Download The transactions demand for money

Demand for Money
Purchasing power; the amount of goods and
services a unit of money (dollar) will buy. When
money loses its purchasing power, it loses its role as
money.
An excessive increase in the money supply will
decrease the purchasing power of each dollar.
A dollar’s purchasing power also varies inversely
with the price level.
When the consumer price index or “cost-of-living”
index goes up, the value of the dollar goes down.
Value of Money
Prices
As price levels increase the value of the dollar
decreases, causing our demand for M1 money to
increase. Since it cost more to buy the G/S that we
need, we demand more money to carry out those
transactions.
This is called the demand for transactional funds
(Dt).
Value of Dollar = (1/PL) X 100
The demand that the economy has for transactional funds can be
illustrated in the model below.
Transactions Demand Model
RIR
10
7.5
5
2.5
Dt
A gift for Mrs. Walton
0
0
50 100 150 200 250 300
Qm (held as M1)
The demand curve is a vertical line because it is not affected by a
change in IR.
Our demand for money is determined by nominal GDP. The larger
the economy the more money we demand for transactions.
10
7.5
5
2.5
0
Dt
0
50 100 150 200 250 300
The transactions demand for money varies directly with
nominal GDP. So there is a direct relationship between
GDP and the publics demand for dollars (Qm held as M1).
10
7.5
5
2.5
0
Dt
0
50 100 150 200 250 300
The transactions demand for money (Dt) is also
determined by the velocity of money (how many times a
year the average dollar is traded).
10
7.5
5
2.5
0
Dt
Example:
0
50 100 150 200 250 300
GDP is $1000 billion; but the average dollar is traded four
times a year. The economy only demand $250 billion in
currency to carry out all trans
actions.
GDP/V = Dt
There is also a demand for asset money (M2). Money is an
asset that can be held or invested. The opportunity cost of
holding money, compared to investing it, is the interest
income that is lost.
So the asset demand for money varies inversely with the rate
of interest. The lower the interest rate the more desire there
is to hold money as a liquid asset (M1).
RIR
Asset Demand Model
10
7.5
CDs or
5
2.5
0
Da
0 50 100 150 200 250 300
Qm (held as M1)
Where the two curve meet is called the total demand for
money (money supply). By understanding the money
supply we can know how much money is needed for a
stable economy.
Sm
RIR 10
RIR 10
7.5
7.5
10
RIR 10%
7.5
7.5%
5
5
5
5%
2.5
2.5
2.5
2.5%
0
0
Dt
0
50 100 150 200 250 300
Da
Transactions
Demand, Dt
0
50 100 150 200 250 300
Qm
Qm
+
Asset
Demand, Da
Dm
=
0
50 100 150 200 250 300
Qm
Total demand
for money, or MS
Money Market
By regulating
the money RIR
10
supply,
monetary
7.5
authorities
can regulate
5
interest rates.
MS2 MS1
E
2.5
Dm
0
0
50
100
150
200
If the total demand for money is $200 billion, but
the money supply is decreased by $50 billion, the
result will be an increase in interest rates.
250 300
Qm
As less
money is
RIR 10
available the
demand for
7.5
loans
increase. So
5
banks will
2.5
increase the
price of loans
0
(interest
0
rates).
Money Market
MS2 MS1
E
But this change
in interest rates
will affect the
secondary bond
market. Which
we will discuss
later. 
Dm
50
100
150
200
250 300
Qm
The End