Question

Discuss the three demands for money.

Discuss the ways that the Fed will influence interest rates (open market operations, change in the reserve requirements, change in discount rate) – the videotaped lecture will help you understand the way the Fed could change money supply which will then change interest rates given the demand for money.

Answer 1

Three Demands for Money

1) Transaction demand: The demand for money that arises due to transaction purposes is the transaction demand for money. It is needed for exchange of goods and services.

2) Precautionary demand: The demand for money that arises due to precaution for unforseen events in future is the precautionary money.

3) Speculative demand: This type of demand for money arises with the incentive to invest in bonds. It is directly dependent on the prevailing interest rate in the market.

Fed influences interest rates

fed can influence interest rate using the following tools-

1) Open marker operation: In OMO government buys and sells government bonds which directly affects the money supply. Change in money supply again affects the interest rate.

2) change in reserve requirements: change in reserve requirements alters the amount of money that banks have to keep as reserves. If there is an increase in reserve requirements, then banks have less money to loan out. Money supply decreases and interest rate increases.

3) change in discount rate: Discount rate is the interest rate Fed charges while lending to a commercial bank. If it charges higher rate, then banks demand less money and interest rate will increase.