Question

What is the basic determinant of \((a)\) the transactions demand and \((b)\) the asset demand for money? Explain how these two demands can be combined graphically to determine total money demand. How is the equilibrium interest rate in the money market determined? Use a graph to show the effect of an increase in the total demand for money on the equilibrium interest rate (no change in money supply). Use your general knowledge of equilibrium prices to explain why the previous interest rate is no longer sustainable.

Short answer

Transactions demand is determined by nominal GDP; asset demand by interest rates. Total demand curve includes both, intersecting with money supply to set interest rates. Increased demand shifts curve right, raising rates.

Step-by-step solution

Understanding Transactions Demand

The transactions demand for money refers to the need to hold cash for everyday transactions and payments. This is mainly influenced by the nominal GDP, where if the GDP increases, the transactions demand for money also increases because people require more money to buy goods and services.

Understanding Asset Demand

The asset demand for money arises from the desire to hold money as a store of value rather than investing it in financial assets. This demand is inversely related to the interest rate: as interest rates decrease, people prefer holding money rather than investing in lower-yielding assets.

Combining Money Demands

The total demand for money (MD) is the sum of transactions demand and asset demand. It can be graphically represented by placing the total money demand on the vertical axis (interest rate) and the quantity of money on the horizontal axis. The graph shows a downward-sloping MD curve because as the interest rate decreases, the cost of holding onto money decreases, thus increasing total money demand.

Equilibrium Interest Rate

The equilibrium interest rate in the money market is determined at the intersection of the money supply (MS) curve (which is typically vertical) and the total money demand (MD) curve. At this point, the quantity of money demanded is equal to the quantity of money supplied.

Effect of Increased Total Demand for Money

If there is an increase in the total demand for money, the MD curve shifts to the right. Given a constant money supply (MS), this shift leads to a higher equilibrium interest rate because more people want to hold money, creating upward pressure on the interest rate until a new equilibrium is reached.

Why Previous Interest Rate is Unsustainable

If the interest rate remains at its previous level after an increase in money demand, it is unsustainable because the quantity of money demanded would exceed the quantity supplied, leading to excess demand. Thus, in order to reach equilibrium, the interest rate must rise until the quantity of money demanded equals the quantity supplied.

Key concepts

Transactions Demand

Transactions demand for money is a fundamental component of money demand. It represents the amount of money people decide to hold in liquid form to manage their day-to-day expenses. Think of it like your wallet money, used for buying groceries, paying bills, or engaging in various other routine transactions.
This kind of demand is heavily influenced by the nominal GDP, which reflects the total economic activity of a country. Why? Because when the GDP increases, indicating a rise in the production of goods and services, individuals and businesses require more money to facilitate these increased transactions.
More economic activity means more exchanges, and hence a higher transactions demand for money.

Asset Demand

Asset demand for money involves holding cash for potential future investments or as a safeguard against financial uncertainty. It is essentially money held as a store of value, rather than for immediate transaction purposes.
Unlike transactions demand, asset demand is inversely related to interest rates. Here's why: when interest rates are low, people often prefer to hold onto cash because the benefits of parking money in interest-bearing assets are reduced.
This makes money more attractive as a store of value. Conversely, when interest rates are high, individuals are likely to invest in bonds or savings accounts to earn returns, thus reducing their asset demand for money.

Equilibrium Interest Rate

The equilibrium interest rate in the money market is like the balance point where money supply meets money demand. Imagine a market where the money supply curve, which often stays vertical, intersects with the money demand curve. This intersection marks the equilibrium interest rate.
At this sweet spot, the quantity of money that people wish to hold (demand) equals the quantity of money available (supply). If either the money demand or supply changes, the equilibrium interest rate will adjust to maintain balance.
Equilibrium ensures that the market doesn't face a surplus of money (which could lead to inflation) or a shortage (which could lead to economic stagnation).

Money Market

The money market is where all the action between money demand and money supply occurs. Imagine it as a bustling marketplace, but instead of tomatoes and cucumbers, it's money that people are demanding or supplying.
This market helps in determining interest rates and liquidity in the economy. The supply side in the money market is typically controlled by monetary authorities or central banks and is depicted by a vertical line, as it remains fixed irrespective of the interest rate for the short term.
Meanwhile, the demand side consists of the total demand for money, comprising both transactions and asset demands. This creates a dynamic interplay where the market settles on an interest rate that equilibrates supply and demand.

Nominal GDP

Nominal GDP is crucial in understanding the transactions demand for money. It represents the total value of all goods and services produced in an economy without adjusting for inflation.
Because it reflects current prices and quantities produced, an increase in nominal GDP typically means more economic activities are happening. For each increase in the overall level of transactions, a corresponding increase in money demand is necessary.

• If the nominal GDP rises, more transactions take place, requiring more money to facilitate these exchanges.
• Conversely, if nominal GDP falls, fewer goods and services are exchanged, thus lowering the transactions demand for money.

In this way, nominal GDP provides a snapshot of economic vitality and plays a pivotal role in shaping money demand directly tied to transactions.