Question

define money demand function. discuss the effect of the three of the following macroeconomic variables on the demand of money:

1. Price Level

2. Real Income

3. Real Interest Rate

4. Expected Inflation

Answer 1

The money demand function states the relation between amount of money people want to hold and price level, real income and interest rates. In general term it is depicted as , where Md is the nominal demand for money, P is the price level, Y is the real income and i is the interest rate. In empirical form, which is ususally used in macroeconomic framework, the demand fuction can be depicted as , for Md/P is the real demand for money, and L is the liquidity preference fucntion. The nominal interest rate can be broken into real interest rate and expected inflation as where r is the real interest rate and pi-e is the expected rate of inflation. It is to be noted that money is demanded as per motives for transaction, precautionary, speculative and opportunity cost; and the demand function given is used to include reflections of these motives.

1. The demand function can be formed also as , according to which, as the price level increases, so does the nominal demand for money. Hence .

2. The real demand for money increases as the real income increase, and decreases as the real income decrease. The relation is positive. However, the price elasticity of demand is less than 1, meaning for a unit percentage change in price, less than as unit percentage change in money demand is induced.

3. As interest rate increases, people would demand less money for transaction and would ivest more in non-money assets or other deposits with less liquidity. The relation is hence, negative. However, the interest elasticiy is negatively less than one, ie in between -1/2 and 0 (arguably).

4. A rise in expected inflation reduces the demand for money, as it induces the increase in nominal interest rate and hence induces a decrease in demand for money. Hence, the relation is negative.