Money Demand Curve

What happens when individuals hold cash and don’t have their money invested in stocks or other assets? What are some reasons that would push people to hold more cash? What’s the relationship between money demand and interest rate? You will be able to answer all these questions once you read our explanation of the money demand curve. Ready? Then let's get started!

Money Demand and Money Demand Curve Definition

Money demand refers to the overall demand for holding cash in an economy, whilst the money demand curve represents the relationship between the quantity of money demanded and the interest rate in the economy. Let's step back for a moment and provide a background for these terms.It is convenient for individuals to hold money in their pocket or in their bank accounts. They can make daily payments while buying groceries or going out with friends. However, keeping money in the form of cash or in checking deposits comes with a cost. That cost is known as the opportunity cost of holding money, and it refers to the money you would have made if you had invested them in an asset that generates returns. Even holding money in a checking account involves a trade-off between convenience and interest payments.

You have long-term interest rates and short-term interest rates for which you can earn money. Short term interest rate is the interest rate you make on a financial asset that matures within one year. In contrast, a long-term interest rate has a more extended period of maturity, which is usually more than one year.

If you were to keep your money in a checking account or under the pillow, you would be forgoing the interest rate that is paid on savings accounts. This means that your money will not grow as time passes, but it remains the same. This is especially important when there are inflationary periods when if you were not to place your money in an asset that generates a return, the money you have would lose value.

Usually, during an inflationary time, the money demand increases significantly, as people demand more cash and want to have their money in their pockets to keep up with the rising cost of goods. One important thing to keep in mind is that when the interest rate is high, there is less demand for money, and when the interest rate is low, there is more demand for money. That is because people don't have the incentive to put their money in a savings account when it is not providing a high return.

The money demand curve represents the relationship between the quantity of money demanded and the interest rate in the economy. Whenever there is a decrease in the interest rate, the quantity demanded of money increases. On the other hand, the amount of money demanded drops as the interest rate rises.

Money demand curve is negatively sloped as there is a negative relationship between the quantity of money demanded and the interest rate. In other words, the money demand curve is downward sloping because of the interest rate, which represents the opportunity cost of holding money.

Money Demand Graph

The money demand curve can be depicted on a graph which represents the relationship between the quantity of money demanded and the interest rate in the economy.

Figure 1. Money demand curve, StudySmarter Originals

Figure 1 above shows the money demand curve. Notice, that whenever there is a decrease in the interest rate, the quantity demanded of money increases. On the other hand, the quantity of money demanded drops as the interest rate rises.

Why is the money demand curve downward sloping?

The money demand curve is downward sloping because the economy's overall interest rate affects the opportunity cost individuals face when holding money at different levels of the interest rate. When the interest rate is low, the opportunity cost of maintaining cash is also low. Therefore, people have more cash on hand than when the interest rate is high. This causes an inverse relationship between the quantity of money demanded and the interest rate in the economy.

Often people confuse the change in interest rate with shifts in the money demand curve. The truth is that whenever there is a change in interest rate, it results in a movement along the money demand curve, not a shift. The only change in external factors, apart from the interest rate, cause the money demand curve to shift.

Figure 2. Movement along the money demand curve, StudySmarter Originals

Figure 2 shows movement along the money demand curve. Notice that when the interest rate falls from r₁ to r₂, the quantity of money demanded increases from Q₁ to Q₂. On the other hand, when the interest rate increases from r₁ to r₃, the quantity of money demanded drops from Q₁ to Q₃.

Causes of a Shift in the Money Demand Curve

The money demand curve is sensitive to many external factors, which could cause it to shift.

Some of the leading causes of the shift in the money demand curve include:

• changes in the aggregate price level
• changes in real GDP
• changes in technology
• changes in institutions

Figure 3. Shifts in the money demand curve, StudySmarter Originals

Figure 3 shows a rightward (from MD₁ to MD₂) and a leftward (from MD₁ to MD₃) shift in the money demand curve. At any given interest rate level such as r₁ more money will be demanded (Q₂ compared to Q₁) when there is a shift of the curve to the right. Similarly, at any given interest rate such as r₁ less money will be demanded (Q₃ compared to Q₁) when there is a shift of the curve to the left.

Note, that on the vertical axis, it is the nominal interest rate rather than the real interest rate. The reason for that is the nominal interest rate captures the real return you receive from investing in a financial asset as well as the loss in purchasing power that results from inflation.

Let’s look at how each of the external factors could influence the money demand curve.

Change in the Aggregate Price Level

If the prices increase significantly, you will have to have more money in your pocket to cover the additional expenses that you would incur. To make it more accurate, think about the money in your pocket your parents had to have when they were your age. The prices at the time your parents were young were significantly lower: almost anything cost less than it costs now. Therefore, they needed to keep less money in their pocket. On the other hand, you need to hold much more cash than your parents had to as everything now is more expensive than it used to be. This then causes the money demand curve to shift to the right.

In general, an increase in the aggregate price level will cause a rightward shift in the money demand curve. This means that individuals in the economy will demand more money at any given level of interest rate. If there is a decrease in the aggregate price level, it will be associated with a leftward shift in the money demand curve. This means that individuals in the economy will demand less money at any given level of interest rate.

Changes in Real GDP

Real GDP measures the total value of all goods and services produced in the economy adjusted for inflation. Whenever there is an increase in real GDP, it means that there are more goods and services available than there were before. These additional goods and services will be consumed, and to consume them, people will need to purchase them by using money. As a result, there will be an increase in money demand whenever there is a positive change in real GDP.

In general, when more goods and services are produced in the economy, the money demand curve will experience a rightward shift, resulting in more quantity demanded at any given interest rate. On the other hand, when there is a drop in the real GDP, the money demand curve will shift leftward, resulting in less quantity of money demanded at any given interest rate.

Changes in Technology

Changes in technology refer to the availability of money for individuals, which affects the money demand curve.

Before a significant growth in information technologies, it was much harder for individuals to access cash from the bank. They had to wait forever in line to cash out their checks. In today’s world, ATMs and other forms of fintech have made the accessibility of money much easier for individuals. Think about Apple Pay, PayPal, Credit cards, and Debit cards: almost all stores in the U.S. accept payments from such technologies. This then has impacted the money demand of individuals as it became easier for them to make payments without having to hold cash. This, arguably, resulted in an overall decrease in the quantity of money demanded in the economy, due to a leftward shift in the money demand curve.

Changes in Institutions

Changes in institutions refer to rules and regulations that influence the money demand curve. Before, banks weren’t allowed to provide interest payments on checking accounts in the United States. However, this has changed, and now banks are allowed to pay interest on checking accounts. Interest paid on checking accounts has significantly impacted the money demand curve. Individuals can keep their money in checking accounts while still receiving an interest payment on them.

This caused the demand for money to increase, as the opportunity cost of holding money instead of investing it in an interest-bearing asset was removed. This, arguably, caused the money demand curve to shift rightward. However, there is no significant impact compared to price levels or real GDP, as the interest paid on checking accounts is not as high as some other alternative assets.

Examples of the Money Demand Curve

Let's take a look at some examples of money demand curves.