Quiz 14: Modern Macroeconomics and Monetary Policy

Business

Money in any economy serves three purposes. It can works as units of account, medium of exchange and also has store value. People want to hold money because of three reasons ? Transaction purpose ? Precaution purpose ? Speculative purpose People want money for day to day transaction. They need money to buy goods and services. The money that people demand for consumption purpose is called the transaction demand for money. The transaction demand depends on the interest rate and inflation. As interest rate increases, the transactions demand for money falls and vice versa. People also hold money to face any emergencies that arises either in personal life or in economy. The demand for money that people want to hold to combat emergency is called the precautionary demand for money. The precautionary demand depends on the income of individual and interest rate. It has been seen that the people with higher income hold more money to combat contingencies. On the other hand, as the interest rate increases the credit becomes easily available, people hold less money for precaution and precautionary demand falls. People hold money to avoid the capital loss that arises by holding bond. This happens when interest rate is high, the price of bond falls and people experience loss from existing bonds. If people expect a lower interest rate in future, people will held more money in bond and the money for speculative demand will be low. The money people want to hold if they perceive a higher gain from holding money is called the speculative demand for money. At higher interest rate, the bond price is low; people expect a higher capital gain and buy bonds. Thus, they hold less money for speculation. Therefore, the speculative demand for money is low at higher interest rate and vice versa. From the discussion above we can see that the transaction demand, the speculative demand and the precautionary demand all are inversely related to interest rate. That is if the interest rate increases then all these demand for money will fall and vice versa. Therefore, the demand for money as a whole is also inversely related to interest rate.

(a) Money in any economy serves three purposes. It can works as units of account, medium of exchange and has store value. People want to hold money because of three reasons ? Transaction purpose ? Precaution purpose ? Speculative purpose The transaction demand, the speculative demand and the precautionary demand all are inversely related to interest rate, positively related to income and inflation rate. The demand for money increases if people find money more profitable that other assets or they simply need it due to rise in price or rise in demand. If the interest rate in checking deposit increases people will earn interest on the money they keep in the checking account. Therefore, it will be more profitable to put money on checking deposit than to hold it liquid. Hence, the demand for money will decrease as the interest rate on checking deposit increases. (b) If people expect that there will be higher inflation in the future, they will hold more money. This is because; people will need more money for transaction as price of good will increase. Hence, demand for money will increase if the expected rate of inflation increases. (c) If the income of the individual increases, the demand for money will also increase. This is because, as people have more money in hand they will buy certain things they planned to and even increase day to day consumption. (d) If the difference between interests earn on checking deposit and money market mutual fund increases, then people will find it profitable to put money in checking deposit. Thus, more money will be needed to put in the checking deposits and hence, the demand for money will increase in the economy.

The opportunity cost is the cost of foregoing the next best alternative use of a resource. If 'A' quits his $300/month job to join collage. Then his opportunity cost of attending college is $300 multiplied by the number of months he attends the college. Then in the same logic, opportunity cost of obtaining $100,000 house is the other alternative use of the money, such as the bond that could have bought or the car that could have bought with the money. The opportunity cost of holding the house for one year is the interest that is forgone if the money could have been kept in any financial institution or the capital gain that is forgone if some bond would have bought with the money. The opportunity cost of obtaining $1000 is the next alternative use of time and labor taken to obtain $1000. Other much more productive use could have been done with done that could have proved more profitable. The money in the checking deposit earns little or no interest and very liquid. The holding $1000 in checking deposit for one year certainly earns much less interest rate than the other deposit or other financial assets. Therefore, the opportunity cost of $1000 held in checking account is he interest rate forgone by not opting to high interest earning option.

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