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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