Lesson 5 of 19
The demand for money refers to the total amount of wealth held by the household and companies. The demand for money is affected by several factors such as income levels, interest rates, price levels (inflation), and uncertainty.
The impact of these factors on the demand for money is explained in terms of the three primary reasons to hold money. The three reasons are:
Transactions: This is the money needed for fulfilling transactions. As the total number and size of transactions increases in an economy, the transaction demand for money also increases.
Precautionary: This is the money needed for uncertain future needs, for example, unexpected medical expenses. The precautionary demand for money increases as the size of economy increases.
Speculative: People also hold money for speculative purposes so that they can take advantage of investment opportunities in the future. If the current returns on financial products are high, people will rather invest than hold money with a speculative motive. We can say that the demand for money for speculative motive increases with the increase in perceived risk in other financial instruments.
There is an inverse relationship between the short-term interest rates and the demand for money that households and firms want to hold. If the interest rates are low, the demand for money is high and if the interest rates are high, the demand for money is low. This is because as interest rates increase, the opportunity cost of holding money increases, and people will be better off by investing in other financial instruments than holding money.
The supply of money in an economy is controlled by its central bank, for example, Fed in the US. The Fed may change the money supply by using open market operations or by changing reserve requirements.
Demand and Supply Curve
The demand and supply curve for money can be represented as follows:
As you can see, the money supply curve is completely inelastic. The money demand curve is downward sloping, i.e., the demand for holding money increases with decrease in interest rates.
The short-term interest rate (i) is determined by the equilibrium of the supply and demand for money. If the interest rates are above the equilibrium, there is excess supply of money. This means the households and firms are holding more money and they will purchase securities to lower their money balances. This will lead to an increase in security prices and a drop in interest rates. Similarly, if interest rates are lower than the equilibrium rate, there is excess demand for money and people desire to hold money than they actually have. To do so, firms and households will sell securities, which will decrease the security prices and increase the interest rates.
The central bank can change the money supply, which will influence the interest rates. An increase in money supply will create excess supply, which will put a downward pressure on interest rates.