Page 312 - Krugmans Economics for AP Text Book_Neat

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Long-term Interest Rates
Long -term interest rates—rates on bonds or year CDs to rise sharply next year. If she puts bonds. If they expect short -term interest rates
loans that mature in several years—don’t nec- her funds in a one -year CD this year, she will be to rise, investors may buy short -term bonds
essarily move with short -term interest rates. able to reinvest the money at a much higher even if long -term bonds offer a higher interest
How is that possible? rate next year. And this could give her a two - rate. If they expect short -term interest rates to
Consider the case of Millie, who has already year rate of return that is higher than if she put fall, investors may buy long -term bonds even if
decided to place $1,000 in CDs for the next her funds into the two -year CD. For example, if short -term bonds offer a higher interest rate.
two years. However, she hasn’t decided the rate of interest on one -year CDs rises from In practice, long -term interest rates reflect
whether to put the money in a one -year CD, 4% this year to 8% next year, putting her funds the average expectation in the market about
at a 4% rate of interest, or a two -year CD, at a in a one -year CD will give her an annual rate of what’s going to happen to short -term rates in
5% rate of interest. return over the next two years of about 6%, bet- the future. When long -term rates are higher
You might think that the two -year CD is a ter than the 5% rate on two -year CDs. than short -term rates, as they were in 2008, the
clearly better deal—but it may not be. Suppose The same considerations apply to investors market is signaling that it expects short -term
that Millie expects the rate of interest on one - deciding between short -term and long -term rates to rise in the future.

rates on demand deposits and currency and the interest rate on CDs. These differ-
Long -term interest rates are interest ences declined sharply between June 2007 and June 2008. This reflects a general re-
rates on financial assets that mature a
number of years in the future. sult: the higher the short -term interest rate, the higher the opportunity cost of
holding money; the lower the short -term interest rate, the lower the opportunity cost
The money demand curve shows the of holding money.
relationship between the quantity of money
demanded and the interest rate. Table 28.2 contains only short -term interest rates. At any given moment, long -
term interest rates—interest rates on financial assets that mature, or come due, a
number of years into the future—may be different from short -term interest rates. The
difference between short -term and long -term interest rates is sometimes important as
a practical matter. Moreover, it’s short -term rates rather than long -term rates that af-
fect money demand, because the decision to hold money involves trading off the con-
venience of holding cash versus the payoff from holding assets that mature in the
short -term—a year or less. For our current purposes, however, it’s useful to ignore the
distinction between short -term and long -term rates and assume that there is only one
interest rate.

The Money Demand Curve
Because the overall level of interest rates affects the opportunity cost of holding money,
the quantity of money individuals and firms want to hold is, other things equal, nega-
tively related to the interest rate. In Figure 28.1, the horizontal axis shows the quantity
of money demanded and the vertical axis shows the nominal interest rate, r, which you
can think of as a representative short -term interest rate such as the rate on one -month
CDs. Why do we place the nominal interest rate and not the real interest rate on the
vertical axis? Because the opportunity cost of holding money includes both the real re-
turn that could be earned on a bank deposit and the erosion in purchasing power
caused by inflation. The nominal interest rate includes both the forgone real return
and the expected loss due to inflation. Hence, r in Figure 28.1 and all subsequent fig-
ures is the nominal interest rate.
The relationship between the interest rate and the quantity of money demanded by
the public is illustrated by the money demand curve, MD, in Figure 28.1. The money
demand curve slopes downward because, other things equal, a higher interest rate in-
creases the opportunity cost of holding money, leading the public to reduce the quan-
tity of money it demands. For example, if the interest rate is very low—say, 1%—the

270 section 5 The Financial Sector