- 1 Demand for Money
- 2 Supply of Money
- 3 FAQs Demand and Supply of Money
- 3.1 What is the composition of total demand for money in an economy?
- 3.2 How does an increase in the money supply affect bond prices and interest rates?
- 3.3 What factors influence speculative demand for money?
- 3.4 What is the velocity of circulation of money, and why is it significant?
- 3.5 What is a liquidity trap, and when does it occur?
- 4 More Articles
Demand for Money
Total demand for money in an economy is composed of Transaction Demand: The amount of money required for current transactions of companies and individuals and Speculative Demand: The desire to have money for the purpose of investing in assets. The former is directly proportional to real GDP and price level, whereas the latter is inversely related to the market rate of interest.
- If the supply of money in the economy increases and people purchase bonds with this extra money, demand for bonds will go up, bond prices will rise and the rate of interest will decline.
- When the interest rate comes down, more and more people expect it to rise in the future and anticipate capital loss. Thus they convert their bonds into money giving rise to a high speculative demand for money.
- When the interest rate is very high, everyone expects it to fall in future and hence anticipates capital gains from bond-holding. Hence people convert their money into bonds. Thus, speculative demand for money is low.
- Velocity of circulation of money: The number of times a unit of money changes hands during the unit period.
- Liquidity Trap: Occurs when interest rates are very low, yet consumers prefer to hoard cash rather than spend or invest their money in higher yielding bonds or other investments.
- Aggregate Money Supply= total currency with the public + demand deposits of the public with banks. When you withdraw Rs. 1,00,000 from the bank, it goes to the currency in hand from demand deposits in banks but it does not change the value of the money supply.
- Interest Coverage Ratio is a debt and profitability ratio used to determine how easily a company can pay interest on its outstanding debt.
Supply of Money
Money in a modern economy includes cash and bank deposits. These are created by the central bank and commercial banking system.
FAQs Demand and Supply of Money
What is the composition of total demand for money in an economy?
The total demand for money comprises transaction demand, necessary for current transactions, and speculative demand, driven by the desire to invest in assets. Transaction demand is influenced by real GDP and price level, while speculative demand is inversely related to the market rate of interest.
How does an increase in the money supply affect bond prices and interest rates?
When the money supply increases and individuals purchase bonds, demand for bonds rises, leading to higher bond prices and a decline in the interest rate.
What factors influence speculative demand for money?
Speculative demand for money is influenced by expectations regarding future interest rates. When interest rates are high, individuals anticipate capital gains from bond-holding, reducing speculative demand. Conversely, when interest rates are low, individuals expect future rate increases, leading to higher speculative demand.
What is the velocity of circulation of money, and why is it significant?
The velocity of circulation refers to how frequently a unit of money changes hands within a specified period. It’s significant as it reflects the efficiency of money flow within an economy, impacting economic activity and GDP.
What is a liquidity trap, and when does it occur?
A liquidity trap occurs when interest rates are low, yet individuals prefer to hold onto cash rather than spend or invest. This phenomenon can hinder monetary policy effectiveness and economic stimulation efforts.
