What is the money demand curve with shifters of it?

What is the money demand curve?

The money demand curve shows the aggregate quantities of money demanded by people in an economy at various interest rates when their income, expectations, and other factors are ceteris paribus (all other things being unchanged or constant).

The money demand curve is negatively sloped. Because there is an inverse relationship between the quantity of money demand in an economy and the interest rate. In other words, the money demand curve is downward sloping because of the interest rate, which represents the opportunity cost of holding money.

The income effect and the substitution effect are displayed on the money demand curve. Both effects encourage to reduction the demand for money when the interest rate rises. Both effects encourage to increase in the demand for money when the interest rate is falling.

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The following money demand curve shows the aggregate quantities of money demanded by people in an economy at various interest rates.

Money market graph shows the money market demand and supply forces and equilibrium of the money market.

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Money Market Graph with Demand, Supply and Equilibrium

What is money demand?

The money demand means the aggregate amount of money that firms and individuals of an economy keep with them. There are three main motives of money demand. They are transaction motive, precautionary motive, and speculative motive.

1. Transaction motive of demand for money

consumers demand for money with the transactive motive to pay food, education, clothes, transportation. Business firms demand for money with the transactive motive to pay factors of production, taxes, and other expenses.

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2. Precautionary motive of demand for money

The precautionary motive of demand for money means keeping some amount of money against unforeseen events. For example, keep money for unexpected situations such as repairs in cars and medicines.

3. Speculative motive of demand for money

The speculative motive of demand for money means people demand money to buy financial assets such as stocks and bonds for profitable opportunities. Money, when used for this purpose, is a means of temporarily storing wealth.

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Relationship between interest rate and money demand

The money demand curve represents the inverse relationship between the quantity of money demand in an economy and the interest rate.

That means if the interest rate is increased, the quantity demanded for money will be decreased, and if the interest rate is decreased, the quantity demanded for money will be increased.

Active money balances are the money balances are kept with the transaction motive and precautionary motive.  People demand for money with the transactive motive and precautionary to use them as a medium of exchange (There are three main functions of money. Medium of exchange is the main function of the money). Interest rates do not influence the active money balances because people keep these money balances for everyday transactions or to pay emergencies.  When people demand money with a speculative motive, it is called idle or passive money balances. They is a negative relationship between money demanded speculative purposes and interest rates.

When interest rates are high, there is a high opportunity of holding money. Because people have to sacrifice a higher percentage of interest income that is received from investment opportunities such as bonds, shares, and securities. Hence this will reduce the speculative balances. However, when interest rates fall, the opportunity cost of holding money will decrease and people will hold more money for speculative purposes.

Why is the money demand curve downward sloping?

The money demand curve downward sloping (negative sloping) because of the inverse relationship between the quantity of money demand in an economy and the interest rate.

When interest rates are high, there is a high opportunity of holding money. Because people have to sacrifice a higher percentage of interest income that is received from investment opportunities such as bonds, shares, and securities. Hence this will reduce the speculative balances. However, when interest rates fall, the opportunity cost of holding money will decrease and people will hold more money for speculative purposes.

Often people confuse the change in interest rate with shifts in the money demand curve. The truth is that whenever there is a change in interest rate, it results in a movement along the money demand curve, not a shift. The only change in external factors, apart from the interest rate, cause the money demand curve to shift. Let’s discuss factors that shift the money demand curve.

What shifts money demand curve?

Factors or determinants that shift the money demand curve are almost same as the factors that shift the traditional demand curve. Let’s discuss about them.

Change in general price level

If general price level is increased, there will be rightward shift in the money demand curve. In other words, if the general price level is increased, individuals require more money at any given level of interest rate.

On the other hand, if general price level is decreased, there will be leftward shift in the money demand curve. In other words, if the general price level is decreased, individuals require less money at any given level of interest rate.

As an example, assume that you need $1000 to buy a bag of goods. But if you consider the price level of before 20 years, you required only $500 to buy this bag of goods. The main reason for this difference is the increase in the general price level. If the prices increase significantly, you will have to have more money in your pocket to cover the additional expenses that you would incur.

Changes in Real GDP

An increase in real GDP shifts the money demand curve to the rightward as result of the increase of money demand.

When nominal GDP is adjusted for the changes in the general price level (inflation or deflation), we call it “real GDP”. Since the real GDP is free from price level changes, it is highly acceptable to measure the economic health of a country. Real GDP is calculated based on a fixed unit of currency.

The increase in the real GDP means people have additional goods and services to consume than earlier. So, people demand more money to purchase this additional amount of goods and services. Finally, the money demand curve shifts to the right.

On the other hand, a decline in real GDP causes the money demand curve to move to the left, which results in less money being wanted at any given interest rate.

Changes in Institutions

Institutional changes are modifications to the laws and ordinances that affect the money demand curve. In the past, banks in the US were not permitted to pay interest on checking accounts. Now, however, banks are permitted to provide interest on checking accounts. The money demand curve has been significantly influenced by interest earned on checking accounts. People can continue to earn interest on their checking accounts while keeping their money there.

The opportunity cost of retaining cash instead of investing it in an asset that would earn interest was reduced, which increased the demand for money. It may be argued that this led to a rightward shift in the money demand curve. However, since the interest paid on checking accounts is not as high as that on some other alternative assets, there is no appreciable impact on price levels or real GDP.

Consumer preference

Consumer preference for money shows a positive relationship with money demand. That means high consumer preference for money increases the money demand which leads to the rightward shift of the money demand curve. On the other hand, low consumer preference for money decreases the money demand which leads to the leftward shift of the money demand curve.

For example, some people prefer to keep money than other alternative investment instruments such as bonds and stocks. Because they believe that money is less risky than other alternative investment instruments. So, they do not consider the interest income of these alternative investment instruments. They prefer to keep the money. So, the demand for money will be increased and finally money demand curve shift to the right.

Change in technology

Before the rapid development of information technologies, it was considerably more difficult for people to obtain cash from the bank. To cash their cheques, they were forced to stand in line for an eternity. ATMs and other fintech devices have greatly facilitated people’s access to money in the modern world. Consider Apple Pay, PayPal, credit and debit cards, which are accepted practically anywhere in the United States. As a result, people’s need for money has been influenced because it is now simpler for them to make payments without holding cash. This, potentially, led to a shift to the left in the money demand curve, which led to a general decline in the amount of money demanded in the economy.