Demand, Supply, and Equilibrium in the Money Market
We have discussed the role of supply and demand in the money market, and we have seen how it has an effect on interest rates as well. Here, you will learn how transfer costs and expectations can affect demand. What is Keynes' theory with regard to the relationship between investment in bonds and money?
The Demand for Money
The Demand Curve for Money
We have seen that the transactions, precautionary, and speculative demands for money vary negatively with the interest rate. Putting those three sources of demand together, we can draw a demand curve for money to show how the interest rate affects the total quantity of money people hold. The demand curve for money shows the quantity of money demanded at each interest rate, all other things unchanged. Such a curve is shown in Figure 25.5 "The Demand Curve for Money". An increase in the interest rate reduces the quantity of money demanded. A reduction in the interest rate increases the quantity of money demanded.
Figure 25.5 The Demand Curve for Money
The demand curve for money shows the quantity of money demanded at each interest rate. Its downward slope expresses the negative relationship between the quantity of money demanded and the interest rate.
The relationship between interest rates and the quantity of money demanded is an application of the law of demand. If we think of the alternative to holding money as holding bonds, then the interest rate - or the differential between the interest rate in the bond market and the interest paid on money deposits - represents the price of holding money. As is the case with all goods and services, an increase in price reduces the quantity demanded.