DEMAND FOR MONEY
Money market equilibrium is determined by demand and supply of money. The function form of demand for money is-
m^d=F( P, Y, i)
where m^d stands for money demand, P stands for price level, and i stands for rate of interest.
(m/P)^d = F ( Y , i )
Demand for money refers to demand for cash balance, there are 2 types of money that is currency and checkable deposits.
Nominal demand for money depends on following 3 factors:
1 RATE OF INTEREST (i)
Money is useful for transactions but it does not earn any interest. On the other hand bonds earn positive interest but they can’t be used for transaction purpose. Therefore, opportunity cost of keeping cash is nominal interest rate that we sacrifice on bond. Therefore, where interest rate is high demand for money is less.
2 LEVEL OF TRANSACTIONS ( Y)
As level of transaction in an economy increases, there will be more need for money because money is used for transaction purpose. Therefore with economic growth there will be increase in demand for money.
3 PRICE LEVEL (P)
As price level increases, there will be increase in demand for money because at higher price we require more money to purchase goods and services .
Therefore , we can write relation between demand for money, nominal interest rate, price level and output as-
m^d= F ( P , Y, I )
m^d = P Y L (i)
m^d = $ Y L (i)
MONEY MARKET EQUILIBRIUM
Equilibrium interest rate is determined by money market equilibrium, which requires m^d= m^s, suppose that central bank decides to supply amount of money m, as we know money demand function is
m^d = P Y L(i)
Therefore, equilibrium in financial market requires that
m^d = m^s
P Y L (i) = m
From this equation it follows, that interest rate must be such that given the nominal income , people are willing to hold amount of money=existing money supply . This equilibrium relationship is known as LM relation.
At any interest rate above equilibrium there will be excess supply of money and it will be used by people to purchase bond. As, a result demand for bond increase , which increase the value of bond and thereby decreases rate of interest . However , if I is below equilibrium then there will be excess demand for money, it means people want to hold more cash, to keep more cash, they will sell bonds. As a result, value of bond decreases and i will increase. Therefore, i continue to change so that money market attains equilibrium.