For very large firms such as Toyota or AT&T, interest rate differentials among various forms of holding their financial assets translate into millions of dollars per day. After 10 days, the money in the checking account is exhausted, and the household withdraws another $1,000 from the bond fund for the next 10 days. You can predict how the real interest rate and the real quantity of money in the money market change. If they expect bond prices to rise, they will reduce their demand for money. An increase in real GDP, the price level, or transfer costs, for example, will increase the quantity of money demanded at any interest rate r, increasing the demand for money from D1 to D2. A higher interest rate in the bond market is likely to increase this differential; a lower interest rate will reduce it. The money marketThe interaction among institutions through which money is supplied to individuals, firms, and other institutions that demand money. That will shift the supply curve for bonds to the right, thus lowering their price. The quantity of money households want to hold varies according to their income and the interest rate; different average quantities of money held can satisfy their transactions and precautionary demands for money. The quantity of money people hold to pay for transactions and to satisfy precautionary and speculative demand is likely to vary with the interest rates they can earn from alternative assets such as bonds. Thus, the Keynesian theory, like the classical theory, is indeterminate. On the other bond, at a lower rate of interest on bonds, they would demand more money to hold. The money people hold for contingencies represents their precautionary demand for moneyThe money people hold for contingencies.. Money held for precautionary purposes may include checking account balances kept for possible home repairs or health-care needs. In a modern economy most goods are produced in the various stages of production.

When interest rates rise relative to the rates that can be earned on money deposits, people hold less money. In the last 10 years these retail sweeps rose from zero to nearly the size of M1 itself! Thus we see that Keynes explained interest in terms of purely monetary forces and not in terms of real forces like productivity of capital and thrift which formed the foundation stones of both classical and loanable fund theories. The household could also maintain a much smaller average quantity of money in its checking account and keep more in its bond fund. The demand for money will change as a result of a change in real GDP, the price level, transfer costs, expectations, or preferences. This excess demand for money will lead to rise in interest to the level where money demand equals the given money supply. Therefore, the Central Bank of a country (in case of India, Reserve Bank of India) is given the right to control the supply of money in the economy. Curve that shows the relationship between the quantity of money supplied and the market interest rate, all other determinants of supply unchanged. 5 M t 900 M t = 1 1.

Thus, by adding demand for money equations.

Figure 25.8 "Money Market Equilibrium" combines demand and supply curves for money to illustrate equilibrium in the market for money. That relationship suggests that money is a normal good: as income increases, people demand more money at each interest rate, and as income falls, they demand less. The contractionary monetary policy means that the Fed sells bonds—a rightward shift of the bond supply curve in Panel (b), which decreases the money supply—as shown by a leftward shift in the money supply curve in Panel (c). The fall in the interest rate will cause a rightward shift in the aggregate demand curve from AD1 to AD2, as shown in Panel (c). In recent years, transfer costs have fallen, leading to a decrease in money demand. The interest rate must fall to r2 to achieve equilibrium.

An increase in output increases the money demand curve, which, in turn, increases the real interest rate without changing the quantity of real money.

Household attitudes toward risk are another aspect of preferences that affect money demand. Thus, V= Y/M where V stands for income velocity of money. An increase in real GDP increases incomes throughout the economy. The expectation of a higher price level means that people expect the money they are holding to fall in value. To see why, suppose a household earns and spends $3,000 per month. She is a member of the American Economic Association, Western Economic Association, European Union Studies Association, and Committee on the Status of Women in the Economics Profession. 9 M t = 900 M t Real rate of return of fiat money: υ t +1 υ t = N t +1 (y-c 1) M t +1 N t (y-c 1) M t = 900 1. In Panel (d), show how it will affect the exchange rate. 17.3 we have therefore drawn a vertical supply curve of money with measuring interest rate on the Y-axis. Such a curve is shown in Figure 25.5 "The Demand Curve for Money". Money people hold to pay for goods and services they anticipate buying. Secondly, demand for money is negatively related to rate of interest (i). is the interaction among institutions through which money is supplied to individuals, firms, and other institutions that demand money. In the next example, a change in the country’s output and nominal money supply is applied to the money market. To see why the interest rate falls, we recall that if people want to hold less money, then they will want to hold more bonds. Thus, interest rate on government or corporate bonds is the opportunity cost of holding money. While we take these methods of payment for granted today, they did not exist before 1980 because of restrictive banking legislation and the lack of technological know-how. But the bond-buying spree would lead to the rise in prices of bonds. Money market is in equilibrium when at a rate of interest demand for and supply of money are equal. So the money market is in equilibrium at 10 per cent rate of interest. In Fig 17.6 assuming that the quantity of money remains unchanged at M, the shift in the money demand curve from MD1 to MD2, the rate of interest rises from i1 to i2 because at i2, the new demand for money is in equilibrium with the supply of money OM. Rate of interest will be determined where the demand for money is in balance or equal to the fixed supply of money OM1. Toward the end of the great German hyperinflation of the early 1920s, prices were doubling as often as three times a day. We shall assume that banks increase the money supply in fixed proportion to their reserves. One reason people hold their assets as money is so that they can purchase goods and services. We have seen that the transactions, precautionary, and speculative demands for money vary negatively with the interest rate. The cash approach requires a quantity of money demanded of $1,500, while the bond fund approach lowers this quantity to $500. People’s attitudes about the trade-off between risk and yields affect the degree to which they hold their wealth as money. Money market equilibrium occurs at the interest rate at which the quantity of money demanded equals the quantity of money supplied. In general, the demand for money will increase as it becomes more expensive to transfer between money and nonmoney accounts. Source: Pedre Teles and Ruilin Zhou, “A Stable Money Demand: Looking for the Right Monetary Aggregate,” Federal Reserve Bank of Chicago Economic Perspectives 29 (First Quarter, 2005): 50–59. The impact of Fed bond purchases is illustrated in Panel (a) of Figure 25.10 "An Increase in the Money Supply". The resulting higher interest rate will lead to a lower quantity of investment. This means that individuals and firms quickly use their money stock for purposes of buying goods and services and do not keep it for a longer period with them or in their banks. It is evident from above analysis that demand for money as an asset, that is, for speculative purposes depends on rate of interest on bonds, which is the opportunity cost of holding money. The supply curve of money is a vertical line at that quantity.

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