Answer to Question #131320 in Microeconomics for Girl

Question

Explain with the aid of a graph the impact of a cut in the interest rate on the demamd gor money

Answer 1

A cut in interest rate results in an increase in the demand for money since interest rate and money demand are inversely related. The only exception is during liquidity trap where a fall in interest rate does not affect money demand.

Interest rate is the cost of borrowing, from the investors' perspective, and is the opportunity cost of holding money, from the savers' perspective. Keynesians define the demand for money as the demand to hold assets in the form of money; demand for money to hold - liquidity preference. They believe that people can hold only two assets namely money and bonds. Interest rate is thus the opportunity cost of holding money. Clasissical economists on the other hand, consider the demand for money as the demand for loanable funds for investment. Interest rate is thus the cost of borrowing.

In both cases, the interest rate and money demand are inversely related. According to Keynesians, as interest rate falls, people hold more cash balances (increase demand for money) because the return on bonds decreases. Therefore, as interest rate falls, money demand rises. From another angle, classical economists argue that a cut in interest rate reduces the cost of borrowing money. As a result, the demand for loanable funds (money for investment) increases. Thus, a fall in interest rate increases money demand. The graph below illustrates this concept.

As shown on the graph, a fall in interest rate from R1 to R2, as indicated, results in an increase in quantity of money demanded from Q1 to Q2.

The only exception is during liquidity trap, interest rate cuts will have no impact on money demand; the liquidity preference curve becomes perfectly elastic - flat. This region is on the far right portion of the graph where interest rates are lowest. One major explanation is that during recessions, 'animal spirits' entice people into increasing their rate of saving and reducing investment in interest bearing assets - bonds.