Changes In Real Money Demand

18.6 Money Demand

A change in the price level changes people’s real wealth. Suppose, for example, that your wealth includes $10,000 in a bond account. An increase in the price level would reduce the real value of this money, reduce your real wealth, and thus reduce your consumption. An Increase in Money Demand. An increase in real GDP, the price level, or transfer costs, for example, will increase the quantity of money demanded at any interest rate r, increasing the demand for money from D1 to D2. The quantity of money demanded at interest rate r rises from M to M′.

Learning Objective

Changes In Real Money Demand Will

Where M d stands for nominal demand for money and M d /P for demand for real money balances, W stands for wealth of the individuals, h for the proportion of human wealth to the total wealth held by the individuals, r m for rate of return or interest on money, r b for rate of interest on bonds, r e for rate of return on equities, P for the price. Second, real money demand increases, which causes excess demand in the money market. The economic agents therefore try to sell bonds, which causes the interest rate to increase, until equilibrium in the money market is restored. These changes in the money market are described by a shift along LM-curve to the right.

  1. Learn the determinants of money demand in an economy.

The demand for money represents the desire of households and businesses to hold assets in a form that can be easily exchanged for goods and services. Spendability (or liquidity) is the key aspect of money that distinguishes it from other types of assets. For this reason, the demand for money is sometimes called the demand for liquidity.

The demand for money is often broken into two distinct categories: the transactions demand and the speculative demand.

Transactions Demand for Money

The primary reason people hold money is because they expect to use it to buy something sometime soon. In other words, people expect to make transactions for goods or services. How much money a person holds onto should probably depend on the value of the transactions that are anticipated. Thus a person on vacation might demand more money than on a typical day. Wealthier people might also demand more money because their average daily expenditures are higher than the average person’s.

However, in this section we are interested not so much in an individual’s demand for money but rather in what determines the aggregate, economy-wide demand for money. Extrapolating from the individual to the group, we could conclude that the total value of all transactions in the economy during a period would influence the aggregate transactions demand for money. Gross domestic product (GDP), the value of all goods and services produced during the year, will influence the aggregate value of all transactions since all GDP produced will be purchased by someone during the year. GDP may underestimate the demand for money, though, since people will also need money to buy used goods, intermediate goods, and assets. Nonetheless, changes in GDP are very likely to affect transactions demand.

Anytime GDP rises, there will be a demand for more money to make the transactions necessary to buy the extra GDP. If GDP falls, then people demand less money for transactions.

The GDP that matters here is nominal GDP, meaning GDP measured in terms of the prices that currently prevail (GDP at current prices). Economists often break up GDP into a nominal component and a real component, where real GDP corresponds to a quantity of goods and services produced after eliminating any price level changes that have occurred since the price level base year. To convert nominal to real GDP, simply divide nominal GDP by the current U.S. price level (P$); thus

real GDP = nominal GDP/P$.

If we use the variable Y$ to represent real U.S. GDP and rearrange the equation, we can get

nominal GDP = P$Y$.

By rewriting in this way we can now indicate that since the transactions demand for money rises with an increase in nominal GDP, it will also rise with either an increase in the general price level or an increase in real GDP.

Thus if the amount of goods and services produced in the economy rises while the prices of all products remain the same, then total GDP will rise and people will demand more money to make the additional transactions. On the other hand, if the average prices of goods and services produced in the economy rise, then even if the economy produces no additional products, people will still demand more money to purchase the higher valued GDP, hence the demand for money to make transactions will rise.

Speculative Demand for Money

The second type of money demand arises by considering the opportunity cost of holding money. Recall that holding money is just one of many ways to hold value or wealth. Alternative opportunities include holding wealth in the form of savings deposits, certificate of deposits, mutual funds, stock, or even real estate. For many of these alternative assets interest payments, or at least a positive rate of return, may be obtained. Most assets considered money, such as coin and currency and most checking account deposits, do not pay any interest. If one does hold money in the form of a negotiable order of withdrawal (NOW) account, a checking account with interest, the interest earned on that deposit will almost surely be less than on a savings deposit at the same institution.

Thus to hold money implies giving up the opportunity of holding other assets that pay interest. The interest one gives up is the opportunity cost of holding money.

Changes In Real Money Demand Graph

Since holding money is costly—that is, there is an opportunity cost—people’s demand for money should be affected by changes in its cost. Since the interest rate on each person’s next best opportunity may differ across money holders, we can use the average interest rate (i$) in the economy as a proxy for the opportunity cost. It is likely that as average interest rates rise, the opportunity cost of holding money for all money holders will also rise, and vice versa. And as the cost of holding money rises, people should demand less money.

The intuition is straightforward, especially if we exaggerate the story. Suppose interest rates on time deposits suddenly increased to 50 percent per year (from a very low base). Such a high interest rate would undoubtedly lead individuals and businesses to reduce the amount of cash they hold, preferring instead to shift it into the high-interest-yielding time deposits. The same relationship is quite likely to hold even for much smaller changes in interest rates. This implies that as interest rates rise (fall), the demand for money will fall (rise). The speculative demand for money, then, simply relates to component of the money demand related to interest rate effects.

Key Takeaways

  • Anytime the gross domestic product (GDP) rises, there will be a demand for more money to make the transactions necessary to buy the extra GDP. If GDP falls, then people demand less money for transactions.
  • The interest one gives up is the opportunity cost of holding money.
  • As interest rates rise (fall), the demand for money will fall (rise).

Exercise

  1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”

    1. Of increase, decrease, or no change, the effect on the transactions demand for money when interest rates fall.
    2. Of increase, decrease, or no change, the effect on the transactions demand for money when GDP falls.
    3. Of increase, decrease, or no change, the effect on the speculative demand for money when GDP falls.
    4. Of increase, decrease, or no change, the effect on the speculative demand for money when interest rates fall.
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Let us make an in-depth study of the LM Curve:- 1. Subject-Matter of the LM Curve 2. The Slope and Position of the LM Curve.

Subject-Matter of the LM Curve:

The demand for real money balances is found simply by adding together the transactions demand for money and the asset demand for money.

As the transactions demand for real money balances is an increasing function of real income, the total demand for real money balances can be shown as a function of the real rate of interest that shifts to the right as real income is increased. This is shown in figure 14.3 (a). As real income increases from Y1 to Y2, the demand for real money balances shifts from LPY1 to LPY2 and so on as income increases in real terms through Y3 and Y4.

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Suppose that the economy is initially in an equilibrium position with real income as K3 and the real interest rate at r3. This equilibrium position for the money market is shown in Figure 14.3 (a). If conditions in the product market change, the level of real income being generated will change and equilibrium in the money market would be disturbed. For example, if real aggregate demand increases, real output from the product market will rise and the additional real income will increase demand for real money balances.

If this product market adjustment increases real income to Y4, the demand for real balances curve will shift to the right to LPy4 as shown in figure 14.3(a). The increased transaction demand for real money balances will generate an excess demand for real money balances at the old equilibrium rate of r3. This excess demand for real money balances will induce adjustment in the money market.

Fig. 14. (a) Equilibrium in the money market

Fig. 14.3 (b) Derivation of the LM curve

Changes In Real Money Demand Curve

The market real rate of interest will rise as individuals sell off some of their holdings of bonds and attempt to borrow the additional real money balances desired. The market real rate of interest will rise until the money market reaches the new equilibrium position at the real interest rate r4. Different equilibrium positions in the money market for various levels of real income are shown in figure 14.3(a)

The relationship between levels of real income and the corresponding equilibrium real interest rates in the money market is called the LM curve. For the real income level Y3 equilibrium between the demand for real money balances and the quantity of real balances supplied occurs at real interest rate r3. When real income increases to Y4 equilibrium in the money market occurs at real interest rate r4.

The equilibrium positions in the money market for a given supply of real money balances (that is, both a given price level and a given nominal money supply) and a constant anticipated rate of change in prices is shown as the LM curve in figure 14.3(b). The upward sloping nature of the LM curve is the result of the shifts in the demand for real money balance function as the level of real output increases.

At higher real income levels the demand for real money balances is greater. Thus, reduction of the real rate of interest is necessary to reduce the quantity of real balances demanded for asset purposes so as to bring about equality between supply and demand in the market.

The Demand Curve For Money

The liquidity trap segment of the liquidity preference curve (demand for real money balances curve) also shows up in the LM curve. If in fact there is a minimum expected level of real interest rates where the asset demand for real money balances is perfectly elastic with respect to the market real rate of interest, the LM curve also would be perfectly elastic in this region. For example, in Figure 14.3 (b) an increase in real income from Y1 to Y2 increases the demand for real money balances but this is not sufficient to induce a rise in the market real rate of interest. The same quantity of real balances demanded at the real income level of Y2 and the real interest rate of r1 would have been demanded at lower levels of real income.

The Slope and Position of the LM Curve:

The slope of the LM curve depends upon the income elasticity and the interest elasticity of the demand for money. Income-elasticity measures the responsiveness of the demand for money to changes in income while interest elasticity measures the responsiveness of the demand for money to changes in the rate of interest. The larger the income-elasticity, and the lower the interest-elasticity of the demand for money, the steeper the LM curve will be.

Changes In Real Money Demand Equation

In case the demand for money is relatively insensitive to the interest rate, the LM curve is nearly vertical. If the demand for money is very sensitive to the interest rate, then the LM curve is close to horizontal. In that case, a small change in the interest rate is accompanied by a large change in the level of income to maintain money-market equilibrium.

What Affects Money Demand

We know that the real money supply is held constant along the LM curve. It follows that the position of the curve depends upon the amount of real money supply available in the market. A change in the real money supply will shift the LM curve.

Let us consider the effect of an increase in real money supply as a result of which the money supply schedule shifts to the right. At the given level of income and hence with the given demand for real money balances, there is now an excess supply of money. To restore money market equilibrium at the initial level of income, the interest rate has to decline which means a downward shift of the LM curve. Another way of adjustment in the money market is to change the level of income.

In this case of the increase in money supply, the excess supply of money can be absorbed by increased demand for real balances arising out of the increased level of income induced by the fall in interest rate. When the level of income increases as a result of the fall in the rate of interest, the LM curve is shifted to the right. We can thus conclude that an increase in the supply of real money balances (MIP) leads to the rightward shift of the LM curve.

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