Quiz 30: The Short-Run Trade-Off Between Inflation and Unemployment

Business

Factors affecting Demand for Money Demand for money is defined as the quantity of money households desire to hold in hand. Money demanded by households in an economy is sensitive to changes in price level, real aggregate output, market interest rate etc.a.Price level and Demand for Money Money demanded by households and price level are positively related. A fall in the price level will lead to decrease in the quantity of money households desire to hold. This is because, a fall in the price level would increase the real purchasing power of people and thus, the consumption expenditure would increase.Due to increase in real purchasing power, people would prefer to consume rather than to save. As a result, the demand for money curve will shift to the left. Similarly, an increase in price level would cause demand for money to increase and the demand for money curve to shift rightwards. b.Real aggregate output and Demand for Money Demand for money and real aggregate output are inversely related. An increase in real aggregate output will lead to increase in the quantity of money households desire to hold. This is because, increase in real aggregate output will lead to increase in consumption expenditure by households. Hence, the increase in the consumption expenditure will shift the demand for money curve to the right. Similarly, in case of reduction in real aggregate output, the demand for money curve would shift to the right. c.Money as a store of value and Demand for Money Demand for money and a store of value are inversely related. An increase in the ability of money to act as a store of value will lead to increase in the quantity of money households desire to hold. This is because increase in ability of money to act as a store of value will induce households to save more than to consume. Increase in saving would shift the demand for money curve to the right. Similarly, a shrink in the ability of money to act as a store of a value would shift the demand for money curve to the left. d.Market interest rate and Demand for Money Market interest rate and demand for money are inversely related. An increase in market interest rate will lead to a fall in the demand for money by the people. On the other hand, market interest rate will persuade investors to invest less and thus, the demand for money will decrease. As a result, there would be an upward movement along the demand for money curve.Similarly, in case of low interest rate, there would be downward movement along the demand for money curve.

Opportunity cost of money holding by households Money functions as a medium of exchange, a measure of value, a standard of deferred payments, and a store of value. Thus, money is demanded by households to exchange it directly against the goods and services, to use money as a store of wealth, to pay deferred payments etc.In general, demand for money indicates an inverse relationship between quantities of money demanded and the market rate of interest. That is, an increase in the market rate of interest results in a decrease in the quantity of money demanded by households and vice-versa.Households cannot store their entire wealth in terms of money because while storing wealth in terms of money, households incur an opportunity cost of losing the purchasing power of money in the near future when the rate of inflation is high in the economy. In general, interest rate earned on savings is lower than the interest earned on other financial assets. This difference between the interest rate earned on financial assets and interest earned on the saving is also an opportunity cost of households for holding money in hand. This opportunity cost increases with increase in the market rate of interest. Thus, Household would not use money only as a store of value; rather it will demand money for day-to-day transactions purpose, to use it as a standard of deferred payments, as well as to store wealth.

Required reserve ratio (RRR) and Aggregate Demand (AD)Required reserve ratio is the amount which each bank must keep as reserve from the depositor's money deposit. The RRR is fixed by the Central bank of a country. Example: If Federal Reserve fixes 10 percent of the required reserve, then the bank having $1 billion depositor's money must have 100 million as the required reserve ratio. A fall in the required reserve ratio will increase the money supply in the economy. Increase in money supply will lead to fall in market rate of interest, and thereby, it will induce investment. An increase in investment results in an increase in aggregate demand, because people demand more money to invest in financial assets and in other production activities when the market rate of interest is low. Thus, the aggregate demand curve would shift to the right.

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