Question

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

Short answer

The basic determinant of transaction demand is the nominal GDP, and asset demand is the interest rate. The transaction-demand curve is vertical as it depends on the nominal GDP, and the asset-demand curve is downward sloping as it is inversely related to the interest rate.

This is how market demand is determined.

This is how the equilibrium rate of interest is determined.

Step-by-step solution

Step 1. Graph depicting the total money demand

The graph given above shows the interest rates on the y-axis and the amount of money demanded on the x-axis. The total money demand is the amalgamation of the transaction demand of money, which is vertical, and asset demand for money, which is downward sloping.

The total demand for money is also downward sloping as the transaction demand is vertical, which means that there is no change due to changes in interest rates as it depends on the nominal GDP. Therefore, the total demand takes the shape of the asset demand.

Step 2. Graph depicting the determination of equilibrium interest rate and effect on this rate due to increased demand

In the graph given above, the interest rate is depicted on the y-axis, and the amount of money demand and supply is depicted on the x-axis. As the supply of money is assumed to be constant, the curve, Sm, is vertical, and the Dm, that is, the demand for money curve, is downward sloping. The equilibrium interest rate is determined where these two are equal such that, on point E, interest rate I is determined.

Suppose there is an increase in demand for money due to this, and the demand curve will shift to the right. As the supply of money is constant, new interest rates are determined at L1 where demand and supply are equal.

Step 3. Reason for the previous interest rates being unsustainable

The previous interest rates, represented by I, are no longer sustainable after the demand for money increases as the supply of money is constant. If the demand keeps on increasing, it will be met. Therefore, the interest rate needs to increase to reduce the demand.