Develop and improve products. List of Partners vendors. All else being equal, a larger money supply lowers market interest rates , making it less expensive for consumers to borrow.
Conversely, smaller money supplies tend to raise market interest rates, making it pricier for consumers to take out a loan. The current level of liquid money supply coordinates with the total demand for liquid money demand to help determine interest rates. In a market economy , all prices, even prices for present money, are coordinated by supply and demand.
To get more present money, these individuals enter the credit market and borrow from those who have an excess of present money savers. Interest rates determine the cost of the borrowed present money. The current Federal funds rate, as of October , is the rate that banks charge each other for overnight loans and a measure of the economy's health. The money supply in the United States fluctuates based on the actions of the Federal Reserve and commercial banks.
By the law of supply , the interest rates charged to borrow money tend to be lower when there is more of it. However, market risk is another pressure on interest rates that influences them in a significant way. Economists call these dual functions "liquidity preference" and "risk premium. Interest rates aren't only the result of the interaction between the supply and demand for money; they also reflect the level of risk investors and lenders are willing to accept.
This is the risk premium. Suppose an investor has excess present money and he's willing to lend or invest the extra cash over the next two years.
It's not immediately clear which he should choose because he needs to know the likelihood that he'll be paid back. For a given level of expenditures, reducing the quantity of money demanded requires more frequent transfers between nonmoney and money deposits.
As the cost of such transfers rises, some consumers will choose to make fewer of them. They will therefore increase the quantity of money they demand. In general, the demand for money will increase as it becomes more expensive to transfer between money and nonmoney accounts. The demand for money will fall if transfer costs decline.
In recent years, transfer costs have fallen, leading to a decrease in money demand. Preferences also play a role in determining the demand for money.
Some people place a high value on having a considerable amount of money on hand. For others, this may not be important. Household attitudes toward risk are another aspect of preferences that affect money demand. As we have seen, bonds pay higher interest rates than money deposits, but holding bonds entails a risk that bond prices might fall.
There is also a chance that the issuer of a bond will default, that is, will not pay the amount specified on the bond to bondholders; indeed, bond issuers may end up paying nothing at all. A money deposit, such as a savings deposit, might earn a lower yield, but it is a safe yield. Heightened concerns about risk in the last half of led many households to increase their demand for money.
Such an increase could result from a higher real GDP, a higher price level, a change in expectations, an increase in transfer costs, or a change in preferences. An Increase in Money Demand. An increase in real GDP, the price level, or transfer costs, for example, will increase the quantity of money demanded at any interest rate r, increasing the demand for money from D1 to D2. The reverse of any such events would reduce the quantity of money demanded at every interest rate, shifting the demand curve to the left.
Answer the question s below to see how well you understand the topics covered in the previous section. This short quiz does not count toward your grade in the class, and you can retake it an unlimited number of times. Use this quiz to check your understanding and decide whether to 1 study the previous section further or 2 move on to the next section. Skip to main content. Module: Monetary Policy. Search for:. Reading: The Demand for Money Motives for Holding Money In deciding how much money to hold, people make a choice about how to hold their wealth.
Interest Rates and the Demand for Money The quantity of money people hold to pay for transactions and to satisfy precautionary and speculative demand is likely to vary with the interest rates they can earn from alternative assets such as bonds. Bond Funds The bond fund approach generates some interest income.
The Demand Curve for Money We have seen that the transactions, precautionary, and speculative demands for money vary negatively with the interest rate. Other Determinants of the Demand for Money We draw the demand curve for money to show the quantity of money people will hold at each interest rate, all other determinants of money demand unchanged.
The Price Level The higher the price level, the more money is required to purchase a given quantity of goods and services. Expectations The speculative demand for money is based on expectations about bond prices. Transfer Costs For a given level of expenditures, reducing the quantity of money demanded requires more frequent transfers between nonmoney and money deposits.
Preferences Preferences also play a role in determining the demand for money. The total number of transactions made in an economy tends to increase over time as income rises. Hence, as income or GDP rises, the transactions demand for money also rises. Precautionary motive. People often demand money as a precaution against an uncertain future.
Unexpected expenses, such as medical or car repair bills, often require immediate payment. The need to have money available in such situations is referred to as the precautionary motive for demanding money. Interest rates can be affected by monetary and fiscal policy, but also by changes in the broader economy and the money supply. Interest rates fluctuate over time in the short-run and long-run.
Within an economy, there are numerous factors that contribute to the level of the interest rate:. Fluctuation in Interest Rates : This graph shows the fluctuation in interest rates in Germany from to Interest rates fluctuate over time as the result of numerous factors.
This graph illustrates the fluctuations that can occur in the short-run and long-run. Interest rates fluctuate based on certain economic factors. In economics, equilibrium is a state where economic forces such as supply and demand are balanced and without external influences, the equilibrium will stay the same.
Market equilibrium refers to a condition where a market price is established through competition where the amount of goods and services sought by buyers is equal to the amount of goods and services produced by the sellers. In the case of money supply, the market equilibrium exists where the interest rate and the money supply are balanced. The money supply is the total amount of monetary assets available in an economy at a specific time.
Without external influences, the interest rate and the money supply will stay in balance. Privacy Policy. Skip to main content. Monetary Policy. Search for:. Introduction to Monetary Policy. The Demand for Money In economics, the demand for money is the desired holding of financial assets in the form of money cash or bank deposits.
Learning Objectives Relate the level of the interest rate to the demand for money. Key Takeaways Key Points Money provides liquidity which creates a trade-off between the liquidity advantage of holding money and the interest advantage of holding other assets.
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