Question

If the price level rises how does this affect nominal money demand? How does this affect real money demand? Fully explain your reasoning. (5 pts.)

Answer 1

Since the nominal demand for money increases with the level of nominal output and nominal output is calculated in the following way;

Nominal output = Price level * real output

So as the price level increases the nominal demand for money also increases because the nominal output increases with the increase in the price level. In other words it can be said that the nominal money demand rises proportionally with the increase in the price level.

This is because if price level is high, more money would be needed for transactions.  

The real demand for money= the nominal amount of money demanded / the price level

As it can be seen the formula that price level and real demand for money is inversely related. Hence as the price level increases, the real demand for money decreases.

Hence it can be concluded that If the price level rises the nominal money demand also rises. But with the increase in the price level the real money demand decreases.