Effects pertain to the real rate of interest, not to nominal market rates. An increase in the monetary growth rate, if it persists, will increase the rate of change of prices and, eventually, anticipations of that rate. By Fisher's theory, an increase in the anticipated rate of price change will raise nominal interest rates commensurately. D) None of the above answers is correct because the relationship between the demand for money and the nominal interest rate changes with the inflation rate. 16) The opportunity cost of holding money increases when. A) the purchasing power of money rises. B) the nominal interest rate rises. C) the price level falls. D) consumers' real incomes.

When Nominal Interest Rate Increases Demand For Real Money Balances Using
When Nominal Interest Rate Increases Demand For Real Money Balances Within

The Demand for Money on the Basis of its Functions!

The basic point about the demand for money is that individuals are interested in the purchasing power of their money holdings — the value of their cash balances in terms of the goods the cash will buy.

So money demand increases in proportion to the increase in the price level, given the constancy of the real variables such as the interest rate, real income and real wealth.

When the nominal interest rate increases the demand for real money balances

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An individual is assumed to be free from money illusion if a change in the level of prices, holding all real variables constant, leaves real behaviour, including real money demand, unchanged. By contrast, an individual whose real behaviour is affected by a change in the price level, all real variables remaining unchanged, is said to suffer from money illusion.

The demand for money is important in determining the effectiveness of fiscal policy in changing the level of income. Changes in fiscal variables, such as tax rates or government spending, affect the level of income if the demand for money changes when the interest rate changes — if the demand for money is interest-elastic.

When Nominal Interest Rate Increases Demand For Real Money Balances Using

If the demand for money is totally interest-inelastic — if it does not react at all to changes in the interest rate — increases in government spending totally crowd out private spending and leave the level of income unaffected. The demand should increase as the level of real income rises and decrease as the nominal interest rate rises.

The concept of demand for money originates from the Cambridge version of the quantity theory of money. According to this theory the demand for money is essentially one of real balances (M/P)_d and is proportional to income. It is presented as (M/P)_d = kY

where k is the fraction or proportion of income (Y) which people desire to hold in the form of real balance. The Cambridge economists used the concept of demand for money to show the link between money and prices.

Keynes, however, extended the concept of demand for money and considered a more general and realistic money demand function that assumes the demand for real money balances to depend on both the income and the rate of interest:

(M/P)_d = f(Y, i),

where i is the nominal interest rate.

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The link between money and interest rate was also shown by the IS-LM model developed in Chapter 9. It may be recalled that the shape of the LM curve depends on interest elasticity of demand for money. Keynes distinguished among three motives in people’s demand for money — a transaction motive, a precautionary motive, and a speculative motive.

The post- Keynesian economists have refined these categories and Keynes’ classification scheme has been revised somewhat. In particular, W. J. Baumol and James Tobin have said much more about the determinants of the demand for money than Keynes and the classicists. Milton Friedman has also restated the quantity theory of money.

A related point may also be noted at the outset. We know that money performs three main functions: it is a unit of account, a store of value, and a medium of exchange. The first function — money as an unit of account — does not generate any demand for money, because one can quote prices in money (in rupee or dollar) without holding it.

By contrast, money can serve its two other functions only if people hold it. Alternatively stated, theories of demand for money emphasise the role of money either as a store of value or as a medium of exchange. See Fig. 19.1 which is self-explanatory.

To start with we discuss the Keynesian theory of demand for money. It has subsequently been extended in two other directions, to which we turn later.

The classical economists were concerned with transactions demand for money because, to them, money was just a medium of exchange. According to the Cambridge version of the quantity theory of money the demand for money is expressed as

M_d = kPY … (1)

In this equation money demand is proportional to nominal income (the price level, P, times real income, Y). In equilibrium situations the proportion of income held in the form of money (k) was assumed to remain fairly stable.

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Alternatively, the Fisher version of the quantity theory of money is written as MV = PY … (2)

The velocity of money (V), equal to 1/K was assumed to remain stable. In the classical analysis, the rate of interest did not affect money demand.

Reading: AB, chapter 7, sections 2 and 3.

The demand for money

Consumption and saving decisions indirectly involve a decision about how much money to hold

Individuals need money for transactions involving consumption goods and services. This is the transactions demand for money.
Given income, what is not consumed is saved. Individuals must then decide how divide their savings into various kinds of assets: cash, savings accounts, government bonds, stocks etc. This is the asset allocation or portfolio problem. Since money pays very little interest (has a low return) the higher the interest rate on non-money assets the higher the opportunity cost of holding money.

Simplifying assumptions

Since the general asset allocation problem involves many different kinds of assets with different risk and return characteristics we simplify this decision by assuming that there are only two kinds of financial assets in the economy.

Money assets - low return, high liquidity and low risk. i_m = nominal interest rate on money assets.
Non-money assets (bonds) - higher return than on money assets and less liquidity. We assume that the risk associated with investing in bonds is not too high (think of government bonds as the generic non-money asset). Let i denote the nominal interest rate on non-money assets. Note that, by assumption, i > i_m. Also, recall that i = r + ^e, where r denotes the real return on non-money assets and ^e denotes expected inflation.

Model for money demand

Our model for the demand for nominal money balances takes the following form: https://trakyellow.amebaownd.com/posts/22989428.

where

M^d = demand for nominal money balances (demand for M1)

L^d = demand for liquidity function

P = aggregate price level (CPI or GDP deflator)

Y = real income (real GDP) Does james bond get the money back in casino royale.

When Nominal Interest Rate Increases Demand For Real Money Balances

I = nominal interest rate on non-money assets

r = real interest rate on non-money assets

^e = expected inflation

Remarks

Nominal money demand is proportional to the price level. For example, if prices go up by 10% then individuals need 10% more money for transactions.
As Y increases, desired consumption increases and so individuals need more money for the increased number of desired transactions.
As th