The Demand for Money - Online Tutor, Practice Problems & Exam Prep

The demand for money is influenced by the interest rate, with a downward-sloping demand curve reflecting that as interest rates decrease, the quantity of money demanded increases. Factors shifting this curve include changes in the price level and real GDP. An increase in price levels raises money demand, while an increase in real GDP also necessitates more money for transactions. Conversely, a decrease in either leads to a leftward shift in the demand curve. Understanding these dynamics is crucial for grasping monetary policy and economic behavior.

The Demand for Money

So we've talked about the money supply in other videos. Now, let's get into the demand for money and how that demand curve will shift. We're going to be using what's called the theory of liquidity preference. And it's basically a fancy name for just doing supply and demand analysis in the money market. So, we're thinking about money as the good that we're basically demanding and supplying in this market. When we think about the price of money, the price of money is going to be the interest rate. For you to get money, let's say you wanted to get more money right now on demand, you'd have to go to a bank and pay them interest. And the quantity of money in this situation is just going to be the number of dollars and the amount of money available. It's more about thinking about the price of money as interest. For you to get money, you're going to pay interest.

So, the demand for money, let's look at it on the graph real quick and let's set up our graph here. Remember, whenever we did our supply and demand graphs, we've had price on the y-axis, quantity down here on the x-axis. Here, the price of money is the interest rate. So that's going to be on our y-axis just like we're used to with supply and demand. And then the quantity of money, we'll just label it as Q, will be there just like we're used to, quantity on the x-axis. So what about a demand curve? What was our little mnemonic that we always remember? The double D's, right? Downward demand. Our demand for money is going to have a downward slope just like we're used to and this is going to be our money demand curve.

So let's analyze a couple of points on this graph. At a high-interest rate, the demand for money is going to be low. So, we'll mark rate high, quantity demanded down here as Quantity 1. What about at a low interest rate? Rate low, the quantity demanded increases, right? So Quantity 2 is high. As the rate goes down, the quantity demanded goes up. And that's how we remember the law of demand, right? As prices fall, quantity demanded goes up. So how does that relate to the money market here? Let's talk about why we have this downward demand curve. Think about holding money. You can have cash right here, right now, or you could invest that cash in, let's say, a short-term investment like treasury securities.

Treasury securities, such as a treasury bond or a treasury bill, are very safe investments because they are backed by the US government, and they pay more interest than just having cash in your hand. Let's compare this: holding money to holding a financial asset like a treasury bill. If you have cash, you can buy goods and services with it. You could go to the grocery store and buy your groceries and pay in cash. However, you cannot go to the grocery store and pay with a treasury bill. They're not going to accept a security from the government at the grocery store in place of cash.

So, you're going to demand money when you need to buy goods and services. Money earns no interest when you have cash in your hand. If you have $100 in your pocket today, tomorrow, it's still going to be $100 in your pocket. However, treasury bills earn some interest. As the interest rate increases, the opportunity cost of holding money increases because the higher the interest you could be earning by investing in a treasury security, the more interest you're giving up by holding cash. Notice, when the interest rate is high, we have a low demand for cash because we would rather invest it and earn that high interest rate. But when the interest rate is low, we'll go ahead and hold cash instead because there's not as much of an opportunity cost for holding the cash. So that's why we have our downward demand curve here for the money demand. And that's the reasoning behind it but it's nice that it follows the same rules where we've got our double D downward demand curve.

Let's pause here and then let's talk about shifting the money demand curve on the graph in the next discussion.

Shifting Money Demand Curve

Alright. So now let's consider why the money demand curve would shift left or shift right on the graph. First, let's think about a change in price. Remember when we talked about the demand curve and how a change in the price would only move us along the demand curve, right? So that would be a change in price in this case is like a change in the interest rate. If we go back to the previous page, if just the interest rate, say we started at the high interest rate and the interest rate is what changes in the market. So let's say this was 10% over here and this is 4% over here. Well, if the only change in the market is that the interest rate went from 10% to 4%, we wouldn't draw a new demand curve. We would just move from this quantity demanded right here, whatever this quantity is, quantity 1, we would move to this new quantity demanded along the same demand curve at quantity 2, okay? So we would not be drawing a new curve over here. Nothing like that. If the only thing that changes is the price. So in this case, the price of money is the interest rate, right? And if you don't remember that, definitely go back and review shifting demand and just the simple market demand and supply and just review those videos and why we move, when we shift the graph, shift the line, and when we just move along the line. So that's the key here. If just the interest rate changes, well, that's the price of money moving and we move along the curve.

Now, these other two things are the main reason why we would draw a new curve where we would have our first money demand curve and then draw a new one to the left or right because a good thing or a bad thing happened for money demand. So let's think about first, the price level. So the price level is just the general price level in the economy which we usually measure through the CPI. Remember the CPI which is the Consumer Price Index. How much are the average prices in the economy? The price level in the economy. So if the price level increases, so the prices of everything are generally higher in the economy, do you think we're going to demand more money or less money? We're going to demand more money, right? Because we need more cash to buy everything. So the money demand increases with price levels. And the opposite. Right? If the price level decreases, well, we don't need as much cash on hand to buy stuff. A good example is to think about in the 1950s, you could have purchased a meal at McDonald's. So in the 1950s for approximately 50¢. You could have got the burger, the fries, the shake, whatever you got at McDonald's, 50¢ was the price of the meal. The same meal would cost about $6 today. To buy the same amount of goods, you're buying a sandwich and a soda and some fries. In 1950, you just keep a couple quarters in your pocket. Now, you need to have $5 another dollar, right? You need to have a bunch of cash in your pocket to afford the same stuff. So, as price levels increase, well, you're going to need more money to buy the same goods. Cool?

How about the next one? Real GDP. So what was real GDP again? Real GDP is a measure of the quantity of things being produced in our economy. Okay? So we're measuring how much stuff is being produced and you can imagine, if real GDP increases, more stuff is being produced. What we're going to need more money to purchase it. So money demand is going to increase when real GDP increases. Oh. And this should say decreases. I'm sure yours says the right thing. The money demand would decrease when real GDP decreases. Okay? So as an example here, think about it. When real GDP increases, the quantity of goods and services bought and sold increased. So if there's more exchanges are being made, more money is needed. Right? We're going to need more money to make these transactions happen.

So those are the two main things. So just like we're used to, we shift left when something bad happens for money demand and we shift right when something good happens for money demand. So if it's something that would increase the demand for money, we shift to the right And if it's something that would decrease it, we would shift to the left. So let's draw our original money demand here. This will be our y axis again? Remember, this is always going to be price and quantity. But what's the price of money? The interest rate. Right? The interest you have to pay to get money is going to be our y axis and then we've got the quantity of money, just the amount that there is, down there on the x axis. So same thing over here. We'll have this as our axis interest rate and quantity.

So let's start here on the left graph, shifting left. So let's say something happens like the price level decreases, right? The price level in the economy decreases so we don't need as much money to purchase our goods. Well, we would shift to the right or, excuse me, shift to the left. Right? There's lower prices. We don't need as much money. So we would shift to the left and I'll draw the new curve in green. We'll draw a new curve here. Right? There would be a new curve to the left and notice what happens in this case. So if we pick one level of the interest rate right here, let's say that was the interest rate. Well, what happens? At this interest rate, we originally demanded this much money this much money, quantity 1 right there. But at the same interest rate, since we've shifted to the left, we're demanding less money and that's because something other than the interest rate has changed. In this case, the price level decreased. So we just need less money at the same interest rate. Okay. So the quantity would decrease in that case. We would shift to the left. Alright? And that would be demand curve 2, the new demand curve right there. Okay. And shifting to the right, well, that's the opposite. Now let's say something like real GDP increases in the economy. There's more goods and services being produced and sold. There's more transactions being made. Well, we're gonna shift the other way. Let me get out of the way. So this would be demand curve 1 and we would shift now to the right. And we would have our new curve out here, demand curve 2. So the same logic applies here. If we're at if we have some interest rate in the economy, but something else in the economy got affected that wasn't the interest rate, the level of real GDP increased. Well, what's happening to money demand? Money demand originally was here at q 1. And now with that same interest rate, we're demanding more money because there's just more real GDP, more goods being trend, more transactions being made. So we want more money available there. Okay? We're demanding more money after the shift, okay? At the same interest rate. So that should be something you're familiar with. Shifting curves left and right. We've done it before. Nothing's really changing here other than what the product is. In this case, it's money. Alright? So let's pause here and let's move on.

Here’s what students ask on this topic:

What is the theory of liquidity preference?

The theory of liquidity preference, introduced by John Maynard Keynes, explains how the interest rate is determined by the supply and demand for money. In this theory, money is considered a liquid asset that people prefer to hold for transactions, precautionary, and speculative purposes. The interest rate is the 'price' of money, influencing how much money people demand. When interest rates are high, people prefer to invest in interest-bearing assets rather than hold money, leading to a lower demand for money. Conversely, when interest rates are low, the opportunity cost of holding money decreases, increasing the demand for money. This theory helps in understanding the dynamics of monetary policy and its impact on the economy.

How does the interest rate affect the demand for money?

The interest rate significantly impacts the demand for money. When interest rates are high, the opportunity cost of holding money increases because individuals and businesses can earn more by investing in interest-bearing assets like treasury bills. As a result, the demand for money decreases. Conversely, when interest rates are low, the opportunity cost of holding money is reduced, making it more attractive to hold cash for transactions and precautionary purposes. This relationship is depicted by a downward-sloping demand curve for money, where a decrease in interest rates leads to an increase in the quantity of money demanded.

What factors can shift the money demand curve?

Several factors can shift the money demand curve. Two primary factors are changes in the price level and changes in real GDP. An increase in the price level, measured by the Consumer Price Index (CPI), raises the demand for money because more cash is needed to purchase goods and services. Similarly, an increase in real GDP, which indicates higher production and more transactions in the economy, also increases the demand for money. Conversely, a decrease in the price level or real GDP will shift the money demand curve to the left, indicating a lower demand for money at the same interest rate.

Why does the money demand curve slope downward?

The money demand curve slopes downward due to the inverse relationship between the interest rate and the quantity of money demanded. When interest rates are high, the opportunity cost of holding money is also high because individuals and businesses can earn more by investing in interest-bearing assets. Therefore, the demand for money decreases. Conversely, when interest rates are low, the opportunity cost of holding money is reduced, making it more attractive to hold cash for transactions and precautionary purposes. This inverse relationship results in a downward-sloping demand curve for money.

How do changes in the price level affect the demand for money?

Changes in the price level, typically measured by the Consumer Price Index (CPI), directly affect the demand for money. When the price level increases, the cost of goods and services rises, requiring more money to make the same purchases. Consequently, the demand for money increases, shifting the money demand curve to the right. Conversely, when the price level decreases, the cost of goods and services falls, requiring less money for transactions, which decreases the demand for money and shifts the money demand curve to the left. This relationship highlights the importance of price stability in monetary policy.