Question

Explain what happens to the level of money demand for speculative motives when the benchmark interest rate in the market increases, and the Government decides to tax the average rate of return on bond ownership owned by the public. Use charts to provide analysis.

Answer 1

Figure-1 in the document attached below illusrates the impact of an increase in the benchmark interest on the money or loanable funds market. In figure-1 the y and the x axes represent the interest rate or r and the quantity of money or M respectively. The initial money supply and demand curves in the market are denoted as MS1 and MD1 and the initial equilibrium interest rate and the quantity of money in the money market are indicated as r*1 and M*1 respectively corresponding to the intersection between MS1 and MD1 curves. Now, an increase in the benchmark interest rate in the market can also be reflected by a leftward shif of the money supply curve as depicted by a leftward shift of the money supply curve from its initial position MS1 to MS2 subsequently. As a result, the equilibrium interest rate in the money or loanable funds market increases from r*1 to r*2 or the cost of financial borrowing increases corresponding to the intersection between MS2 and MD1 curves. As the equilibrium interest rate increases the quantity of money demand in the market decreases as indicated by the movement along the MD1 curve and the equilibrium level of money in the market decreases from M*1 to M*2 subsequently. Now, if the government decides to impose tax on the average rate of return on bond ownership, the interest payment earned from any bond would decrease and the real holding of money would decrease among the public and people would reduce the purchase of bonds due to lower returns on the bonds. This would also consequently lead to an increase in the interest rate and the overall quantity of money in the money or loanable funds market.