(a) The demand for money balances is a demand for real balances—that is, the demand for nominal balances rises in proportion to changes in the price level. Classical and Keynesian Theories: Output, Employment, Equilibrium in a Perfectly Competitive Market, Labor Demand and Supply in a Perfectly Competitive Market. A household with an income of $10,000 per month is likely to demand a larger quantity of money than a household with an income of $1,000 per month. The relationship between interest rates and the quantity of money demanded is an application of the law of demand. That suggests that high bond prices—low interest rates—would increase the quantity of money held for speculative purposes. These robust determinants are found to be unit root variables. Firms, too, must determine how to manage their earnings and expenditures. Household attitudes toward risk are another aspect of preferences that affect money demand. Rather than facing the difference of $10 versus $7.50 in interest earnings used in our household example, this small firm would face a difference of $2,500 per month ($10,000 versus $7,500). The Determinants of the Demand for Money: Keynes made the demand for money a function of two variables, namely income (Y) 4 and the rate of interest (r). Key (related) factors in an analysis of debt sustainability should include: the demand for base money (or high powered money); projected fiscal balance; the real interest rate; and the rate of income growth. Bonds, treasury bills or treasury certificates are not included in the theory of the demand for money. A rise in inflation causes a rise in the nominal money demand but real money demand stays constant. The higher the price level, the more money balances a person has to hold in order to purchase a given quantity of goods. The higher the price level, the more money is required to purchase a given quantity of goods and services. Money held for precautionary purposes may include checking account balances kept for possible home repairs or health-care needs. To try to get the money, they will sell their only other asset—bonds— and the price will fall. The demand for money is affected by several factors, including the level of income, interest rates, and inflation as well as uncertainty about the future. For a given level of expenditures, reducing the quantity of money demanded requires more frequent transfers between nonmoney and money deposits. Money is essentially a good, so as such is ruled by the axioms of supply and demand. With this strategy, the household demands a quantity of money of $750. The demand for money is affected by several factors such as income levels, interest rates, price levels (inflation), and uncertainty. Of course, a good reason to keep money with you (or on your debit account) is the relevance of money as the medium of exchange.. A standard money demand example. Such a curve is shown in Figure 10.7 “The Demand Curve for Money.” An increase in the interest rate reduces the quantity of money demanded. United Kingdom, money is endogenous - the Bank supplies base money on demand at its prevailing interest rate, and broad money is created by the banking system’ (King, 1994 p.264). The money held for the purchase of goods and services may be for everyday transactions such as buying groceries or paying the rent, or it may be kept on hand for contingencies such as having the funds available to pay to have the car fixed or to pay for a trip to the doctor. This is since money, in the economic sense, covers the broadest array of needs and the demand for it has previously only been analysed in terms of its functions. According to Keynes, the demand for money is split up into three types – Transactionary, Precautionary and Speculative. The disadvantage of the bond fund, of course, is that it requires more attention—$1,000 must be transferred from the fund twice each month. If they expect bond prices to rise, they will reduce their demand for money. It functions based on the general acceptance of its value within a governmental economy and … One way the household could manage this spending would be to leave the money in a checking account, which we will assume pays zero interest. Of course, the bond fund strategy we have examined here is just one of many. Answer the question(s) below to see how well you understand the topics covered in the previous section. There is more than one interest rate in an economy and even more than one interest rate on government-issued … The demand for money is a demand for real cash balances because people hold money for the purpose of buying goods and services. We can exchange it for any commodity or service and so people prefer to hold on to their cash. Toward the end of the great German hyperinflation of the early 1920s, prices were doubling as often as three times a day. An increase in real GDP increases incomes throughout the economy. Fiscal and Monetary Policy. And so one of the most important functions of money. Removing #book# The household could begin each month with $1,500 in the checking account and $1,500 in the bond fund, transferring $1,500 to the checking account midway through the month. Of course, money is money. This paper takes the needs for money from humanist psychology, namely the Theory of Motivation by Maslow, and relates these needs to the functions of Explain with the aid of a graph, the impact of a cut in interest rate on the demand for money. BEL AIR, MD — The Harford Mall has changed its hours, staying open until 8 p.m. Monday to Saturday. Unexpected expenses, such as medical or car repair bills, often require immediate payment. Money is a liquid asset used in the settlement of transactions. Keynes’s theory argued that the interest rate in the demand for money is affected by supply and demand (Intelligent Economist, 2018). Start studying MacroEconomics 16.1 The Demand for Money. When interest rates fall, people hold more money. The money demand curve slopes downward because as the value of money decreases, consumers are forced to carry more money to make purchases because goods and services cost more money. The speculative demand for money is based on expectations about bond prices. A price for any good is the amount of money it takes to get that good. b.medium of exchange. speculative demand for money the demand for MONEY balances that are held in highly liquid form in the hope of taking advantage of bargains in the form of low-priced BONDS or real ASSETS.. (Source: Moneycontrol) Demand for Money. Some people place a high value on having a considerable amount of money on hand. They will therefore increase the quantity of money they demand. (1981) ‘Demand for money in open economies’, Journal of Monetary Economics, Vol.7, No.1, pp.69-83. If people expect bond prices to fall, for example, they will sell their bonds, exchanging them for money. Question. http://2012books.lardbucket.org/books/macroeconomics-principles-v1.0/s13-02-demand-supply-and-equilibrium-.html, CC BY-NC-SA: Attribution-NonCommercial-ShareAlike. Demand forecasting isn’t just about perfecting a business’s production schedule to supply demand, but it should also help price products based on the demand. The transactions motive for demanding money arises from the fact that most transactions involve an exchange of money. We have seen that the transactions, precautionary, and speculative demands for money vary negatively with the interest rate. Learn vocabulary, terms, and more with flashcards, games, and other study tools. That is, transaction demand for money is a measure of how much of a certain currency people need in order to buy the goods and services they use. The money people hold for contingencies represents their precautionary demand for money. The creation of savings plans, which began in the 1970s and 1980s, that allowed easy transfer of funds between interest-earning assets and checkable deposits tended to reduce the demand for money. Similarly, expectations of higher inflation presage a greater depreciation in the purchasing power of money and therefore lessen the speculative motive for demanding money. 49334_14_ch14_p291-310.indd 292 49334_14_ch14_p291-310.indd 292 12/7/12 11:10 AM 12/7/12 11:10 AM 293 PART 5 you’ll earn $6 a year. The quantity of money demanded at interest rate r rises from M to M′. 3.4 Money Demand as a Function of the Interest Rate So far, we have two reasons why the amount of money that people wish to hold might vary with the interest rate. Being a Cambridge economist, Keynes retained the influence of the Cambridge approach to the demand for money under which M d is hypothesised to be a function of Y. An increase in the spread between rates on money deposits and the interest rate in the bond market reduces the quantity of money demanded; a reduction in the spread increases the quantity of money demanded. Its downward slope expresses the negative relationship between the quantity of money demanded and the interest rate. This strategy requires one less transfer, but it also generates less interest—$7.50 (= $1,500 × 0.01 × 1/2). Among the most important variables that can shift the demand for money are the level of income and real GDP, the price level, expectations, transfer costs, and preferences. Interest Rates. After 10 days, the money in the checking account is exhausted, and the household withdraws another $1,000 from the bond fund for the next 10 days. Assume the bond fund pays 1% interest per month, or an annual interest rate of 12.7%. To see why, suppose a household earns and spends $3,000 per month. We will think of the demand for money as a curve that represents the outcomes of choices between the greater liquidity of money deposits and the higher interest rates that can be earned by holding a bond fund. Similarly, when the value of money is high, consumers demand little money because goods and services can be purchased for low prices. Holding bonds is one alternative to holding money, so these same expectations can affect the demand for money. People with higher incomes keep more liquid money at hand to meet their need-based transactions. The demand for money is the desired holding of financial assets in the form of money, that is, cash or bank deposits. Because of this, the Federal Reserve moved away from using the money supply as its main policy indicator, and moved to interest rates as its main monetary policy indicator. Illustrate your answer graphically. One reason people hold their assets as money is so that they can purchase goods and services. Functions of Money, Next All other things unchanged, if people expect bond prices to fall, they will increase their demand for money. Want to see this answer and more? Understanding the market and potential opportunities, businesses can grow, formulate competitive pricing , employ the right marketing strategies, and invest in their growth. Demand forecasting can help you spend less money on both inventory purchase orders and warehousing as the more inventory you carry, ... but it should also help price products based on the demand. Demand of Money. Transactions motive. Ch. The quantity of money households want to hold varies according to their income and the interest rate; different average quantities of money held can satisfy their transactions and precautionary demands for money. Some money deposits, such as savings accounts and money market deposit accounts, pay interest. All rights reserved. The first theory to answer these questions known as the Keynesian theory of demand for money is based on a model called the regressive expectations model. With this strategy, the household has an average daily balance of $500, which is the quantity of money it demands. Hence, as income or GDP rises, the transactions demand for money also rises. For others, this may not be important. Use this quiz to check your understanding and decide whether to (1) study the previous section further or (2) move on to the next section. If prices rise very rapidly and people expect them to continue rising, people are likely to try to reduce the amount of money they hold, knowing that it will fall in value as it sits in their wallets or their bank accounts. • Demand for money is a question of how much of wealth individuals wish to hold in the form of money at any point in time. - Interest Rates have no effect of the demand for $ - M x V = P x Y - Movement in the price level result solely from changes in the quantity of $ Demand on high-quality software talks about the performance expectations people have for the software. Being a Cambridge economist, Keynes retained the influence of the Cambridge approach to the demand for money under which M d is hypothesised to be a function of Y. A change in those “other determinants” will shift the demand for money. Let us call this money management strategy the “bond fund approach.”. Expert Answer . If they expect bond prices to rise, they will reduce their demand for money. • So people choose a certain amount of real balances based on the interest rate, and income: 16. It spends an equal amount of money each day. from your Reading List will also remove any If interest rates are expected to rise, the opportunity cost of holding money will become greater, which in turn diminishes the speculative motive for demanding money. A money deposit, such as a savings deposit, might earn a lower yield, but it is a safe yield. Bondholders enjoy gains when bond prices rise and suffer losses when bond prices fall. An individual's demand for money is then based on the costs and benefits of holding money. In deciding how much money to hold, people make a choice about how to hold their wealth. Q.2.1 The theory of the demand for money is based on John Keynes’ Liquidity Preference Theory. Expectations about future price levels also affect the demand for money. 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