Question

Explain how the following events will affect the demand for money according to the portfolio theories of money demand:

a. The economy experiences a business cycle contraction

b. Brokerage fees decline, making bond transactions cheaper.

c. The stock market crashes. (Hint: Consider both the increase in stock price volatility following a market crash and the decrease in wealth of stockholders.)

Short answer

a. When the economy faces a business cycle downturn, money demand rises.

b. Brokerage fees fall, making bond trades more affordable, leading to a rise in demand.

b. Stock market downturns will raise demand for money.

Step-by-step solution

Step 1. Define demand.

Demand refers to the quantity of a product that customers are capable and willing to buy at various prices throughout a particular time period.

Step 2. Explain how the given events will affect the demand for money according to the portfolio theories of money demand: 

a. The economy goes through a business cycle shrinkage: As the threat of alternative assets increases, so will their accessibility, so interest rates are predicted to decline, leading to a rise in monetary aggregates. It is important to note that even if wealth drops, the impact on economic growth will be minimal.

b. Brokerage fees fall, making bond transactions more affordable: Lower bond lender or borrower costs make the bond market increasingly liquid, raising demand for treasury bonds and, as a consequence, decreasing purchasing power.

c. Stock market crashes: A share price fall would increase volatility and consequently risk in shares, driving up demand for money. The decrease in the stock market would reduce wealth, but it will most likely have only a slight negative impact on money demand, leading to higher total money demand.