Transaction demand (for money) The need to accommodate a firm's expected cash transactions. New muni bond issues scheduled to come to market within the next 30 days. Monetarist Rule. Proposal that the money supply be increased at a steady rate equal approximately to the real rate of growth of the economy. Of a stable money demand function, and the strategy adopted by the ECB. We also provide new evidence on the stability of euro area money demand based on a framework that captures the effect of uncertainty on the demand for money, an idea first proposed by Friedman (1956). The remainder of this paper is structured as follows.

Demand for money

The demand for money is the desired holding of financial assets in the form of money: that is, cash or bank deposits. It can refer to the demand for money narrowly defined as M1, or for money in the broader sense of M2 or M3.Money in the sense of M1 is dominated as a store of value by interest-bearing assets. However, money is necessary to carry out transactions; in other words, it provides liquidity. This creates a trade-off between the liquidity advantage of holding money and the interest advantage of holding other assets. The demand for money is a result of this trade-off regarding the form in which a person's wealth should be held. In macroeconomics motivations for holding one's wealth in the form of money can roughly be divided into the transaction motive and the asset motive. These can be further subdivided into more microeconomically founded motivations for holding money.Generally, the nominal demand for money increases with the level of nominal output and decreases with the nominal interest rate. The real demand for money is defined as the nominal amount of money demanded divided by the price level.

To keep the demand for money equal to a constant money supply as the interest rate rises and we move along the LM curve, the level of income must increase. An increase in the money supply holding the real interest rate constant requires a higher level of income to make the demand for money equal to that greater supply, shifting LM to the right. In the money market Real money demand and the real money supply as functions of the real interest rate are illustrated in the above graph. Real money demand is graphed holding fixed real income and expected inflation. The real money supply is equal to the nominal amount of M1.

Demand

A money demand function intends to display the influence that some economic aggregate variables will have upon the aggregate demand for money. The above discussion indicates that money demand will depend positively on the level of real GDP and the price level due to the demand for transactions. Money demand will depend negatively on average interest rates due to speculative concerns. We can depict these relationships simply using the following functional representation.

Here M^D is the aggregate, economy-wide money demand, P_$ is the current US price level, Y_$ is US real GDP, and i$ is the average US interest rate. The f stands for 'function.' f is not a variable or parameter value, it simply means that some function exists that would map values for the right-hand-side variables, contained within the brackets, into the left-hand-side variable. The '+' symbols above the price level and GDP levels mean that there is a positive relationship between changes in that variable and changes in money demand. For example, an increase (decrease) in P_$ would cause an increase (decrease) in M^D. A '-' symbol above the interest rate indicates that changes in i$ in one direction will cause money demand to change in the opposite direction.

For historical reasons, the money demand function is often transformed into a real money demand function as follows. First, rewrite the function on the right-hand side to get,

In this version, the price level, P_$, is brought outside the function f( ) and multiplied to a new function labeled L( ), called the liquidity function. Note that L( ) is different from f( ) since it contains only Y and i$ as variables. Since P_$ is multiplied to L( ) it will maintain the positive relationship to M^D and thus is perfectly consistent with the previous specification. Finally, by moving the price level variable to the left-hand-side we can write out the general form of the real money demand function as,

This states that real money demand, M^D/P_$, is positively related to changes in real GDP (Y$) and the average interest rate (i_$) according to the liquidity function. We can also say that the liquidity function represents the real demand for money in the economy. That is, the liquidity function is equivalent to real money demand.

Finally, simply for intuition's sake, any real variable represents the purchasing power of the variable in terms of prices that prevailed in the base year of the price index. Thus, real money demand can be thought of as the purchasing power of money demanded in terms of base year prices.

Supply

Money supply is much easier to describe because we imagine that the level of money balances available in an economy is simply set by the actions of the central bank. For this reason it will not depend upon other aggregate variables and thus we need no function to describe it.

We will use the parameter M^S_$ to represent the nominal US money supply and assume that the FED, using its three levers, can set this variable wherever it chooses. To represent real money supply, however, we will need to convert by dividing by the price level. Hence let, represent the real money supply in terms of prices that prevailed in the base year.

Equilibrium

The equilibrium interest rate is determined at the level that will equalize real money supply with real money demand. We can depict the equilibrium by graphing the money supply and demand functions on the following diagram

The functions are drawn on the adjoining diagram with real money, both supply and demand, plotted along the horizontal axis and the interest rate plotted along the vertical axis.

Real Money Demand Definition Economics

Real money supply, , is drawn as a vertical line at the level of money balances, measured best by M1. It is vertical because changes in the interest rate will not affect the money supply in the economy.

Real money demand, i.e., the liquidity function L(Y_$, i_$) is a downward sloping line in i_$ reflecting the speculative demand for money. In other words, there is a negative relationship presumed to prevail between the interest rate and real money demand.

Where the two lines cross determines the equilibrium interest rate in the economy, i_$ since this is the only interest rate that will equalize real money supply with real money demand.

Real Money Demand Function

International Finance Theory and Policy - Chapter 40-7: Last Updated on 1/11/05