Question

There are several factors that influence money demand. Explain the effects of the following influences on money demand:
(i) An increase in income.
(ii) An increase in interest rates.
(iii) An increase in inflation.
(iv) An increase in credit availability.

Answer 1

(i)

An increase in income - It shall be noted that a household with an income of $10,000 per month is likely to demand a larger quantity of money than a household with an income of $1,000 per month. That relationship suggests that money is a normal good: as income increases, people demand more money at each interest rate, and as income falls, they demand less.

(ii)

An increase in interest rates - The transactions, precautionary, and speculative demands for money vary negatively with the interest rate. When interest rates rise relative to the rates that can be earned on money deposits, people hold less money. When interest rates fall, people hold more money.

(iii)

An increase in inflation - The higher the price level (higher the inflation), the more money is required to purchase a given quantity of goods and services. All other things unchanged, the higher the inflation the greater the demand for money.

(iv)

An increase in credit availability - If credit is more available, precautionary demand for money will fall as individuals feel they can borrow – if they meet short-term difficulties.