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demand for money

Asked by kevineboue | Mar 11, 2008 | A Level > Economics > Homework
kevineboue asks:

discuss whether it is inevitable that the rise in prices will reduce the demand for money?

etutor answers:

This is a question about 'the demand for money' - or, in Keynesian terms, 'liquidity preference'. Assuming that money can be defined as notes, coins and current account bank deposits,. the key question is: how much will individuals seek to keep their wealth in the form of money (as defined above) rather than interest-earning assets such as deposit accounts and bonds, or shares or physical assets such as houses? The demand for money arises from three motives. Money is needed for the purpose of carrying out our daily transactions, while some wealth is likely to be kept in the form of money as a precaution against unexpected events. Economists describe these as the transactions demand and precautionary demand for money. However, there is also a speculative demand. If wealth is kept in the form of notes, coins or current accounts, little or no interest is received. By keeping wealth in assets such as bonds or shares a higher rate of return can be earned even though wealth holders must accept a higher degree of risk, since the asset price itself may fall, constituting a reduction in wealth. How much people choose to hold their wealth in the form of money will depend upon the rate of interest. If the rate of interest is high it will make sense to store wealth in assets such as deposit accounts. However, if the rate of interest is low, the opportunity cost of holding wealth in the form of notes, coins or current accounts is low. Therefore, people are more likely to hold their wealth in the form of money when interest rates are low and vice versa. Adding the transactions, precautionary and speculative motives for holding money together gives us the demand curve for money. The transactions and precautionary motives are generally seen as independent of interest rate changes, while the speculative motive is affected by changes in interest rates (or in bond prices, since an nicrease in bond prices by definition constitutes a fall in interest rates, and vice versa).

It is important to distinguish the demand for real money balances from nominal money demand. Real money demand is the number of units of purchasing power that the public wishes to hold in the form of money balances rather than some other form of wealth. So the demand for money in real terms refers to the amount of money demanded with a constant price level. If interest rates, real wealth and real GDP are unchanged, then, say, a doubling of the price level will leave the demand for REAL money balances unchanged, though would double the demand for NOMINAL balances. So the nominal demand for money balances (other things remaining equal) varies in proportion to the price level.

In looking at the effect of inflation, we are thus confined to considering its effect on the NOMINAL demand for money. A higher price level will increase the transactions demand for money, since more cash is now needed to buy more expensive goods and services. Since inflation is usually associated with greater uncertainty, it will increase the precautionary demand too. Assuming that inflation affects not only the prices of goods and services, but also the prices of assets such as housing, bonds and shares, it is likely that people will want to hold more of these appreciating assets and thus the speculative demand for money will fall; moreover, given that money earns little or no interest, its real value will fall and so it becomes less attractive to hold. The overall effect on the demand for money depends on whether the increase in demand for transactions and precautionary purposes outweighs the fall in demand for speculative purposes.

Expectations of future inflation are also significant. If inflation is generally expected to be higher in the future, people may bring forward their purchases of goods and services, and so the transactions (and precautionary) demand will rise. Higher inflation is normally associated with higher interest rates (to control it). Hence if interest rates are expected to rise, then bond prices are automatically expected to fall. So people, in order to avoid a capital loss, will switch out of such interest-earning assets into money, and hence the speculative demand for money will rise. Hence all component parts of the demand for money would be expected to increase in these circumstances.

I hope this is helpful.

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