12.2 The Theory of Money Demand

Question 1

What is the relationship between the decision to hold more bonds or more money?

Answer 1

A decision to hold more bonds is at the same time a decision to hold less money, and the decision to hold more money is a decision to hold fewer bonds. We can therefore build our theory by considering the desire to hold bonds or by considering the desire to hold money.

Question 2

What is the demand for money?

Answer 2

Demand for money

The total amount of money that the public wants to hold for all purposes.

Question 3

Three reasons for holding money instead of bonds

Answer 3

• First, households and firms hold money in order to carry out transactions. Economists call this the transactions demand for money.
• A second and related reason firms and households hold money is that they are uncertain about when some expenditures will be necessary, and they hold money as a precaution to avoid the problems associated with missing a transaction. This is referred to as the precautionary demand for money.
• Applies more to large businesses and to professional money managers than to individuals because it involves speculating about how interest rates are likely to change in the future. Economists call this the speculative demand for money.

Question 4

How does interest rates affect how much money people wish to hold as opposte to bonds?

Answer 4

If interest rates are expected to rise in the future, bond prices will be expected to fall. Whenever bond prices fall, bondholders experience a decline in the value of their bond holdings. The expectation of increases in future interest rates will therefore lead to the holding of more money (and fewer bonds) now as financial managers adjust their portfolios in order to preserve their values.

Question 5

What are the three determinants of money demand?

Answer 5

The interest rate
The level of real GDP
The price level.

Question 6

What is the cost of holding money?

Answer 6

The cost of holding money is the income that could have been earned if that wealth were instead held in the form of interest-earning bonds. This is the opportunity cost of holding money.

Question 7

Relationship between demand for money and interest rate.

Answer 7

Other things being equal, the demand for money is assumed to be negatively related to the interest rate.

Question 8

Graph of Money Demand as a Function of the Interest Rate, Real GDP, and the Price Level (Interest rate)

Answer 8

Question 9

How is the quantity of money demanded related to interest rate, real GDp and price level?

Answer 9

The quantity of money demanded is assumed to be negatively related to the interest rate and positively related to real GDP and the price level.

Question 10

Why is the Md slope negativly sloped?

Answer 10

Question 11

Relationship between money demanded and real GDP.

Answer 11

Question 12

Relationship between money demanded and Price level

Answer 12

Question 13

If real GDP and interest rate are constant, what is the relationship between price level and demand for money?

Answer 13

For this reason, economists usually assume that if real GDP and the interest rate are constant, the demand for money is proportional to the price level.

Question 14

What is another name for the money demand function?

Answer 14

Since the demand for money reflects firms’ and households’ preference to hold their wealth in the form of a liquid asset (money) rather than a less liquid asset (bonds), economists sometimes refer to the money demand function as a** liquidity preference function.**

Question 15

What is the algebraic function for money demand?

Answer 15

Question 16

What are the 3 central assumptions we make about the money demand curve?

Answer 16

Question 17

How is money demand related to bond demand?

Answer 17

Remember that money demand is also related to bond demand. Firms and households must decide at any time how to divide their financial assets between money and bonds. Therefore, our statements here about money demand apply in reverse to the demand for bonds.

For example, in Figure 12-1, a movement down the curve from point A to point B indicates that firms and households are deciding to hold more money and fewer bonds as the interest rate falls. In other words, the movement from A to B involves a substitution away from holding bonds and toward holding money.

Question 18

How can perceived riskiness of bonds effect demand for money? How could this influence the interest rate?

Answer 18

Though it happens only infrequently, sometimes there is a sudden increase in the perceived riskiness of the bonds that households and firms are holding in their portfolios.

For example, this may happen during an economic or financial crisis when bondholders begin doubting whether the issuers of the bonds will be able to fully repay their debts. When such risks arise, there is generally a sharp increase in the demand for money as portfolio managers attempt to sell their bonds and increase their cash holdings.