Description                                  
The liquidity provided by cash vs. interest-bearing investments is examined in this presentation to discover optimal money balance for Max and for the macroeconomy as a whole. 

Customer #1: 
I'm really hungry... I could eat a bunch of burgers. 

Customer #2: 
Seven burgers....and four O'nuggets please. 

Customer #3: 
Mmmmmm.... I'm hungry. 

Customer #4: 
Five O'burgers please. 

Max: 
Talking to his friend. Hey... I'll buy you lunch. I just got a raise. 

Narrator: 
Max just got a raise, so he's got more money available to make transactions. His purchase illustrates the transaction's motive for money. 

Narrator: 
When Max, or households in general, receive income, they have two basic options; hold some in the form of money which does not earn interest and use the rest to purchase securities such as bonds or treasury bills that do earn interest. They choose between the liquidity provided by cash and demand deposit accounts and the interest income provided by securities. 

Narrator: 
The transactions motive is the primary motive for holding cash or a balance in a demand deposit account. It represents the transactions demand for money. Households would put all their money into interest bearing securities if they could liquidate their investment at any time and there were no costs associated with these transactions. But, in fact, there are transaction's costs and even if there weren't, there is a convenience factor in having a cash balance available between paychecks. 

Narrator: 
So how do households make the choice between interest and liquidity? To answer this, we assume that there are only two assets available to households: money and bonds. 

Narrator: 
We also assume that there is a mismatch between the timing of household income inflows and the timing of spending outflows. Economists refer to this process as the nonsynchronisation of income and spending. 

Narrator: 
We also assume that spending each month is exactly equal to income. 

Narrator: 
Finally, we assume that Max is a typical household. 

Narrator: 
With his raise, he's paid $2000 a month and deposits the entire amount into his checking account. He proceeds to spend all of his money, so that at the end of the month his balance is $0. If we calculate Max's average balance over the month by adding his beginning balance and his ending balance and dividing by two, it is exactly $1000. 

Narrator: 
During the first half of the month, more than half of Max's income rests idle in his non-interest-bearing checking account. So, suppose Max deposits only $1000 of his paycheck and buys a bond with the remainder. Max runs out of money halfway through the month. So, he sells the bond and has $1000 plus the interest he earned from the bond over the fifteen-day period. Max's average balance using this process is $500. By cutting his balance in half, he is able to purchase an interest-bearing asset for one half of the month and increase his total income.nbsp;

Narrator: 
Theoretically, Max can use this process to reduce his average balance so that he holds all of his money in bonds up to the very moment when he needs to make a purchase. Only then does he sell the bond and make the purchase. 

Narrator: 
This process would clearly be optimal for Max if there were no transaction's costs and Max would never hold any money, he would always hold interest-earning bonds. In practice, however, transaction's costs are significant, and at the same time, holding money has costs in terms of foregone interest. 

Narrator: 
To determine his optimal money balance, Max must weigh the cost of foregone interest against the transaction's costs. When the interest rate increases, his foregone interest income increases so it would become profitable for him to make more transfers from bonds to his checking account. 

Narrator: 
Turning from Max back to the macroeconomy, as the interest rate on bonds rises, money balances shrink. It is this process that helps to account for the downward sloping money demand curve with respect to the interest rate. 

Narrator: 
Also, firms have the same demands for money and the same tradeoffs in money management that households have. Firms receive cash from sales and must decide how to allocate this cash between liquid checking accounts that satisfy payroll and other transactions and interest-bearing accounts that earn more income. 

Narrator: 
Thus, the aggregate demand for money is the summation of the demand by households and by firms. The aggregate money demand curve shows the inverse relationship between the quantity of money demanded and the interest rate. Households and firms demand more money when the interest rate is low reflecting the low opportunity cost for holding cash. And, when the interest rate is high, households and firms invest their money and demand declines. 

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