[MUSIC] So far, we have talked about the functions of money, and the price of money. These discussions lead logically, to a broader discussion of the demand for money. The two major determinants of money demand, are known as the Transactions Demand, and the Asset Demand. The transactions demand for money arises because people and firm use it as a medium of exchange. For example, households need money to buy groceries and firms need money to pay for materials and labor. This figure illustrates the mechanics of transactions demand. The figure shows the average money holdings of a family that earns a three thousand dollar paycheck per month. Keeps it only in money, and spends the money during the month. A simple calculation will show that the family holds $1,500 on average in money balances. Basic determinant of the amount of money demanded for transactions, is the level of nominal GDP. The larger the total money value of all goods and services that are exchanged in the economy, the larger amount of money need, to negotiate these transactions. So, what do you think will happen to the transactions demand for money if prices and nominal GDP double? If prices and nominal GDP double, the transactions demand for money will double. The asset demand or, speculative motive for holding money, arises because people use money as a store of value. As an example of the asset demand for money, suppose you were interested in buying some stocks or bonds. But maybe you think that the present prices are too high. In this case, you might want to hold some money, so that you can be ready to buy the stocks or bonds when the price becomes more attractive. Essentially then, you are speculating that a better financial opportunity will appear soon. Note, however, that while money is an asset, money provides no rate of return or interest, like other assets, such as stocks and savings accounts do. Moreover, when you hold money, it's value can depreciate, because of inflation. So here's the punch line, there is an opportunity cost of holding money. That includes the interest or rate of return that could have been earned by lending or investing the money. As well as the loss in value from holding money during inflation. So what do you think will happen to the Asset Demand for money, if interest rates rise, or the expectation of inflation increases? If either the interest rate, or the expectation of inflation increases, the opportunity cost of holding money increases. So, the Asset Demand for money must decrease.
