The transaction demand for money and the rate of interest are:

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The demand for money represents the desire of households and businesses to hold assets in a form that can be easily exchanged for goods and services. Spendability (or liquidity) is the key aspect of money that distinguishes it from other types of assets. For this reason, the demand for money is sometimes called the demand for liquidity.

The demand for money is often broken into two distinct categories: the transactions demand and the speculative demand.

The primary reason people hold money is because they expect to use it to buy something sometime soon. In other words, people expect to make transactions for goods or services. How much money a person holds onto should probably depend on the value of the transactions that are anticipated. Thus a person on vacation might demand more money than on a typical day. Wealthier people might also demand more money because their average daily expenditures are higher than the average person’s.

However, in this section we are interested not so much in an individual’s demand for money but rather in what determines the aggregate, economy-wide demand for money. Extrapolating from the individual to the group, we could conclude that the total value of all transactions in the economy during a period would influence the aggregate transactions demand for money. Gross domestic product (GDP), the value of all goods and services produced during the year, will influence the aggregate value of all transactions since all GDP produced will be purchased by someone during the year. GDP may underestimate the demand for money, though, since people will also need money to buy used goods, intermediate goods, and assets. Nonetheless, changes in GDP are very likely to affect transactions demand.

Anytime GDP rises, there will be a demand for more money to make the transactions necessary to buy the extra GDP. If GDP falls, then people demand less money for transactions.

The GDP that matters here is nominal GDP, meaning GDP measured in terms of the prices that currently prevail (GDP at current prices). Economists often break up GDP into a nominal component and a real component, where real GDP corresponds to a quantity of goods and services produced after eliminating any price level changes that have occurred since the price level base year. To convert nominal to real GDP, simply divide nominal GDP by the current U.S. price level (P$); thus

real GDP = nominal GDP/P$.

If we use the variable Y$ to represent real U.S. GDP and rearrange the equation, we can get

nominal GDP = P$ Y$.

By rewriting in this way we can now indicate that since the transactions demand for money rises with an increase in nominal GDP, it will also rise with either an increase in the general price level or an increase in real GDP.

Thus if the amount of goods and services produced in the economy rises while the prices of all products remain the same, then total GDP will rise and people will demand more money to make the additional transactions. On the other hand, if the average prices of goods and services produced in the economy rise, then even if the economy produces no additional products, people will still demand more money to purchase the higher valued GDP, hence the demand for money to make transactions will rise.

The second type of money demand arises by considering the opportunity cost of holding money. Recall that holding money is just one of many ways to hold value or wealth. Alternative opportunities include holding wealth in the form of savings deposits, certificate of deposits, mutual funds, stock, or even real estate. For many of these alternative assets interest payments, or at least a positive rate of return, may be obtained. Most assets considered money, such as coin and currency and most checking account deposits, do not pay any interest. If one does hold money in the form of a negotiable order of withdrawal (NOW) account, a checking account with interest, the interest earned on that deposit will almost surely be less than on a savings deposit at the same institution.

Thus to hold money implies giving up the opportunity of holding other assets that pay interest. The interest one gives up is the opportunity cost of holding money.

Since holding money is costly—that is, there is an opportunity cost—people’s demand for money should be affected by changes in its cost. Since the interest rate on each person’s next best opportunity may differ across money holders, we can use the average interest rate (i$) in the economy as a proxy for the opportunity cost. It is likely that as average interest rates rise, the opportunity cost of holding money for all money holders will also rise, and vice versa. And as the cost of holding money rises, people should demand less money.

The intuition is straightforward, especially if we exaggerate the story. Suppose interest rates on time deposits suddenly increased to 50 percent per year (from a very low base). Such a high interest rate would undoubtedly lead individuals and businesses to reduce the amount of cash they hold, preferring instead to shift it into the high-interest-yielding time deposits. The same relationship is quite likely to hold even for much smaller changes in interest rates. This implies that as interest rates rise (fall), the demand for money will fall (rise). The speculative demand for money, then, simply relates to component of the money demand related to interest rate effects.

Key Takeaways

Anytime the gross domestic product (GDP) rises, there will be a demand for more money to make the transactions necessary to buy the extra GDP. If GDP falls, then people demand less money for transactions.
The interest one gives up is the opportunity cost of holding money.
As interest rates rise (fall), the demand for money will fall (rise).

Exercise

Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
1. Of increase, decrease, or no change, the effect on the transactions demand for money when interest rates fall.
2. Of increase, decrease, or no change, the effect on the transactions demand for money when GDP falls.
3. Of increase, decrease, or no change, the effect on the speculative demand for money when GDP falls.
4. Of increase, decrease, or no change, the effect on the speculative demand for money when interest rates fall.

The demand for money has two components: transactional demand and asset demand.

Transactional demand (Dt) is money kept for purchases and will vary directly with GDP.

Asset demand (Da) is money kept as a store of value for later use. . Asset demand varies inversely with the interest rate, since that is the price of holding idle money.

Total demand for money will equal quantities of money demanded for assets plus that for transactions. The demand curve for money illustrates the inverse relationship between the quantity demanded of money and the interest rate.

The supply of money is a vertical line, suggesting the quantity of money is fixed at a level largely determined by the Fed.

Equilibrium in the money market exists when the quantity demanded of money equals the quantity supplied.

In the above graph, it shows an equilibrium of the money market at interest rate of 6%, and quantity of money at 600 billions. The vertical curve indicates the money supply decided by the Federal Reserve.

At any interest rate above the equilibrium rate, there is an excess supply of money. At any interest rate below the equilibrium rate, there is an excess demand of money.

Fed can influence the market interest rate by adjusting the money supply. If the money supply increases (moving the vertical curve in the above graph towards the right), the interception point will demonstrate a lower interest rate in the market. If the money supply decreases (moving the vertical curve in the above graph towards the left), the interception point will demonstrate a higher interest rate. Therefore, market's interest rate is closely related to the monetary policy of the Fed.

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MONEY, BANKING, AND MONETARY POLICY

The focus of this first week is on the basic concepts of the United States’ financial system. Students will first learn what money is, how banks and the banking systems can influence and control the supply and disposition of money, and the function of the Federal Reserve. Lastly, the relationship between money and various economic variables will be discussed.

OBJECTIVES

1. Identify the functions of money and the money supply.

2. Illustrate the creation of money using the money multiplier effect.

3. Delineate the role of the Federal Reserve System in designing and implementing U.S. Monetary policies.

4. Describe how changes in the money supply impact inflation.

5. Analyze the effect of changes in the reserve requirement, discount rate, and open market policies.

TOPICS

Please read all the lectures by clicking on the following topics.

FUNCTIONS OF MONEY

MEASURES OF MONEY

BANKS AND MONEY CREATION

FEDERAL RESERVE SYSTEM

MONETARY POLICY

THE MONEY MARKET

EQUATION OF EXCHANGE

Page 3

The focus of this lecture is the basic concepts of economics. Students will learn to think like an economist by applying some economic models to practical examples.