Economic Modelling - the Demand for Money - Research Paper Example

Demand for Money (Course Name and Code) (Institutions’ Name) (Departments’ Name) (Students’ Name) Students’ Number) (Instructors’ Name) October 23, 2008 Introduction Money in many cases is a medium of exchange and a store of wealth. Therefore, the demand for money is the amount of wealth that is kept in the form of money, either in bank deposit or currency. Hence, common motives that are associated with holding money are to settle transactions, precautionary store of liquidity and to reduce the risk of a portfolio of assets. The demand for money as brought about many factors that have been used to classify them. This research focuses on developing a new idea on the reasons that lie behind the idea of demand for money. The method that will be followed will include analyzing previous literature, describing the data, obtaining the results and discussing both subjectively and objectively the results that were obtained (Bradbury 2006, p. 120). Previous Literature There has been a wide research in the issue of demand for money. Many researches are carried out with the help of error-correction model across developing countries and a range of industrial enterprises. Error correction model presents issues that relates to estimating and modeling the demand for money scenario, data frequency and period, co-integration and unit root technique and stability tests. Model Employed In this research the model that was employed is the error correction in which it brings into consideration the long term, co-integrating the relationship that stands between the levels of variables in collaborating with the short run relationship between the initial differences of the variables. Data Descriptions The data that was employed was between the periods 2001 to 2006. The data was in four aspects concerning the requirements or expectations of the research. The data that was obtained was in terms of level of prices, real GDP, interest rates and financial innovation. This data was grouped into quarterly period and the data was analyzed. Results The data that was obtained was used to draw graphs of level of prices, real GDP, interest rates and financial innovation. An understanding of Keynesian demand for money theory was used to analyze the data. Some graphs are shown in the appendices section. Information concerning interest rates was obtained from the central bank, commercial banks and exchange bureaus in determining the relationship between the demand for money and how people borrow the money. It is seen that when the interest rate is small say 5% more people will borrow the cash. However, when the interest rate goes up i.e. 9% the amount of money borrowed drastically reduces. The interests also contribute in the growth of the GDP in relationship in which consumers demand for the cash. It is obtained that even if the interest rate is high there is a higher chance of demand for cash. From figure II, the demand for cash moved from level MD1 to level MD2. The price of commodities determines the amount of money that is needed. When the price of commodities increases it means that the money that is demanded increase in a ratio that brings into consideration the change of value. Furthermore, the influence of financial innovation affects the amount of money that is demanded. Discussion In most cases the demand for money is usually indicated by the mathematical equation M/P=f(Y,i), where M represents the quantity of money that is demanded, i the interest rate while Y is the GDP. Hence, when the money market demand is at equilibrium, the equation applies: m = α+µp+βy+λi+ε. In this scenario, the value µ is the transaction demand for money, β is the speculative demand while the λ is the precautionary demand (Osborne 2005, p. 70). Transaction money demand is the amount of money that is supposed to fulfill a mission. There are different demands for money models that are developed by any consumer that shows that money balances that are held for transaction purposes to some extent are sensitive to the level of interest rates. In this scenario, it usually occurs when a hypothetical person receives payments within a specific period and they spend this amount over a period which results in them developing there own money demand model. This means that when the interest rate increases, it means that the amount that is held for transaction purposes will also decrease or decline. This will in turn mean that the velocity will increase as interest rates increases (Charlene 2006, p. 89). The transaction money is also affected by the inflation. When inflation occurs goods and services become more expensive that results in consumers to have more money. This means that the level of money that is held for transaction purposes will rise at the same rate as the prices. Hence, when the nominal demand for money rises, the real demand for money is constant. Precautionary demand for money is the amount of money that is available for use any time. This means that there are many benefits that are associated with storing or holding precautionary money balances, which in hand causes an opportunity cost of interest to be forgone by holding the said amount. Hence, the amount that is hold by an individual makes the individual to be less likely to incur the costs that are associated with illiquidity. This further means that the more amount of money that is hold by an individual, results in more interests that the individual decides to give up. Therefore, when the interest rates rises means that the opportunity cost of holding the precautionary balances raises which results in money balances to fall. Hence, it means that the more the precautionary demand for money negatively impacts the interest rates. Speculative demand for money is the amount of money that is ready to be used in the near future. This means that it understands the motive of transaction and precautionary for money which is emphasized by the medium of exchange function that is supported by the money function. This means that the transaction and precautionary demand for money is the aim to have money in hand so that to make it possible for payments. Therefore, the speculative demand for money is directly associated with wealth and the interest rate controls the amount of money that can be hold as to be referred to as a store of wealth. This results in the contribution of the demand for money in developing of interest rates. The store of wealth which sometimes may be referred as speculative demand for money can be stored in terms of money and bonds. These two aspects counterchange to fulfill their requirements: the money is used to acquire the bonds while the bonds redeemed for money. However, there is minor difference that is associated with store of wealth. Bonds attract interest and cannot be used for instant purchase of services since they have first to be converted into cash. Money attracts minimal interest rates and is available to purchase services and goods. Bonds pay interest; therefore people will use money to purchase the bonds. Hence, when the interest rate increases, the demand for bonds will increase which will make the demand for cash to drastically reduce. On the other hand, when the interest rates fall the demand for cash also rise. This scenario is seen in the period of demand for goods increases such as Christmas. Many people will require cash to be able to purchase goods and services. This means that when the demand for consumer spending increases it will result in an increase in demand for money. Furthermore, GDP affects the demand for money. Figure II shows that when the GDP improves the demand for money moves from position MDI to MDII. This occurs even if the interest rate remains constant. Financial innovation as depicted in figure II affects the demand for money. If the financial innovation improves the demand for money decreases; the demand for money moves from MDI and decreases to MDII (Howard 2003, p. 56). Conclusion The demand for money is an aspect that is important in fulfilling different dreams. There has been a wide research that is associated with the demand for cash. The most common issues that are depicted in the result and discussions are the interest rate. Interest rate and GDP controls the amount of money that can be hold. However, there are other reasons that require holding of money. This brings in three common demands for money; transaction, precautionary and speculative. Transaction demand for money results when there should be money that can be used instantly for exchange of services and goods. Speculative demand for money is the amounts that are planned to be used in the near future while precautionary are the demand for money that is available at any time when a need arises. Bibliography Bradbury, C. 2006. Financial Banking Enterprises. Macmillan Publishers, London. Charlene, K. 2006. Introduction to Economics. Prentice Hall, New York. Cohen, Y. 2005. Monetary Transactions. Prentice Hall of Jakarta, Jakarta. Howard, L. 2003. Introduction to Microeconomics. Prentice Hall, New York. McDonald, L. 2006. Introduction to Banking Businesses. McGraw Publishers, New York. Osborne, M. 2005. Business Management and Economics. Oxford University Press, London. Appendices Read More