This is because increasing demand for real estate takes the prices higher causing buyers to queue up to buy what appear to be “profitable investments” Now, excess money as well as excess demand in the system leads to the growth in the prices of real estate units. Feb 02, 2000 The demand for real balances Since the demand for nominal balances is proportional to the aggregate price level, we can divide both sides of the nominal money demand equation by P. This gives the liquidity demand function or the demand for real balances.
18.6 Money Demand
Learning Objective
- Learn the determinants of money demand in an economy.
The demand for money represents the desire of households and businesses to hold assets in a form that can be easily exchanged for goods and services. Spendability (or liquidity) is the key aspect of money that distinguishes it from other types of assets. For this reason, the demand for money is sometimes called the demand for liquidity.
The demand for money is often broken into two distinct categories: the transactions demand and the speculative demand.
Transactions Demand for Money
The primary reason people hold money is because they expect to use it to buy something sometime soon. In other words, people expect to make transactions for goods or services. How much money a person holds onto should probably depend on the value of the transactions that are anticipated. Thus a person on vacation might demand more money than on a typical day. Wealthier people might also demand more money because their average daily expenditures are higher than the average person’s.
However, in this section we are interested not so much in an individual’s demand for money but rather in what determines the aggregate, economy-wide demand for money. Extrapolating from the individual to the group, we could conclude that the total value of all transactions in the economy during a period would influence the aggregate transactions demand for money. Gross domestic product (GDP), the value of all goods and services produced during the year, will influence the aggregate value of all transactions since all GDP produced will be purchased by someone during the year. GDP may underestimate the demand for money, though, since people will also need money to buy used goods, intermediate goods, and assets. Nonetheless, changes in GDP are very likely to affect transactions demand.
Anytime GDP rises, there will be a demand for more money to make the transactions necessary to buy the extra GDP. If GDP falls, then people demand less money for transactions.
The GDP that matters here is nominal GDP, meaning GDP measured in terms of the prices that currently prevail (GDP at current prices). Economists often break up GDP into a nominal component and a real component, where real GDP corresponds to a quantity of goods and services produced after eliminating any price level changes that have occurred since the price level base year. To convert nominal to real GDP, simply divide nominal GDP by the current U.S. price level (P$); thus
real GDP = nominal GDP/P$.If we use the variable Y$ to represent real U.S. GDP and rearrange the equation, we can get
nominal GDP = P$Y$.By rewriting in this way we can now indicate that since the transactions demand for money rises with an increase in nominal GDP, it will also rise with either an increase in the general price level or an increase in real GDP.
Thus if the amount of goods and services produced in the economy rises while the prices of all products remain the same, then total GDP will rise and people will demand more money to make the additional transactions. On the other hand, if the average prices of goods and services produced in the economy rise, then even if the economy produces no additional products, people will still demand more money to purchase the higher valued GDP, hence the demand for money to make transactions will rise.
Speculative Demand for Money
The second type of money demand arises by considering the opportunity cost of holding money. Recall that holding money is just one of many ways to hold value or wealth. Alternative opportunities include holding wealth in the form of savings deposits, certificate of deposits, mutual funds, stock, or even real estate. For many of these alternative assets interest payments, or at least a positive rate of return, may be obtained. Most assets considered money, such as coin and currency and most checking account deposits, do not pay any interest. If one does hold money in the form of a negotiable order of withdrawal (NOW) account, a checking account with interest, the interest earned on that deposit will almost surely be less than on a savings deposit at the same institution.
Thus to hold money implies giving up the opportunity of holding other assets that pay interest. The interest one gives up is the opportunity cost of holding money.
Since holding money is costly—that is, there is an opportunity cost—people’s demand for money should be affected by changes in its cost. Since the interest rate on each person’s next best opportunity may differ across money holders, we can use the average interest rate (i$) in the economy as a proxy for the opportunity cost. It is likely that as average interest rates rise, the opportunity cost of holding money for all money holders will also rise, and vice versa. And as the cost of holding money rises, people should demand less money.
The intuition is straightforward, especially if we exaggerate the story. Suppose interest rates on time deposits suddenly increased to 50 percent per year (from a very low base). Such a high interest rate would undoubtedly lead individuals and businesses to reduce the amount of cash they hold, preferring instead to shift it into the high-interest-yielding time deposits. The same relationship is quite likely to hold even for much smaller changes in interest rates. This implies that as interest rates rise (fall), the demand for money will fall (rise). The speculative demand for money, then, simply relates to component of the money demand related to interest rate effects.
Key Takeaways
- Anytime the gross domestic product (GDP) rises, there will be a demand for more money to make the transactions necessary to buy the extra GDP. If GDP falls, then people demand less money for transactions.
- The interest one gives up is the opportunity cost of holding money.
- As interest rates rise (fall), the demand for money will fall (rise).
Exercise
Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
- Of increase, decrease, or no change, the effect on the transactions demand for money when interest rates fall.
- Of increase, decrease, or no change, the effect on the transactions demand for money when GDP falls.
- Of increase, decrease, or no change, the effect on the speculative demand for money when GDP falls.
- Of increase, decrease, or no change, the effect on the speculative demand for money when interest rates fall.
Demand for money means demand for holding cash.
Unlike demand for consumer goods, money is not demanded for its own sake.
Money performs two important functions:
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(i) Medium of exchange
(ii) Store of value
It is due to these two functions that money is considered as indispensable by the society. Therefore, demand for money is a derived demand. Demand for money is a very crucial concept as the value of money depends on the demand for money. There are different concepts of the demand for money.
Classical View:
I. The Classical economists viewed that money does not have any inherent utility of its own but is demanded for transaction motive. Money serves as a medium of exchange. Irving Fisher’s version of the quantity theory of money which he developed in his book “Purchasing Power of Money” is the most famous version and represents the Classical approach to the analysis of the relationship between the quantity of money and the price level.
With V and T remaining constant, P changes proportionately to the changes in M, such that if M is doubled, P is also doubled but the value of money is halved.
Limitations:
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1. It does not explain how a change in M changes P
2. P is regarded as a passive factor which is unrealistic
3. Not only M determines P but also P determines M.
Neo-Classical Theory/Cambridge Version:
II. According to the neo-classical theory given by Marshall, Pigou, etc., money does not serve only as a medium of exchange but also as a store of value. The price level is affected only by that part of money which people hold in form of cash for transaction purpose and not by MV as suggested by the Classical theory. The theory assumes that the demand for real balances is proportional to the income level.
Limitation:
Although the Cambridge version links the demand for money to the money income, and recognizes that the other variables like rate of interest influences the value of k, it failed to incorporate it systematically in the analysis. The most sadly neglected part of pre-Keynesian analysis is the relationship between the asset demand for money and the interest rate.
Keynesian Concept of Demand for Money/Liquidity Preference Theory of Demand for Money:
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III. Credit goes to Keynes for discussing the relationship between the interest rate and demand for real balances. He in his book “The General Theory of Employment and Money (1936)” uses a different term for demand for money and called it Liquidity Preference.
He does not disagree with the classical and neo-classical concept that money is demanded as a medium of exchange but he differs on the point that money is demanded only as a medium of exchange. Keynes viewed that money has a ready purchasing power and can be converted into any commodity when desired, then why to prefer liquidity or cash balance. The Neoclassical economists failed to recognize this.
Keynes viewed that money is demanded due to three main motives:
1. Transaction Motive (Lt):
It is the demand for money to meet daily transactions. It depends directly on the level of income.
Lt =f(Y) …(3i)
2. Precautionary motive (Lp):
It is the demand for money for meeting future contingencies. This depends directly on the level of income.
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Lp = f(Y) …(3ii)
Since both Lt and Lp depend directly on the income level, Keynes called it as L1.
L1 = f (Y) …(3iii)
L1 is interest inelastic.
IV. Speculative Motive (L2): In a dynamic society there is no certainty regarding future. In such a situation, the store of value function is more important. This leads to speculative motive for hoarding money, a new approach discussed by Keynes.
It is termed as speculative motive because it depends on the hopes of gains and fears of loss in future. It relates to the desire to hold one’s resources in liquid form in order to take advantage of the market movements regarding future change in the interest rate. The amount of money held for speculative motive will depend on the interest rate.
L2 = f (i) …(4)
How To Do Real Demand Of Money Online
L2 indirectly depends on i
L2 curve shows an inverse relationship between L2 and the interest rate (Fig. 21.1).
Total demand for money (M/P)d:
Total demand for money is a function of both income level and the interest rate.
L1 is interest inelastic (Fig. 21.2a)
L2 is inversely related to the interest rate (Fig. 21.2b)
L is the total demand for money which is a horizontal summation of L1 and L2 (Fig. 21.2c)
Limitations:
Tobin criticized Keynesian view on demand for money, held for transaction and speculative motive.
How To Do Real Demand Of Money Calculator
1. Keynes viewed that L1 is interest inelastic but Tobin argued that when interest rate is very high, even in the short run, the demand for money starts responding. He explained this in his Portfolio theory of money demand (Para 22.1).
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2. Tobin criticized Keynes’ view on speculative demand for money. According to Keynes, people will hold the asset either in form of money or bonds depending on the expectations regarding the future interest rate.
How To Do Real Demand Of Money Formula
Tobin in his Portfolio Optimization theory showed that people will hold a combination of money and bonds which is based on uncertainty. (Paras 22.2, 22.3).