Aggregate Money Demand

Running Head: Aggregate Money Demand
Aggregate Money Demand
Customer Inserts His/her Name
Customer Inserts Grade Course
Customer Inserts Tutor`s Name
11 May 2011
Outline
* Introduction
* Components of Aggregate Money Demand
* Factors Affecting Aggregate Money Demand
* Measuring Money Demand
* Conclusion
* References
* Appendix
Introduction
Aggregate money demand is simply the demand for money in the economy which comes from the two basic units of economies- i.e. households and firms. The demand for money is an important aspect for economists as it helps measure the stability of an economy and is also an important factor in determining government intervention policies.
More specifically, in the recent past, with the on set of the financial crisis, the world experienced some of the worst liquidity problems as the aggregate demand for money rose beyond imagination. When BNP Paribas declared that its investors could not withdraw funds from two of its hedge funds due to subprime losses and shortage in cash, people with investments in other institutions also realized that the same thing could happen to them. As a result many investors and depositors started demanding their money back, where aggregate money demand rose to alarming levels, much beyond the cash reserves that these banks had. CITATION BBC09 \l 1033 (BBC, 2009) As a results one of the banks, Northwestern Rock faced the largest run on by depositors who were seeking their money back. As money demand rose, the banks were unable to meet these requirements and the government had to step in as guarantor.
Even if such events are the stuff of nightmare, and are fortunately a rare event, aggregate money demand, knowing how it works, and what are the factors affecting it is important for economists and policy makers to understand in order to formulate effective policies to balance the economy.
Before the paper proceeds to analyze the demand for money, it is important to define what money is. There are basically two types of money, Currency- which includes notes and coins in circulation, and checkable deposits on which account holders can write checks and these too function as money as they are immediately effective in giving the owner the right to purchase.
Components of Aggregate Money Demand
The three components of aggregate money demand are derived from the functions that money serves as a medium of exchange and as a store of value. These three components are demand for transactions balances, the demand for speculative balances and finally the demand for precautionary balances. These three demands are the components of the aggregate demand for money, discussing each in turn will help understand the functions of money better and will also help understand the reasons for the various fluctuations in money demand. CITATION Jer02 \l 1033 (Mushin, 2002)
With regards to the demand for transaction balances, these balances are the money held in hand in order to make cash payments. These are held in hand to deal with the demand for paying money when there is a timing lag between payments and receipts. The transactional balance that is kept at hand is directly related to the income of the firms and households, as the more income there is, the higher is the balance in terms of transaction demand. Additionally, given that households and firms have to pay a specified amount of money, if the frequency of the payments is more, the transactional amount will be smaller as compared to transactional balances that are required in less frequent payment requirements.
The next component of aggregate demand is speculation balance that is held for investment is shares or currency where fluctuations create capital gains. The decision to hold speculative balances is merely to maximize profits, they are held as a form of wealth. This is in contradiction to the Keynesian school of thought which indicates that money does not generate income and that speculative balances are held in order to avoid the losses that could occur from holding other assets. However the Keynesian school of thought that money does not earn income does not apply as in recent times, checking accounts which are also considered cash also earn interest in some places. Due to its relationship to other assets, as described by the Keynesian school of thought, the money is held in to ward of risks, and it is therefore related to the costs of other assets, therefore if interest levels falls, the price of financial instruments rises due to the increase in yield on instruments as compared to deposits, and when this occurs, the prices of assets rise and there is a risk of the prices of financial instruments falling, which is why there is higher speculative demand in times of higher interest rates. The third component of money demand is precautionary demand which indicates that some money is kept as a reserve in case of disasters so that the money can be useful in times of crisis. CITATION Jer02 \l 1033 (Mushin, 2002)
In keeping in view these components of money demand, understanding how various factors influence this phenomenon can be comprehended in much greater detail and analyzed in the context within which they occur.
Factors Affecting Aggregate Money Demand
According to CITATION Pau091 \l 1033 (Krugman & Obstfeld, 2009), aggregate money demand depends on three factors which are income, interest rates and price levels. Each of these factors has a major role to play in affecting money demand as these are the key macro variables that then go on to impact other indicators in the economy.
When we speak of income levels, the income level of firms and households is proportionately related to the money demand because the more the income a household has, higher its capability to spend, and the higher are the needs for money.
As far as interest rates are concerned, the liquidity in the market is closely related to interest rates and is in fact the tool of monetary policy with which money supply is curtailed in the market. However, being concerned with the aggregate demand for money, the relationship is also close, because if interest rates in the market are high, there is a greater attractiveness in people saving in deposit accounts and other securities to earn a higher interest rate, rather than loose out on the potential income by keeping cash. Therefore interest rates and aggregate money demand are inversely related.
Income levels are another factor in the equation that determines money demand in the economy. According to CITATION Pau091 \l 1033 (Krugman & Obstfeld, 2009), considering the real income of the economy, which is the GNP of the country, when GNP rises, people have more purchasing power and they need more money to spend rendering a positive correlation between money demand and GNP. This occurs when the price level remains constant.
In considering the price levels in an economy, the general price levels reflect the average price of a basket of goods that are required by consumers on an average day to day basis to survive. This price is indicated as the general price level in the economy, which in turn is one of the determinants of aggregate money demand in the economy. This is because when price levels rise, the prices of commodity increases which in turn increases the need for people to have more money in order to spend more on the same goods and services. Therefore an increase in prices increases the aggregate demand for money.
Till now we have seen, that from among the three determinants or factors of money demand, interest rates are negatively related while price and income levels are positively related to the aggregate demand for money. Studying the impact of these variables together, we can see that the demand for money shift towards the right, if there is an income increase at a given level of interest rates.
CITATION Oli07 \p 69 \l 1033 (Blanchard, 2007, ...