David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

18. 7 The demand for money
Table 18.3
The demand for money
Effect of rise in
Quantity demanded
Price level
Real income
Interest rate
Nominal money
Rises in proportion
Rises
Falls
Real money
Unaffected
--
Rises
Falls
money. With more real money, we have plenty both for precautionary purposes and for transactions
purposes. Life is easier. The marginal benefit of yet more money holding is low.
Given our real income and transactions, desired money holdings are at E in Figure 18.2. For any level of
real money below L, the marginal benefit of another pound exceeds its marginal cost in interest forgone.
We should hold more money. Above L, the marginal cost exceeds the marginal benefit and we should hold
less. The optimal level of money holding is L.
To emphasize the effect of prices, real income and interest rates on the quantity of money demanded, we
now change each of these variables in turn. If all prices of goods and services double but interest rates and
real income are unaltered, neither MC nor MB shifts. The desired point remains E and the desired level of
real money remains L. Since prices have doubled, people hold twice as much nominal money to preserve
their real money balances at L.
If interest rates on bonds rise, the cost of holding money rises. Figure 18.2 shows this upward shift from
MC to MC'. The desired point is now E' and the desired real money holding falls from L to L'. Higher
interest rates reduce the quantity of real money demanded.6
Finally, consider a rise in real income. At each level of real money holdings, the marginal benefit of the last
pound is higher than before. With more transactions to undertake and a greater need for precautionary
balances, a given quantity of real money does not make life as easy as it did when transactions and real
income were lower. The benefit of a bit more money is now greater. Hence we show the MB schedule
shifting up to MB' when real income rises.
At the original interest rate and MC schedule, the desired level of money balances is L0• Thus a rise in real
income raises the quantity of real money balances demanded. Table 18.3 summarizes our discussion of the
demand for money as a medium of exchange.
So far we have studied the demand for MO, the narrowest measure of money. Wider definitions of money
must also recognize the asset motive for holding money. To explain the demand for M4, we interpret MC
as the average extra return by putting the last pound into risky assets rather than time deposits, which are
safe but yield a lower return. For a given wealth, MB is the marginal benefit of time deposits in reducing
the risk of the portfolio. If no wealth is invested in time deposits, the portfolio is very risky. A bad year is a
disaster. There is a big benefit in having some time deposits. As the quantity of time deposits increases, the
danger of a disaster recedes and the marginal benefit of more time deposits falls.
A rise in the average interest differential between risky assets and time deposits shifts the cost of holding
broad money from MC to MC', reducing the quantity of broad money demanded. Higher wealth shifts the
marginal benefit from MB to MB'. More time deposits are demanded.
6 The cost of holding money is the differential return between bonds and money. If 7t is the inflation rate and r the nominal
interest rate, the real interest rate is r - 1t. In financial terms, the real return on money is -7t, the rate at which the purchasing
power of money is eroded by inflation. The differential real return between bonds and money is (r - 7t) - (-7t) = r. The nominal
interest rate is the opportunity cost of holding money.
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