Question

Write the money demand function and explain what are the factors directly affecting the demand for money.

Answer 1

Solution:

Generally, the nominal demand for money increases with the level of nominal output (price level times real output) and decreases with the nominal interest rate. For a given money supply the locus of income-interest rate pairs at which money demand equals money supply is known as the LM curve.

According to the portfolio theories of money demand, the riskiness of other assets wealth inflation risk and the liquidity of other assets determine the demand for money.

Money is medium of exchange and so people need it to buy things, goods and services they need for necessities for some, for comforts for some, for happiness for some and for better life, social status, or luxury for some.

Money Demand generally speaks about speculative demand of money for instance Let us think in terms of opportunity cost

When we hold money we have an opportunity cost of forgo interest we would have earned if the sum is kept in bank deposit. Hence this opportunity cost in terms of interest rate increase with increase in interest rate and speculative demand i.e. money demand goes down and similarly in opposite case when rates go down there is small opportunity cost for forgo when we hold money hence demand for money is high when interest goes down therefore dMd/di<0

Hence Money Demand curve is always downward sloping.

The demand for money will increase if:

• The riskiness of other assets increases.

- People prefer to hold onto money when other alternative options are riskier.

• Wealth increases.

- People have more resources to purchase assets when wealth increases. Hence, they will demand more money to do so.

• Inflation risk decreases. - Inflation lowers the demand for money because it decreases the real return of money

. Or the liquidity of other assets decreases. - People prefer to hold onto money for their purchases if other assets are not as liquid and do not offer them the convenience to make such purchases.

Factors impacting money demand curve

1) Change in expectations

2) Change in relative prices of good

3) Change in Interest rate