The Functions of Money: Changes in Money Demand

Changes in Money Demand A change in money demand is a change in the relationship between the level of interest rates and the stock of money demanded in the economy caused by a change in economic conditions. When there's a change in money demand, the entire demand curve for money will shift inward or outward. A change in the transaction demand for money at any given interest rate level results in a change in money demand. As pointed out earlier, a change in nominal GNP will result in a change in the transaction demand for money. Nominal GNP will increase either when real GNP goes up or the price level goes up. It follows that either an increase in real GNP or an increase in the price level will shift the money demand curve outward, as illustrated in graph A in Box 3. Similarly, a decrease in real GNP or a decrease in the price level will shift the money demand curve inward, as shown in graph B. Given the price level, it's therefore reasonable to expect that an increase in real GNP will increase money demand. During periods of economic expansion, the money demand curve will be shifting outward. Similarly, given the price level, decreases in real GNP will imply decreases in the demand for money. During periods of contraction or recession, it's therefore reasonable to expect that the demand for money will decrease. The money demand curve can also shift in response to other changes in economic conditions. For example, the invention of automatic teller machines has reduced the transaction cost of obtaining currency. You can now easily obtain currency from your savings account, even on evenings and weekends when banks are closed. This innovation is likely to have affected your demand to hold currency and checkable deposits. The proliferation of credit cards is another financial innovation that has affected the demand for money. With a credit card you can consolidate many bills into one that you can pay each month, and if you pay in full you'll incur no interest expense. By using a credit card, you can keep less money in checkable deposits and hold more in savings accounts or money market accounts that yield interest. You can then withdraw funds from these accounts as needed to meet credit card bills. A decrease in the transaction cost of converting near money to money will decrease the demand for money. The cost of converting bonds, savings deposits, and other assets to currency and checkable deposits can fall when the time to do so or the penalties involved in doing so are reduced. People hold less money when the transaction costs of converting near money to money fall, because it's less advantageous to do so. They therefore shift some of their wealth to bonds and near money. A decrease in the transaction cost of converting near money to money thus will shift the money demand curve inward. Similarly, an increase in the transaction cost of converting near money to money will shift the money demand curve outward. The demand for money will also change with changes in the risk associated with holding alternative assets other than money. For example, in periods when bond prices are expected to rise, the demand for money is likely to decline as people seek to hold lower money balances at any given interest rate so they can acquire more bonds. If, however, bond prices are expected to fall, the demand for money is likely to increase because money becomes a more attractive asset as the probability increase of incurring a loss from holding bonds. The demand curve for money will therefore shift inward when bond prices are expected to rise and shift outward when bond prices are expected to fall.