interest rate is high - in other words, the demand curve for money slopes downward.
The intersection of the money demand and (vertical) money supply curves is the equilibrium in the money market and determines the equilibrium interest rate. (The equilibrium quantity of money, by the way, is always equal to the supply of money -- since the money supply curve is vertical, the equilibrium quantity of money will not be affected by shifts in the demand curve for money.)
