Demand for money represents the wealth people hold in the form of money.
There are three types of money balances:
- Transactions money balances represent money held to finance transactions;
- Precautionary money balances are held to meet any unforeseen obligations, and
- Speculative (portfolio) money balances refer to money held in the hope that the value of other financial assets would fall.
Transactions and precautionary money balances increase with an increase in GDP. Speculative money balances vary directly with the perceived risk of other financial assets and inversely with expected return on those assets. If we plot a demand for money curve with the nominal interest rate on the y-axis and quantity of money (in nominal terms) on the x-axis, it would slope downwards indicating that at the lower interest rate, demand for money is high.
The supply of money is generally assumed to be fixed at any given time. Hence the supply for the money curve is vertical.
The quantity theory of money
The quantity theory of money shows that total spending is proportional to the quantity of money. This is expressed through the quantity equation of exchange
M × V = P × Y
Where M is the quantity of money, V is the velocity of money, the number of times a dollar is used to purchase goods and services, P is the price level and Y is the real output.
If we take velocity as constant, the quantity theory of money represents money neutrality, the notion that any change in the quantity of money does not affect the real output but affects only the price level. Economists who believe in the quantity theory of money are called monetarists and they argue that the inflation rate can be controlled by managing the growth rate of the money supply.
Equilibrium of demand and supply for money
Demand for money equals the supply of money at the equilibrium interest rate. If interest rates on financial assets (say bonds) is greater than the equilibrium interest level, there would be an excess supply of money which people would use to buy financial assets until the interest rate reaches the equilibrium level and vice versa. Similarly, if the money supply increases but demand does not change, it means that money is more plentiful, hence, the interest rate and the value of money falls which causes an increase in the general price level. Even though a change in the money supply can have a short-run effect, in the long run, a change in the money supply would simply change the aggregate price level and would have no effect on real variables such as real output and unemployment. This phenomenon is called money-neutrality and it holds because output depends on labor, capital, natural resources, etc.