Question

How will the following events affect the demand for money? In each case, specify whether there is a shift of the demand curve or a movement along the demand curve and its direction. a. There is a fall in the interest rate from \(12 \%\) to \(10 \%\). b. Thanksgiving arrives and, with it, the beginning of the holiday shopping season. c. McDonald's and other fast-food restaurants begin to accept credit cards. d. The Fed engages in an open-market purchase of U.S. Treasury bills.

Short answer

a. Movement along the demand curve to the right. b. Rightward shift of the demand curve. c. Leftward shift of the demand curve. d. Movement along the demand curve to the right.

Step-by-step solution

Analyzing the Effect of a Fall in the Interest Rate

A fall in the interest rate from 12% to 10% would generally increase the quantity of money demanded because holding cash becomes less expensive, as the opportunity cost of holding money (foregone interest) decreases. This is a movement along the demand curve to the right, as people want to hold more money at the lower interest rate.

Assessing the Impact of the Holiday Shopping Season

The arrival of Thanksgiving and the beginning of the holiday shopping season increases the demand for money as people need more liquidity to make purchases. This results in a rightward shift of the demand curve for money, as the change is not due to a variation in the interest rate but rather a change in the spending habits.

Effects of Fast-Food Restaurants Accepting Credit Cards

When entities like McDonald's and other fast-food restaurants begin to accept credit cards, it decreases the need for consumers to carry cash. This leads to a decrease in the demand for money, which is represented by a leftward shift of the demand curve for money.

Implications of the Fed's Open-Market Purchase of U.S. Treasury Bills

An open-market purchase of U.S. Treasury bills by the Federal Reserve increases the money supply directly by injecting more money into the economy. This is usually aimed to reduce interest rates, which would increase the demand for money due to the lower opportunity cost of holding money. This moves people along the demand curve to the right for money, but does not shift the demand curve itself.

Key concepts

Interest Rates

When discussing economic principles, understanding the role of interest rates is fundamental. Interest rates effectively represent the cost of borrowing money, which is expressed as a percentage of the principal, the initial amount of money borrowed or invested. They are crucial in governing the flow of money within the economy.

A decrease in interest rates, as seen from a fall from 12% to 10%, decreases the opportunity cost of holding on to money rather than investing it. This encourages individuals and businesses to hold more cash because it will cost them less in terms of foregone interest. To visualize this, imagine you have the option to either keep $1000 in your pocket or deposit it in a savings account. If the interest rate decreases, the interest you’re giving up by not depositing the money is smaller, hence you might be more inclined to keep the cash handy.

With lower interest rates, we see a movement along the demand curve for money to the right, which means that at the same price levels, the quantity of money demanded increases. It's important to correlate this movement with real-world situations, such as lower interest rates typically leading to increased consumer spending and borrowing.

Liquidity Preference

The liquidity preference theory is a concept that seeks to explain the role of money as a liquid asset and the desire to hold cash. The term 'liquidity' refers to the convenience of having money available to purchase goods and services or to quickly convert assets into cash. It's the preference for how liquid — easily spent or accessed — one's assets are.

Seasonal shopping trends, such as the rise in shopping during the Thanksgiving holiday, provide a practical example of changes in liquidity preference. During this time, consumers’ preference for liquidity increases since they anticipate spending more money. Hence, they choose to hold more cash or keep their funds in more liquid forms, rather than in investments or long-term savings.

This change in habits causes a shift in the demand curve for money to the right, representing an increase in overall demand for liquid money at all interest rates. It is not just a movement along the curve because the cause is not related to interest rates, but to a change in liquidity needs.

Monetary Policy

In the dialogue about money and the economy, you cannot overlook the role of monetary policy, which is the process by which a central authority, like the Federal Reserve (the Fed) in the United States, manages the supply of money and interest rates to achieve macroeconomic objectives.

An example of a monetary policy action is the Fed engaging in an open-market purchase of U.S. Treasury bills. This move injects more money into the banking system, making additional funds available to lend. As a result, this can lead to lower interest rates, which, as discussed earlier, affect the opportunity cost of holding money. When the Fed injects money into the economy, it’s not directly changing people’s preferences or the money demand curve itself; rather, it's providing the impetus for a movement along the demand curve.

The impact of such policy measures on the demand for money is significant and can be used to steer the economy towards desired outcomes, such as stimulating growth during a recession or controlling inflation during economic booms. Understanding the intended and unintended consequences of changes in monetary policy is essential for comprehending the broader economic landscape.