At any given interest rate, the amount of wealth that households and businesses desire to hold in the form of money balances, either as cash or any other highly liquid form of value (such as checking accounts), is called the demand for money.

People hold (demand) money to conduct transactions, to deal with emergencies (precautionary motive), and for speculative activities.

There is an inverse relationship between the demand for money and interest rates when all other influences on the amount of money that people wish to hold remain the same.

A rise in the interest rate brings a decrease in the quantity of money demanded. A fall in the interest rate brings an increase in the quantity of money demanded.

The money supply schedule is vertical since domestic supply of money is determined by the central bank and reserve requirements. The supply of money is not affected by changes in the interest rate.

Money market equilibrium occurs when people are willing to hold all the money supplied by the monetary authorities at the prevailing interest rate; the supply of money equals the demand for money. It occurs at i_e in the diagram.

However, disequilibrium exists at the interest rate i₂.

People are not willing to hold all the money supplied by the monetary authorities as money balances. Instead, they demand high-interest earning assets such as bonds. This will increase the price of bonds, which in turn reduces their interest yield, driving i₂ down towards i_e and eventually restoring equilibrium.

Disequilibrium also exists at the interest rate i₃.

People would like to hold more money balances than the monetary authorities are willing to supply. The resultant low demand for bonds reduces their prices, thus increasing their interest rate (yield), and slowly restores equilibrium at i_e.

The Fisher Effect

R_nom = R_real + R_inflation + risk premium

The nominal rate of interest is comprised of three components:

• A real required rate of return.
• A component to compensate lenders for future inflation.
• A risk premium to compensate lenders for uncertainty.

Practice Question 1

Which type of demand for money will tend to fall as the returns on the other financial assets rise?

A. Transactions-related
B. Precautionary
C. Speculative

Correct Answer: C

Speculative balances will tend to be inversely related to the expected return on other financial assets.

Practice Question 2

The quantity of money that people plan to hold depends on all of the following except the ______.

A. velocity of circulation
B. price level
C. interest rate

Correct Answer: A

One more factor in this decision is real GDP.

Practice Question 3

As interest rates rise, which type of demand for money falls?

A. Transactions-related
B. Precautionary
C. Speculative

Correct Answer: C

The interest rate is the price of money. It is the opportunity cost of holding money instead of investing in other financial instruments.

Practice Question 4

A decrease in real GDP will cause a ______.

A. movement up along the demand curve for money
B. rightward shift in the demand curve for money
C. leftward shift in the demand curve for money

Correct Answer: C

Practice Question 5

In the market for money, money and bonds are ______.

A. complements
B. the same item
C. substitutes
D. unrelated

Correct Answer: C

Practice Question 6

What factor will increase the quantity of real money that people plan to hold?

I. A rise in the nominal interest rate
II. A drop in the nominal interest rate
III. A rise in the price level
IV. A drop in the price level

Correct Answer: II

Similarly, a rise in the nominal interest rate on other assets decreases the quantity of real money that people plan to hold.

A rise in the price level increases the quantity of nominal money but doesn't change the quantity of real money that people plan to hold.

Practice Question 7

The Fisher effect says an increase in inflation will result in an increase in ______.

A. nominal interest rate
B. real interest rate
C. risk premium

Correct Answer: A

Practice Question 8

According to the Fisher effect, if the real interest rate is 2% and the risk premium is 4%, an increase of inflation rate from 3% to 4% will increase the nominal interest rate by ______.

A. 0%
B. 1%
C. 2%

Correct Answer: B

Nominal interest rate = real interest rate + inflation rate + risk premium

Practice Question 9

The vertical money supply curve represents the ______

A. idea that the money supply is increasing in the interest rate.
B. idea that the money supply is decreasing in the interest rate.
C. belief that the central bank has complete control over the money supply.
D. belief that the central bank has no control over the money supply.
E. The money supply curve is not vertical.

Correct Answer: C

A vertical money supply curve implies that the central bank can set the money supply independently of the interest rate.

Practice Question 10

Refer to the graph below. Monetary policy that shifts the AD curve from AD0 to AD1 but does not affect the price level decreases ______.

A. nominal output but not real output
B. both real and nominal output
C. real output but not nominal output

Correct Answer: B

Since the price level is fixed, a shift of the aggregate demand curve to the left must reduce both real and nominal output.

Practice Question 11

Which type of demand for money will tend to fall as the perceived risk in other financial assets falls?

A. Transactions-related
B. Precautionary
C. Speculative

Correct Answer: C

Speculative balances will tend to be directly related to the perceived risk of other financial assets.

Practice Question 12

Which type of demand for money is not directly linked to GDP?

A. Transactions-related
B. Precautionary
C. Speculative

Correct Answer: C

Both transactions-related balances and precautionary balances will tend to rise with the volume and value of transactions in the economy and GDP as well.

Practice Question 13

The need for money arises when income is received only occasionally (say once a month) in discrete amounts, but expenditures occur continuously. This type of demand for money is ______.

A. transactions-related
B. precautionary
C. speculative

Correct Answer: A

Money is needed for the purchase of goods and services.

Practice Question 14

Which of the following will increase the demand for money?

A. A fall in the price level or a decrease in the inflation rate
B. An increase in real output
C. An increase in the interest rate

Correct Answer: B

As output increases and, thus, incomes increase, individuals will wish to make more purchases, and money demand increases.

Practice Question 15

An increase in real output will cause which of the following?

A. An increase in interest rates and an increase in bond prices
B. An increase in interest rates and a fall in bond prices
C. A decrease in interest rates and an increase in bond prices

Correct Answer: B

An increase in real output causes an increase in money demand, which causes a rise in interest rates. This, in turn, causes a fall in bond prices, which are inversely related to the interest rate.

Practice Question 16

The quantity of real money that people plan to hold depends on these factors:

I. The price level
II. The nominal interest rate
III. Real GDP
IV. Financial innovation

A. II, III and IV
B. I and II
C. All of them

Correct Answer: A

All of the 4 factors affect the quantity of nominal money people hold. However, the price level does not affect the real money people hold.

Practice Question 17

Given a constant money supply, people may be expected to purchase more bonds if the money interest rate ______ the equilibrium rate in the money balances market.

A. has no relationship to
B. is lower than
C. is higher than

Correct Answer: C

When actual interest rate is higher than the equilibrium rate, there is an excess of money supply. People are expected to reduce their holdings of money balances and purchase some bonds to take advantage of high rates. The process will move the market for money balances toward equilibrium.

Practice Question 18

If the interest rate is falling, we can conclude that ______

A. the central bank is instituting an expansionary monetary policy.
B. the central bank is instituting a restrictive monetary policy.
C. We cannot conclude anything about the current monetary policy by looking at the interest rates.

Correct Answer: C

Interest rates are often a misleading gauge of monetary policy. For example, an unanticipated expansionary monetary policy can reduce the interest rate in the short run, but in the long run the result will be the opposite.