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Mastering Money Demand and Supply: Key to Economic Understanding
Dive into the world of money demand and supply. Uncover how these crucial concepts shape economies, influence financial markets, and impact your daily life. Start your learning journey today!

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Now Playing:Money demand and supply – Example 0a
Intros
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  1. 4 Factors for the Quantity of Money
    • Price Level
    • Real GDP
    • Nominal Interest Rate
    • Financial Innovation
  2. Money Demand Curve
    • Demand for quantity of real money
    • Real GDP  ↑  \, \uparrow \, →  \, Money Demand  ↑  \, \uparrow \,
    • Real GDP  ↓  \, \downarrow \, or Financial Innovation   \, →  \, Money Demand  ↓  \, \downarrow \,
Money definitions
Jump to:NotesConceptFAQsPrerequisites
Notes

4 Factors of Money Holding

The quantity of money demanded is the amount of money people plan to hold on any given day. The amount of money that people plan to hold is based on the following 4 factors:

  1. The Price Level: The changes in price level causes someone to hold more or hold less nominal money (the quantity of money measured in dollars).

    Nominal money is proportional to the price level. Others remaining the same, if the price level
    1. Increases by xx %, then people hold xx %, more nominal money.
    2. Decreases by xx %,, then people hold xx %, less nominal money.

    Real money is the quantity of money measured in constant dollars (2005 dollars), and measures in terms of what it will buy. It is calculated using the following:

    Real Money = Nominal  MoneyPriced  Level\frac{Nominal\;Money} {Priced\;Level}


    Note: An xx % change in nominal money and price level will keep real money constant, other things remaining the same.

  2. Real GDP: The amount of money a household or firm plan to hold is based on the amount they are spending (consumer expenditure).

    If you think of it in terms of the whole economy, then the quantity of demand for money is based on aggregate expenditure (real GDP).

  3. Nominal Interest Rate: the nominal interest rate changes the amount of money people plan to hold because of opportunity costs.

    The higher the nominal interest rate, the higher the opportunity cost is for holding money.
    The lower the nominal interest rate, the lower the opportunity cost is for holding money.

    If the nominal interest rate is high, people would rather buy assets like savings bonds or Treasury bills to get the interest earned from them.

  4. Financial Innovation: The amount of money people plans to hold is influenced by technological changes, and new financial products. Some examples of financial innovations are daily interest checking deposits, credit cards and debit cards, and internet banking.

All these factors on money holding can be represented by using the Money Demand Curve.

Money Demand Curve

Demand for Money: is the relationship between the demand for quantity of real money and nominal interest rates (all other factors remaining the same).

The following graph illustrates the Money Demand Curve.

Money Demand & Supply


The higher the nominal interest, the lower the demand for the quantity of money.

The lower the nominal interest, the higher the demand for the quantity of money.

Shifts in Money Demand Curve: The demand for money can shift based on the increases and decreases of real GDP and financial innovation.

Case 1: If there is financial innovation or decrease in real GDP, then the money demand curve decreases, shifting to the left.

Money Demand & Supply


Case 2: If there is an increase in real GDP, then the money demand curve increases, shifting to the right.

Money Demand & Supply



Money Supply Curve

Supply for Money: is the relationship between the supply for quantity of real money and nominal interest rates (all other factors remaining the same), and is determined by banks and the Fed.

The following graph illustrates the Money Supply Curve.

Money Demand & Supply


The increase or decrease of nominal interest rate does not affect the quantity of money.

Shifts in Money Supply Curve: The Fed controls the supply of money.

Case 1: If the Fed increases the quantity of money, then the supply curve increases, shifting to the right,

Money Demand & Supply


Case 2: If the Fed increases the quantity of money, then the supply curve decreases, shifting to the left,

Money Demand & Supply



Short-Run & Long-Run Equilibrium

Short-Run Equilibrium: the equilibrium occurs at the intersection between the money demand curve and money supply curve.

Money Demand & Supply


This is where the demand for quantity of money is equal to supply for quantity of money.

Short-Run Effect from Shift of Money Supply: Suppose there is a shift in the supply curve. There are two cases of short-run equilibrium.

Case 1: The supply money curve shifts to the right.

Money Demand & Supply


People have more money than they plan to hold. With the extra money, people buy bonds. So, the demand for bonds increases and the prices of bonds increase, which decreases interest rates.

Case 2: the supply money curve shifts to the left.

Money Demand & Supply


People have less money than they plan to hold. To get more money, people sells bonds. So, the demand for bonds decrease and the price of bonds decrease, which increases interest rates.

Short-Run Effect from Shift of Money Demand: Suppose there is a shift in the demand curve. There are two cases of short-run equilibrium.

Case 1: The demand money curve shifts to the right.

Money Demand & Supply


People plan to hold more money. To get more money, people sell bonds. The demand for bonds decreases and the price of bonds decrease, which increases interest rates.

Case 2: the demand money curve shifts to the left.

Money Demand & Supply


People plan to hold less money. With the extra money held, people buy bonds. So, the demand for bonds increases and the prices of bonds increase, which decreases interest rates.

Long-Run Equilibrium: This occurs when the following conditions are met
  1. Actual inflation rate = expected inflation rate
  2. Real GDP = potential GDP.

In this case, the money market, loanable funds market, goods market, and labor markets are all in the long-run equilibrium.

Note: If the Fed increases the supply of money, then a new-long run equilibrium occurs but real GDP, employment, real money, and real interest does not change. Only the price level changes.
Concept

Introduction to Money Demand and Supply

Welcome to our exploration of money demand and supply! These fundamental concepts are crucial for understanding how economies function. Money demand refers to the amount of money individuals and businesses want to hold, while money supply is the total amount of money available in an economy. Our introduction video provides a fantastic starting point for grasping these ideas. It breaks down complex economic theories into easy-to-understand explanations, perfect for beginners and those looking to refresh their knowledge. As we dive deeper into this topic, you'll discover how factors like interest rates, income levels, and government policies influence both money demand and supply. This understanding is essential for interpreting economic trends and making informed financial decisions. Remember, mastering these concepts will give you valuable insights into the workings of our financial world. So, let's get started on this exciting journey through the realm of money demand and supply!

FAQs

  1. What is the difference between money demand and money supply?

    Money demand refers to the amount of money individuals and businesses want to hold, while money supply is the total amount of money available in an economy. Money demand is influenced by factors like interest rates, income levels, and price levels, whereas money supply is primarily controlled by central banks through monetary policy tools.

  2. How does the interest rate affect money demand?

    Interest rates have an inverse relationship with money demand. As interest rates rise, the opportunity cost of holding cash increases, leading people to hold less money and invest more in interest-bearing assets. Conversely, when interest rates are low, people tend to hold more money as the opportunity cost decreases.

  3. Why is the money supply curve vertical in the short run?

    The money supply curve is vertical in the short run because it's determined by the central bank and is not directly influenced by interest rates. This means that regardless of changes in interest rates, the quantity of money in circulation remains the same at any given point in time, unless the central bank decides to change it through monetary policy actions.

  4. What is the long-run neutrality of money?

    The long-run neutrality of money is the concept that changes in the money supply only affect nominal variables (like prices) in the long run, not real variables (like output or employment). This means that while increasing the money supply might stimulate the economy in the short term, in the long run, it primarily leads to inflation without affecting real economic growth.

  5. How do shifts in money demand or supply affect market equilibrium?

    Shifts in money demand or supply can change the equilibrium interest rate and quantity of money in the economy. For example, an increase in money demand (shifting the demand curve right) with a fixed money supply would lead to a higher equilibrium interest rate. Conversely, an increase in money supply (shifting the supply curve right) would result in a lower equilibrium interest rate and more money in circulation.

Prerequisites

Understanding money demand and supply is a crucial aspect of economics that requires a solid foundation in various economic concepts. While there are no specific prerequisite topics provided for this subject, it's important to recognize that a comprehensive grasp of basic economic principles is essential for fully comprehending the intricacies of money demand and supply.

To effectively study money demand and supply, students should have a strong understanding of fundamental economic concepts such as supply and demand, market equilibrium, and the role of money in an economy. These foundational principles provide the necessary context for exploring the complex relationships between money, interest rates, and economic activity.

Additionally, familiarity with macroeconomic indicators like GDP, inflation, and unemployment rates is beneficial when delving into money demand and supply. These indicators often influence monetary policy decisions and impact the overall money supply in an economy. Understanding how these factors interrelate can greatly enhance one's ability to analyze and interpret money demand and supply dynamics.

Moreover, knowledge of banking systems and financial institutions is valuable when studying this topic. The role of central banks, commercial banks, and other financial intermediaries in creating and circulating money is integral to comprehending money supply mechanisms. Familiarity with concepts like fractional reserve banking and the money multiplier effect can provide crucial insights into how money supply is affected by various economic factors.

While specific prerequisite topics are not listed for money demand and supply, students should approach this subject with a solid grounding in basic economic theory, macroeconomic concepts, and financial systems. This foundational knowledge will enable them to better grasp the complexities of money demand and supply, including factors that influence them, their impact on interest rates, and their role in shaping monetary policy.

As students progress in their study of money demand and supply, they may find it helpful to review related topics such as monetary policy, interest rate determination, and the quantity theory of money. These areas of study are closely interconnected with money demand and supply and can provide valuable context for understanding their broader economic implications.

In conclusion, while there may not be a specific list of prerequisite topics for studying money demand and supply, a well-rounded understanding of fundamental economic principles is essential. Students who approach this subject with a solid foundation in basic economics, macroeconomic indicators, and financial systems will be better equipped to grasp its complexities and appreciate its significance in the broader economic landscape.