Chapter 16, Problem 1DQ

To determine

Determinants of demand and it relevance to the equilibrium position.

Explanation of Solution

Transaction demand for money is the need for money to meet the day-to-day expenditures. It varies directly with nominal Gross Domestic Product (nominal GDP). If the demand for goods and services is greater, then the transaction demand for money would be larger and vice versa. Transaction demand for money is independent of the interest rate. Hence, the main determinant of Transaction demand for money is the level of nominal GDP.

Asset demand for money refers to the desire of public to hold money in the form of financial assets, such as stocks, bonds and so forth. If the interest rate is greater, then people would be interested to save more thereby the asset demand for money would be lower and vice versa. Thus interest rate is the major determinant of the asset demand for money.

In figure -1, the horizontal axis measures quantity demanded and vertical axis measures the interest rate. The transaction demand for money, represented as D_t, is dependent only on the nominal GDP and has little effect by interest rate, so graphically it is depicted by a vertical line.

The asset demand for money, represented as D_a in the figure has an inverse relation with the interest rate since it involves in the opportunity cost in holding currency and checkable deposits that heeds no interest or have very low interest rates. Hence, asset demand for money is depicted as a downward slope.

The Total Money demand is the sum of Transaction demand and Asset demand for money $\left(Dm=Da+Dt\right)$. Thus the combination has the same downward slope as the asset demand for money.

Figure- 2 depicts the equilibrium market, with quantity demanded and supplied measured in the horizontal axis and interest rate in the vertical axis.

The Monetary Authority (usually, the Central Bank of a country) decides on the Money Supply which is unaffected by the decisions that holds money for transaction or as financial asset. The Money Supply (S_m) is depicted by a vertical straight line which is independent of the rate of interest.

The Total Money demand (D_m) depends on the level of income and interest rate. It can be depicted as a linear function of income and interest rate. Demand for money varies directly with levels of income and inversely with the interest rate and slopes downward.

D_m = aY – bi

A money market is in equilibrium when the Demand for money equals the Supply of money.

D_m = S_m

The interest rate at which equilibrium is made is the equilibrium interest rate (i_e). Thus i_e is determined at the point where Dm = S_m.

Let’s now illustrate the effect on equilibrium interest rate due to an increase in the total demand for money.

In Figure -3, the horizontal axis measures the quantity of money demanded and supplied and vertical axis represents the interest rate. When the Total money demand increases (shifts to right from D_M to D_M1) with money supply (S_M) remaining constant, the equilibrium interest rate goes up from i_e to i_e*.

As the money demand increases, the previous interest rate is no longer sustainable because when the demand for money increases it exceeds the supply of money at the previous interest rate. This limits the money available to borrowers or creditors. Also there would be an upward pressure on the interest rate. Thus previous interest rate is no longer maintainable.

Economics Concept Introduction

Concept Introduction:

Transaction demand for money: It refers to that amount of money required by individuals or firms to finance their current transaction or forthcoming expenditure.

Asset demand for money: It is the extent to which, people hold money in the form of asset.

Total Money demand: It refers to the desire of individuals or firms to hold money in the form of both financial assets and for transactions at each possible interest rate.

Equilibrium Interest rate: It is the point in which demand for money equals with the supply of money.