Question

5. Liquidity demand
a) In the model of demand for liquidity, there are two ways households can
store their wealth. What are the two choices? Describe the tradeo they
face - what makes each alternative attractive?
b) Describe how the demand for real money balances is aected by a decrease
in the interest rate.
c) Describe how an increase in output aects the demand for real money bal-
ances and the interest rate.

Answer 1

(a) Households can store wealth in two ways as follows.

(i) By holding their wealth in form of cash, or

(ii) By holding their wealth by investing in interest-bearing assets.

The trade-off depends on the real interest rate. When real interest rate is positive (because nominal interest rate is higher than inflation rate), opportunity cost of holding cash is positive and so, individuals will choose to store wealth in interest-bearing assets. But if real interest rate is negative (because nominal interest rate is lower than inflation rate), opportunity cost of holding cash is negative and so, individuals will choose to store wealth in form of cash.

(b) As interest rate decreases, real interest rate decreases ceteris paribus and opportunity cost of holding wealth in form of cash decreases. So, people keep more wealth as cash, which increases the demand for real money balances.

(c) As output increases, income also increases, which increases primarily the transactions demand for money (as income rises, households spend more for consumption purposes which raises transactions demand for money). As a result, demand for real money balances increase, shifting the money demand curve rightward which increases interest rate.