The Money Market and The Interest Rate
Do people always want as much money as possible? YES. However, when we talk about demand we know that there are sacrifices that have to be given up, specifically every individual faces a constraint. So the demand for money is how much money people would like to hold, given the constraints that they face.
Money is one of the forms in which people hold their wealth. At a given time, the total amount of wealth is given. If we want to hold more wealth in the form of money, we must hold less wealth in other forms - savings account, money market funds, time deposits, stocks, etc. An individual's quantity of money demanded is the amount of wealth that the individual chooses to hold as money, rather than as other assets.
Why do people want to hold more money? The most important reason is that money is a means of payment. Other forms of wealth are not used for purchases. The other forms of wealth provide a financial return to their owners. Money, pays either zero (cash or non-interest bearing checking accounts) or very little (some types of checking accounts) interest.
When you hold money, you bear an opportunity cost - the interest you could have earned.
Assumption - individuals choose how to divide wealth between two assets: (1) money, which can be used as a means of payment but earns no interest; and (2) bonds, which earn interest, but cannot be used as a means of payment.
What determines how much money an individual will decide to hold?
1) The price level - a rise in the price level, which raises the dollar cost of your purchases, should increase the amount of money you want to hold.
2) Real income -With a rise in income, your purchasing power increases.
3) Interest Rate - Interest payments are what you give up when you hold money - the opportunity cost of money. The greater the interest rate, the greater the opportunity cost of holding money.
Some businesses keep c...