Page 311 - Krugmans Economics for AP Text Book_Neat

Table 28.1 illustrates the opportunity cost of holding money in a table 28.1
specific month, June 2007. The first row shows the interest rate on
one -month certificates of deposit—that is, the interest rate individ-
Selected Interest Rates, June 2007
uals could get if they were willing to tie their funds up for one
month. In June 2007, one -month CDs yielded 5.30%. The second One - month CDs 5.30%
row shows the interest rate on interest -bearing bank accounts Interest - bearing demand deposits 2.478 Section 5 The Financial Sector
(specifically, those included in M1). Funds in these accounts were
Currency 0
more accessible than those in CDs, but the price of that conven-
ience was a much lower interest rate, only 2.478%. Finally, the last Source: Federal Reserve Bank of St. Louis.
row shows the interest rate on currency—cash in your wallet—which
was, of course, zero.
Table 28.1 shows the opportunity cost of holding money at one point in time, but
the opportunity cost of holding money changes when the overall level of interest rates
changes. Specifically, when the overall level of interest rates falls, the opportunity cost
of holding money falls, too.
Table 28.2 illustrates this point by showing how selected interest rates changed
between June 2007 and June 2008, a period when the Federal Reserve was slashing
rates in an effort to fight off recession. Between June 2007 and June 2008, the federal
funds rate, which is the rate the Fed controls most directly, fell by 3.25 percentage
points. The interest rate on one -month CDs fell almost as much, 2.8 percentage
points. That’s not an accident: all short -term interest rates—rates on financial as-
sets that come due, or mature, within less than a year—tend to move together, with
rare exceptions. The reason short -term interest rates tend to move together is that
CDs and other short -term assets (like one-month and three-month U.S. Treasury
bills) are in effect competing for the same business. Any short -term asset that offers a
lower -than -average interest rate will be sold by investors, who will move their wealth
into a higher -yielding short -term asset. The selling of the asset, in turn, forces its
interest rate up because investors must be rewarded with a higher rate in order to in-
duce 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 willing buyers. So interest rates on short -term financial assets
tend to be roughly the same because no asset will consistently offer a higher -than -
average or a lower -than -average interest rate.
But as short -term interest rates fell between June 2007 and June 2008, the interest
rates on money didn’t fall by the same amount. The interest rate on currency, of
course, remained at zero. The interest rate paid on demand deposits did fall, but by Short -term interest rates are the interest
much less than short -term interest rates. As a result, the opportunity cost of holding rates on financial assets that mature within
money fell. The last two rows of Table 28.2 show the differences between the interest less than a year.

table 28.2

Interest Rates and the Opportunity Cost of Holding Money

June 2007 June 2008
Federal funds rate 5.25% 2.00%
One - month certificates of deposit (CD) 5.30 2.50
Interest-bearing demand deposits 2.773 1.353
Currency 0 0
CDs minus interest - bearing demand deposits 2.527 1.147
CDs minus currency 5.30 2.50
Source: Federal Reserve Bank of St. Louis.

module 28 The Money Market 269