Domestic International Money and Microfoundations - Assignment Example

Domestic International Money Question Rational individuals should only hold non-interest-bearing money for transaction purposes. To understand and explain this concept of why individuals should hold non-interest bearing money for his or her purposes, we must understand the modern monetary theory by John Maynard Keynes monetary theory (Steven 67). Keynes argues that there are three reasons why an individual will hold money: 1. An individual will hold money for transaction purposes (Helfied 63). Money is used as medium of exchange and a person can use the money to make purchases of goods and services of his or her choice to make transactions. 2. Precautionary money (Hall 333). An individual can hold money for his or her unexpected or unplanned transactions. 3. Speculative demand for money (Dixon 1168). An individual will hold more than what he needs, both transaction and precautionary purposes, so that the individual can cope with the uncertainty of the interest rates. An individual will hold money with an expectation of good future changes in rate of interest (Dutta and Kappur 554). Mi= Mi1+ M2i Whi = Mi + Bi Where Whi represents the total wealth that an individual holds Mi represents the money holding Mi1 represent the total transaction demand M2i represent the speculative demand Bi represents the total bond an individual can hold. The concept behind the speculative motive of holding money is that an individual will have to shift his or her wealth between the liquid assets and illiquid assets (Gillman 102). That is to say, the individual will shift his or her money, stocks, and bonds as the rate of interest changes. Keynes termed this phenomenon as the liquidity preference Keynes affirms that there inverse relationship that exists between the interest rates and the speculative demand for money. The total money demand is achieved by the summation of the speculative, transactions, and precautionary demands (Mizen 1207). This is represented graphically leading to the liquidity preference curve. The curve depicts that demand is inversely proportional to the rate of interest. Figure 1.0 Keynes emphasizes that the liquidity preference of money demand depends on the rate of interests and the level of GDP (Laidler 1215). This can be written as a linear function and money will be represented as the real balances. The purchasing power of money is considered against the amount of money an individual demands. Therefore, the real balances is represented by M1/P [M1/P]D = demand for real money balances                 = L(r,Y) = f*r - g*Y f>0, 0 Read More