Question

2. (Chapter 5 - Income Effect) Give two reasons why the increase in income would affect the demand for money. Would this also affect interest rate? Draw an appropriate diagram to explain.

Answer 1

Increase in income effect the demand for money, and there is a positive relationship between them. There are some reasons behint it -

1. Increase in consumption of goods - With increase in income people demand more money for the transaction motive as they want to buy many new things which they were not using before.
2. With increase in income of a person his precautionary and speculative demand for money also increases as higher income group people keep more money for fighting unforseen contegencies etc.

Increase in income effects the demand for money which in turn effects the interest rate, there is an inverse relationship between demand for money and interest rate as can be seen from graph below.

As it can be seen from the graph that there is an inverse relationship between interest rate and demand for money. This shows that if the income is low then the demand for money is low then the interest rate is high. And if the interest rate is low then people do not keep their money in bank and hence the demand for money is high.

Money Demand rate, Interest 25 35 45 - Quandity of money