| Learning Objectives |
The Money Market
Transactions demand (Lt) is that volume of money needed
to finance
expenditures.
The transactions demand for money is based on the equation of exchange:
The equilibrium in the money market reflects the simultaneous interaction
of the supply of and, the demand for, money. In this model, the supply of
money is set by the FED and, the demand for money comprises both the
speculative and transactions demand for money. The equilibrium interest
rate determined in the model simultaneously affects the goods market through the demand for investment.
| Where: |
| Lt = M = transactions money demand |
| v = velocity of money |
| P = GDP deflator |
| Y = real income |
The speculative demand for money (Ls) is inversely
related to the market rate
of interest. It is thought that the demand for cash balances to finance
speculative investment will decrease when interest rates rise since the
opportunity cost of holding cash (potential returns for purchasing a
financial instrument) increases when the market rate of
interest goes up. Conversely, the amount of cash held for speculative
purposes will likely increase when interest rates are low since the
opportunity cost of holding cash is low.
The speculative demand for money function specifies constant elasticity
along the function where:
Ls=A*i-
i = the interest rate
= the
interest elasticity of the speculative demand for money =
%
Ls / %
i More elastic speculative demand is consistent with a Keynesian view, whilst a less elastic speculative demand reflects a classical perspective.
Please select some parameters below and the graph you want to inspect. The
parameters related to the transactions demand function are the velocity of
money (V), and the price level (P). The interest elasticity
of the speculative demand for money
(
)
may also be changed to reflect
differing
assumptions about the effectiveness of monetary policy. The money supply
(Ms) may also be changed. The two scenarios will be
shown for each graph (transactions demand, speculative demand, the money
supply and the money market).