Question

Money Market

            Why do people demand to hold money?

            How do interest rates affect demand?

Know how the chain of events works when the Fed decides to affect market outcomes.

Fed Action à MS changes à Interest rate changes à Investment changes àAD changes à Prices/Output changes

How much of an effect does a change in interest rates have on aggregate demand.

What are some of the constraints on monetary policy?

            Relate to the Great Depression.

                        Liquidity Trap

**How do views of Monetarists differ from Keynesians?

*Understand MV = PQ

Answer 1

1. People hold money for different reasons. One of the reason is for transaction purpose. In order to meet daily transaction for purchasing goods and services, people hold liquid money. basically liquid money is used in small amount of transaction such as buying grocery products or paying rent, visiting doctor for illness etc. Second reason is precautionary demand for money. For sudden need of money or cash for different household purpose, people hold money. The third need is speculative demand for money as depicted by Keynes. In the face of falling bond prices, the bond holders try to convert the bond into money to avoid loss in value of bond.

2. Interest rate has negative relation with the demand for money. As interest rate offered by financial institution rises, demand for money held by people decreases. Increasing rate of interest brings an extra income for the people, hence, money holding is like an opportunity cost to people. On the other hand, if interest rate is very high, demand for bond increases as people think that interest rate may fall shortly. People demand more money to purchase bonds.

3. The equation of aggregate demand is AD = C+ I + G

When interest rate falls, demand for investment in the economy rises as investment is a function of interest rate. Investment in different sector of the economy rises and in turn, economy expands as well as the per capita income of household increases. As disposable income rises, it induces aggregate demand to rise.  

4. Monetary policy means control of money supply and demand in the economy by federal bank using different monetary tools. According to Keynes Monetary policy is ineffective when there occurs an even like liquidity trap. When People wish to hold any amount money supplied in the market at a given interest rate. In the other words, demand for money is completely elastic represented by horizontal LM curve. Increase or decrease in money supply hence do not affect the interest rate and therefore the aggregate investment and consumption spending remain unaffected. Monetary policy remains ineffective.