Answer to Question #131309 in Microeconomics for Kutlwano mahlaula

Question

Explain in detail, with the aid of a graph, the two components of the demand for money.
Identity the main determinant of each component.
In your graph, illustrate each component as well as the total demand for money

Answer 1

Demand for money is the amount of money that households and firms want to have at their disposal, depending on the nominal gross domestic product (GDP in monetary terms) and the lending rate. The demand for money consists of the demand for money for transactions and the demand for money from the asset side. Demand for money for transactions (operational demand for money) - the demand from households and firms for the purchase of goods and services, settlements for their obligations.

Operational demand for money depends on:

• on the volume of nominal gross domestic product: the more goods and services are produced, the more money is needed to service trade and payment transactions;

• the speed of circulation of money, the higher it is, the less babbling is needed for commercial transactions and vice versa;

• the level of income in society: the higher it is, the more transactions are made and the more money is required to complete these transactions;

• price level: the higher it is, the more money is needed to carry out trade transactions.

With a certain simplification, we can say that the operational demand for money changes in proportion to the nominal gross domestic product and does not depend on the lending rate. The money demand graph for Dm1 deals is shown in Figure a and looks like a vertical line.

People hold their assets in the form of cash, stocks and bonds, savings accounts, precious metals, etc. The advantage of money as an asset lies in its absolute liquidity, in the ability to immediately use it to purchase goods and make payments. Besides, people have money for contingencies.

The demand for money from assets (speculative demand for money) depends on interest rates. Moreover, the dependence is inverse. The higher the interest rates, the more assets are held in the form of stocks, bonds and savings accounts, and less in the form of cash, and vice versa, the lower the interest rates, the more of their assets, especially financial, the population keeps in the form of cash. The inverse relationship between the interest rate and the amount of money that people want to have as assets is shown in Figure b, where Dm2 is the demand for money from assets.

The aggregate demand for money can be determined by summing the demand for money for transactions and the demand for money from the asset side: Dm = Dm1 + Dm2. Consequently, the aggregate demand for money depends on the level of the nominal interest rate and the volume of nominal GNP. The graph of the total (cumulative) demand for money Dm is constructed by shifting the demand graph from the asset side along the horizontal axis by an amount equal to the demand for money for transactions.

Moreover, the curve of the aggregate demand for money at high interest rates takes an almost vertical shape, since all savings are invested in this situation in securities, the demand for money is limited by the operational demand and does not decrease with further growth of the interest rate.