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Changes in Money Demand

25 April, 2016 - 09:12

Suppose that the money market is initially in equilibrium at r1 with supply curve S and a demand curve D1 as shown in Panel (a) of Figure 25.9. Now suppose that there is a decrease in money demand, all other things unchanged. A decrease in money demand could result from a decrease in the cost of transferring between money and nonmoney deposits, from a change in expectations, or from a change in preferences. Panel (a) shows that the money demand curve shifts to the left to D2. We can see that the interest rate will fall to r2. To see why the interest rate falls, we recall that if people want to hold less money, then they will want to hold more bonds. Thus, Panel (b) shows that the demand for bonds increases. The higher price of bonds means lower interest rates; lower interest rates restore equilibrium in the money market.

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Figure 25.9 A Decrease in the Demand for Money

A decrease in the demand for money due to a change in transactions costs, preferences, or expectations, as shown in Panel (a), will be accompanied by an increase in the demand for bonds as shown in Panel (b), and a fall in the interest rate. The fall in the interest rate will cause a rightward shift in the aggregate demand curve from AD1 to AD2, as shown in Panel (c). As a result, real GDP and the price level rise.

Lower interest rates in turn increase the quantity of investment. They also stimulate net exports, as lower interest rates lead to a lower exchange rate. The aggregate demand curve shifts to the right as shown in Panel (c) from AD1 to AD2. Given the short-run aggregate supply curve SRAS, the economy moves to a higher real GDP and a higher price level.

An increase in money demand due to a change in expectations, preferences, or transactions costs that make people want to hold more money at each interest rate will have the opposite effect. The money demand curve will shift to the right and the demand for bonds will shift to the left. The resulting higher interest rate will lead to a lower quantity of investment. Also, higher interest rates will lead to a higher exchange rate and depress net exports. Thus, the aggregate demand curve will shift to the left. All other things unchanged, real GDP and the price level will fall.