Question

People tend to hold more money as (LO4) a) incomes rise and credit availability rises b) incomes fall and credit availability falls c) incomes rise and credit availability falls d) incomes fall and credit availability rises

Short answer

The short answer is: (c) incomes rise and credit availability falls. This is because when incomes rise, people tend to hold more money to spend or invest. Additionally, when credit availability falls, borrowing becomes more difficult, so people might prefer to hold more money, leading to an increase in money demand.

Step-by-step solution

Understand the Concepts

In monetary economics, people's desire to hold money or money demand is affected by several factors. Two of these factors are income and credit availability. Income refers to the earnings of people while credit availability refers to how easy or difficult it is to borrow money.

Interpret the Options

Now let's examine the four options: a) If incomes rise and credit availability rises, people have more money and they can also easily borrow more. In the short term, they may hold more money to spend or invest. However, if borrowing becomes very easy, people might opt to borrow more instead of holding money, which could decrease money demand. b) When incomes fall and credit availability falls, people have less money and they find it hard to borrow more. This could lead to increased money-saving tendencies thus increasing money demand. c) If incomes rise but credit availability falls, people have more money, but face difficulties in borrowing. In this case, they might keep more cash because getting credit is hard. This could increase the demand for money. d) If incomes fall while credit availability rises, people would have less money but they can borrow much more easily. They might be more likely to borrow and spend, which could decrease the demand for money.

Select the Best Answer

The best answer would be (c) incomes rise and credit availability falls. This is because when incomes rise, people usually tend to hold more money because they have more to spend or invest. When credit availability falls, people would find it harder to borrow, so they might prefer to hold more money. This would lead to an increase in money demand.

Key concepts

Monetary Economics and Money Demand

Delving into the realms of monetary economics, where the intricacies of currency flow and financial stability play a critical role, we encounter the concept of money demand. Money demand is fundamentally the amount of money that households and businesses desire to hold at any given time. This concept is pivotal as it influences central banking decisions and, consequently, the overall economy.

Imagine holding money as keeping a reserve for purchases, investments, and unforeseeable needs—a form of financial security. Factors influencing money demand are diverse, including income levels, interest rates, and the ease of obtaining credit. The more money people earn, the greater their purchasing power, which leads to an increased desire to hold money for potential expenses. Similarly, when interest rates are low, holding cash becomes more attractive compared to saving in banks with meager returns. In understanding monetary economics, one recognizes that individuals strike a balance between the immediate accessibility of cash and the potential gains through other financial channels.

Income Effect on Money Demand

When discussing the income effect, envision people's tendencies to adjust their financial holdings based on changes in their earnings. An increase in income boosts the capacity for both spending and saving, resulting in a heightened demand for money as a transaction medium and a safety net.

Understanding the income effect clarifies why those with rising incomes may seek to hold more money. They foresee more transactions in their future, whether for goods, services, or investments, and need the liquidity to cover these. This effect extends to various income levels, from minimum wage workers to affluent executives. All experience the impact of income fluctuation on their monetary choices. Therefore, in a scenario where incomes rise, regardless of other economic factors, the initial reaction often increases money demand, which directly links to the increased capacity and intent to engage economically.

Credit Availability's Influence on Money Demand

Credit availability can be likened to a doorway to financial resources beyond one's immediate reserves. When this doorway widens, with banks willing to lend more generously and at favorable terms, the reliance on personal reserves of cash may diminish. Conversely, when this doorway narrows, people may clutch their cash tighter for fear of being unable to borrow when needed.

From the steps of interpreting money demand, it is evident that enhanced credit availability can have a countervailing impact on the desire to hold money. With plentiful and easy credit, individuals might feel less need to maintain large cash balances, knowing they have the backing of credit lines for necessary expenses. On the flip side, when credit is scarce or difficult to attain, individuals may raise their cash holdings as a precaution against financial uncertainty. Thus, credit availability operates as a pivotal dial regulating the flow of money people deem necessary to keep on hand.