Answer to Question #88150 in Macroeconomics for Khensane

Question

What relationship does the demand for money has with income and interest rate?

Answer 1

Demand for money refers to the amount of assets that people wish to hold in form of money instead of holding illiquid physical assets. There are different motives for holding cash which include transaction motive, precautionary motive, and speculative motive.

In relation to income, demand for money is a function of income, assuming circulation velocity is stable, thus if income increases, the demand for money will also increase. This is because, money is considered as a normal good, and thus when income increases, individuals will demand more money at every interest rate, and when the income decreases, the demand for money will also decrease.

In relation to interest rates, demand for money has an inverse relationship with interest rate. That is, when interest rate increases, the demand for money decreases and vice versa. This is because, people save money based on returns in their savings. If for example, interest rate is expected to increase in the long term, the returns on savings is also expected to increase. Therefore, the firms and households will prefer to save their money leading to a decrease in demand for money. On the other hand, if interest rate is expected to decrease in the long run, the returns on savings will decrease. Firms and households will prefer not saving their money, thus demand for money will be high. In summary, the relationship between demand for money and interest rate is that at high interest rate, demand for money is low, and at low interest rate demand for money is high.

References

Keynes, J. M. (2008). The general theory of employment, interest, and money. Place of publication not identified: BN Pub.

https://www.agsm.edu.au/bobm/teaching/MM/lect07.pdf