The Demand for Money - Video Tutorials & Practice Problems
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The Demand for Money
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So we've talked about the money supply and other videos. Now let's get into the demand for money and how that demand curve will shift. So we're gonna be using what's called the theory of liquidity preference. And it's basically this is a fancy name for just doing supply and demand analysis in the money market. Okay, So now we're thinking about Mark, uh money is the good that we're basically demanding and supplying in this market. So when we think about the price of money, the price of money is gonna be the interest rate, the interest rate in the market. So think about it, right for you to get money. Let's say you wanted to get more money right now on demand. Well, you'd have to go to a bank and pay them interest, right? If you took out a loan with the bank, you'd pay interest, right? And the quantity of money in this situation, while this is just gonna be kind of the number of dollars, right? And we're going to think about the quantity of money, um just the amount of money available, right quantity. That one's kind of self explanatory. It's more about thinking about the price of money as interest, right for you to get money, you're gonna have to pay interest. Okay, so the demand for money, let's look at it on the graph real quick. And let's set up our graph here. So over here, remember whenever we did our supply and demand graphs, we have price on this axis quantity down here, on the X axis. Well, it's gonna be very similar here. The price of money, right? Was the interest rate. So that's gonna be on our Y axis? Just like we're used to with supply and demand and then the quantity of money, we'll just leave it as q quantity of money will be there. Just like we're used to quantity on the X axis. So what are we used to when we talk about a demand curve? What was our, our little pneumonic that we always remember the double D's, right downward demand. And guess what? We still can use that principle here. Our demand for money is gonna have a downward slope, just like we're used to, and this is going to be our money demand curve. Okay, so let's let's let's analyze a couple of points on this, on this graph. So up here, when the interest rate is high, So we'll say rate high. What happens to the demand for money? There's going to be this low demand for money, right? There's gonna be a quantity demanded down here. But what about at a low interest rate? So let's pick a low interest rate down here, rate low. And now what's happened to the demand for money? The quantity gets high over here, Right? The quantity demanded, I'll say quantity one. Oops, Quantity, one in quantity too. So what happens here as the rate goes down? The quantity demanded goes up, Right? And that's kind of how we, how we remember the law of demand, right? As prices fall, quantity demanded goes up. So how does that relate to the money market here. Well let's go down here and let's think about why we have this downward demand curve. So we have a downward sloping curve like we're used to with demand. But we have to think of the reasons why we're gonna have these double Ds. The double Ds. That we're used to. Right? So think about holding money. Right? So there's there's two things you can have, you can either have the money, let's say cash right here right now. Or you could invest that cash in, let's say a short term investment like Treasury Securities. So when we think about Treasury Securities, something like a Treasury Bond or a Treasury bill, it's a very safe investment because it's backed by the U. S. Government and it pays pays more interest than just having cash in your hand. Right? So let's think about let's compare this holding money to holding a financial asset like a Treasury bill. So money when you have cash, you can buy goods and services right with it, right? You can go to the store, you go to the grocery store and buy your groceries and pay in cash. However, you can't go to the grocery store. You cannot go to the grocery store and pay with a Treasury bill, right? You get you get to the register and you pull out this this security from the government that says hey this is worth $100. Uh Come on accept it. It's worth $100. They're not gonna accept it. They want cash, right? They're not gonna take a Treasury security in in place of cash at the grocery store. So we can think about money. You're gonna demand it when you need to buy goods and services. But you can't uh But when you don't need them you can invest it uh in the short term to get interest, right? So money earns no interest, right? No interest when you have cash in your hand, if you have $100 in your pocket today tomorrow it's still gonna be $100 in your pocket. Right? There's no interest earned. However, Treasury bills earn some interest. You're gonna earn some interest when you invest it in a Treasury bill. I'm gonna write these in different colors. So they stand out a little better. So they cannot buy goods and services with Treasury bills and they are in some interest. Okay, so as the interest rate increases, if we think about the interest rate in the market as it goes up, the opportunity cost of holding money increases, right? Because the higher the interest, let's say the interest you could be earning by investing in a Treasury security. Well that's that the interest rate goes up while you're giving up more and more interest by holding cash. So let's look at how it works here in our in our demand curve, notice when the interest rate is high, we have a low demand for cash because we would rather invest it and earn that high interest rate, right? So we're gonna invest it and earn high interest. But when the interest rate is low, well we'll go ahead and hold cash instead because there's not as much of an opportunity cost for holding the cash. So that's why we have our downward demand curve here uh for for the money demand. And that that's the reasoning behind it, but it's nice that it follows the same rules where we've got our double d downward demand curve. Okay, so let's pause here and then let's talk about shifting the money demand curve on the graph. Let's do that in the.
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Shifting Money Demand Curve
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Alright. So now let's consider why the money demand curve would shift left or shift right on the graph. So first let's think about a change in price. Remember when we talked about the demand curve and how a change in the price would only move us along the demand curve. Right? So that would be a change in price in this case is like a change in the interest rate. If we go back to the previous page, if just the interest rate say we started at the high interest rate And the interest rate is what changes in the market. So let's say this was 10% over here and this is 4% over here. Well if the only change in the market is that the interest rate went from 10% to 4%. We wouldn't draw a new demand curve. We would just move from this quantity demanded right here. Whatever this quantity is quantity one, we would move to this new quantity demanded along the same demand curve at quantity to okay, so we would not be drawing a new curve over here, nothing like that if the only thing that changes is the price. So in this case the price of money is the interest rate right? And if you don't remember that, definitely go back and review shifting demand and just the simple market, demand and supply and just review those videos and why we move when we shift the graph, shift the line and when we just move along the line. So that's the key here. It's just the interest rate changes. Well that's the price of money moving and we move along the curve. Now these other two things are the main reason why we would draw a new curve where we would have our first money demand curve and then draw a new one to the left or right because a good thing or a bad thing happened for money demand. So let's think about first the price level. So the price level is just the general price level in the economy, which we usually measure through the C. P. I remember the C. P. I. Which is the consumer price index. How much is the average prices in the economy? The price level in the economy. So if the price level increases so the prices of everything are generally higher in the economy. Do you think we're gonna demand more money or less money? We're gonna demand more money, right? Because we need more cash to buy everything. So the money the demand increases with price levels. So think about and the opposite right? If the price level decreases well we don't need as much cash on hand to buy stuff. So a good example is to think about. In the 19 fifties you could have purchased a meal at Mcdonald's. So in the 19 fifties for approximately 50 cents you could have got the burger, the fries, the shake whatever you got at Mcdonald's 50 cents was the price of the meal, the same meal would cost about $6 today cost about $6 today, right? So to buy the same amount of goods, you're buying a sandwich and a soda and some fries in 1950 you just keep a couple quarters in your pocket. Now, you need to have $55 and another dollar, right? You need to have a bunch of cash in your pocket to afford the same stuff. So as price levels increase, well, you're gonna need more money to buy the same goods. Cool, how about the next one? Real GDP. So what was Real GDP again? Real GDP is a measure of the quantity of things being produced in our economy. Okay, So we're measuring how much stuff is being produced, and you can imagine if Real GDP increases more stuff is being produced, what we're gonna need more money to purchase it. So money demand is gonna increase when Real GDP increases, and this should say decreases. I'm sure yours says the right thing. Um the money demand would decrease when Real GDP decreases. Okay, So as an example here, think about it when Real GDP increases, the quantity of goods and services bought and sold increased. So if there's more exchanges being made, more money is needed, right? We're gonna need more money to make these transactions happen. Okay, So those are the two main things. So just like we're used to we shift left. When something bad happens for money demand, we shift, right? When something good happens for money demand. So if it's something that would increase the demand for money, we shift to the right, and if it's something that would decrease it, we would shift to the left. So let's draw our original money demand here. This will be our demand curve. D. One for our first money demand curve. And what was our our Y axis again? Remember this is always gonna be price and quantity, but what's the price of money? The interest rate, right? The interest you have to pay to get money is going to be our Y axis. And then we've got the quantity of money. Just the amount that there is uh down there on the X axis. So the same thing over here. We'll have this as our axes interest rate and quantity. So let's start here on the left, graph shifting left. So let's say something happens like the price level decreases right, the price level in the economy decreases. So we don't need as much money to purchase our goods. Well, we would shift to the right. Excuse me, shift to the left, right, there's lower prices, We don't need as much money. So we would shift to the left and I'll draw the new curve in green, we'll draw a new curve here, right, there would be a new curve to the left and notice what happens in this case. So if we pick one level of the interest rate right here, let's say that was the interest rate. Well, what happens at this interest rate? We originally demanded this much money, This much money, quantity one right there, but at the same interest rate, since we've shifted to the left, we're demanding less money. And that's because something other than the interest rate has changed in this case, the price level decreased. So we just need less money at the same interest rate. Okay, So the quantity would decrease. In that case, we would shift to the left. All right, and that would be demand curve to the new demand curve right there. Okay. And shifting to the right. Well, that's the opposite. Now let's say something like Real GDP increases in the economy, there's more goods and services being produced and sold, there's more transactions being made. Well, we're gonna shift the other way. Let me get out of the way. Uh So this would be demand curve one, and we would shift now to the right, and we would have our new curve out here demand curve to. So the same logic applies here, if we're at if we have some interest rate in the economy, but something else in the economy got affected. That wasn't the interest rate, the level of real GDP increased. Well, what's happening to money, demand Money, demand originally was here at Q1, and now with that same interest rate, we're demanding more money because there's just more Real GDP more goods being trend, more transactions being made, so we want more money available there. Okay, We're demanding more money uh after the shift. Okay. At the same interest rate. So that should be something you're familiar with, shifting curves, left and right. We've done it before. Nothing's really changing here, other than what the product is. In this case, it's money. Alright, so let's pause here and let's move on.
