Money Demand
What is Money Demand?
Money demand is the amount of wealth people choose to hold as money rather than in interest-bearing assets.
It slopes downward against the nominal interest rate, which is the opportunity cost of holding money. People hold money for transactions and as a precaution. Money demand shifts with the price level and real GDP.
Money Demand: a worked example
Let money demand in a hypothetical economy be Md = 800 - 20i, with Md in billions of dollars and i the nominal interest rate in percent. At i = 10 the quantity demanded is 800 - 20(10) = $600 billion. At i = 5 the quantity demanded is 800 - 20(5) = $700 billion, so a 5 point drop in the rate raises money holdings by $100 billion. The logic is opportunity cost: keeping $2,000 in a wallet rather than a bond paying 5% gives up 0.05 x $2,000 = $100 of interest a year, and at 10% the sacrifice doubles to $200. Now let real GDP rise, adding $60 billion of money demand at every rate. The curve shifts right to Md = 860 - 20i, and at i = 10 the quantity demanded becomes $660 billion.
The mistake students make with money demand
The classic error is shifting the money demand curve when the interest rate changes. A rate change moves you along a fixed curve, because that curve already reports quantity demanded at every rate. Only the price level, real GDP, or a change in payment technology shifts it. The second error is labeling the vertical axis with the real interest rate. Money demand is graphed against the nominal rate, since the nominal rate measures the full interest a holder gives up by sitting on cash.
Money Demand questions
Why does the money demand curve slope downward?
Holding money means giving up the interest a bond would pay, so the nominal interest rate is the opportunity cost of holding money. When the rate climbs to 10%, keeping $2,000 in cash sacrifices $200 a year and people economize on cash. When the rate falls to 5% the sacrifice halves and they hold more. Higher rates therefore pair with smaller money holdings, which draws the curve downward from left to right.
What shifts the money demand curve?
Money demand shifts when the price level changes, when real GDP changes, or when payment technology changes how much cash transactions require. Higher prices or greater output mean more dollars are needed for the same volume of trade, which shifts the curve right. A shift adds the same amount at every interest rate, so demand of 800 - 20i becomes 860 - 20i once demand grows by $60 billion.
Is money demand graphed against the nominal or the real interest rate?
Money demand uses the nominal interest rate on the vertical axis. Cash pays no interest at all, so what a holder gives up is the full nominal return available on bonds rather than the inflation adjusted return. The loanable funds market is the graph that uses the real interest rate. Mixing up the two axes is a common way to lose points on a free response question.
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