In this video, we're going to be examining money demand. Households, firms, banks, governments, hold money for their transactions. They also hold money for short term store of value. So, we need to examine what drives those decisions about how much money to hold in order to understand the demand for money and then later on we're going to put it together with money supply to see how interest rate is determined in the market. Money demand has a number of determinants, including interest rates, income and the price level. So, let's think about how money demand, how much cash or demand deposit people would like to hold, depending on the situation, depending on changes in interest rate in the real income rate or in the price level. In order to do this, I'm going to give you a quick poll, and ask you to think about this, and provide your own answer we can then put everything together. Remember, that when we say holding money, we are talking about how much cash or demand deposits people are holding. We're not talking about how much assets they have, the stocks or other assets. This is only about the liquidity that they keep for their transactions. So, think about this. Suppose that real incomes rise. People are able to buy more goods and services. Would they hold more money, less money, about the same amount as before, or maybe more or maybe less? Think about this for a moment and let me come back to you with an answer. Well, I hope you've chosen the answer A, and the reason for this, is that when real income rises, we need to carry out more transactions. In fact, real income rising also means we're producing more goods and services for all those transactions included in production, included in consumption, we need more cash for our transactions. Therefore, we need to hold more cash to carry out those transactions. That's why we say, money demand goes up with real income. Now, let's answer the similar question, but this time looking at an increase in the price level. So, assume the real income is given,assume interest rates given, other things are given, the only thing is changing is the price level. You have to pay more for every product that you buy. Keep in mind that when real income goes up it means that with the price level going up, people who also sell goods earn more income in nominal income so that the real income remains the same. So, nominal income is rising with the price level. So, with that in mind, let's think about this. If price level goes up, would people want to hold more money, less money, about the same or maybe more or maybe less? Again the answer should be more money. The reason is that we are buying the same goods and services, we need more money for our transactions because the nominal amount that we pay for the goods and services we buy is higher now. Finally, let's check this. If the interest rate rises, what happens to the demand for the money? People hold more money, less money, about the same or maybe more or maybe less? The answer to this one is different, less money. Interest rate being higher, it means that if you keep cash you're foregoing the value you can get for it, if you had deposited into some savings account or kept it in some more illiquid assets higher interest rates, higher return elsewhere. The opportunity cost of holding money goes up and therefore, if interest rate goes up, people tend to economize on the use of money and hold less money. It means a little bit of hassle because every time they want to buy something, they need to switch their assets from illiquid assets to liquid assets to make their purchases. But if the interest rate is high and they get better returns elsewhere, it's worthwhile to do. Now, with all these things in mind, let's build a model of money as a medium of exchange and also as a store of value and unit of account. As a medium of exchange, we've seen that demand for money must be proportional to the price level and the real income. So, that's why we're showing here that money demand is proportional to PY. P being the price level let's say the GDP deflator and Y, being the real income or GDP. As a store of value, interest rate is the opportunity cost of using money and therefore we've seen that there's an inverse relationship between interest rate and money demand. So, we can actually summarize, what we've discussed as money demand equal to some coefficient K which is a parameter called propensity to hold money times PY, price level times real income and divided by interest rate, an inverse relationship in the interest rate. Let me highlight the names and/or label these variables and these money demand. I, is the interest rate, which is inversely related to money demand, Y, is real GDP, P is the price level, and finally K, remember is the propensity to hold money. Okay. Now, that was algebraic expression of demand for money, one can also show the relationship between money and its determinants in graphic form. Specifically, the relationship between interest rate and quantity of money. Suppose the interest rate is given at i0 and people decide that they would like to hold MD0 as the amount of money in their checking accounts or as cash. If interest rate goes down, it becomes cheaper to hold money, makes transactions easier you don't have to worry about switching between different accounts, and as a result, people tend to hold more money. So, as interest rate goes down, demand for money rises or quantity of money demanded goes up and vice versa. One can look at the points that show the combination of interest rate and money demand, and trace it as interest rate changes, money demand changes, and you get a curve, which you call money demand curve. Like any other demand curve, it's downward, sloping. One can actually look at the impact of other variables other determinants of money demand on this curve. Let's examine the role of income for example, real income. So, let's say income is initially real income is Y0. And it goes up to Y1. Let's see what happens to money demand curve. First, let's look at the initial situation. Income is Y0 interest rate i0 and money demand is MD0, and here's our demand curve. Now, at i0, if real income goes up, you want to make more purchases we need more money. So, at i0, the amount of money that people want to hold is higher, MD1, better than MD0. But this is true for every level of interest, demand for money is going to go up for every rate of interest. So, interest rate money demand combinations are no longer going to be in the place they used to be before, they're going to be at a higher position. In fact, the whole curve is going to shift to the right.
