Question

Graphically and verbally describe how the inflationary price premium is attached to the nominal rate of interest. Your answer must comprise a complete and thoroughgoing explanation of this phenomenon.

Specify and explain the three most important independent variables affecting the demand for money.

Answer 1

Answer to the question:

The price level and nominal rate of interest are related to each other. In order to understand this we will bring the concepts of money demand and money supply.

A increase in price level causes a decreases in the real money supply and a decrease in the price level increases the real money supply. That means there is a negative relationship between price level and real money supply. Real money supply is the money suplly divided by the price level (MS/ P). Now we will explain how the price level is related to nominal interest rate, with the help of the diagram below.

M/P M/P + B is i's Llis, Y) Real Money 2 1

Suppose the economy is in equilibrium at point A. Here, the vertical line shows the real money supply (M/P) and the curve negatively sloped shows the money demand. Now let us assume the price level increases ceteris paribus. Ceteris paribus implies all other variables in the model is remained fix or constant. It will now shift the vertical real money supply line to  M^S/P_$″. Now given the money demand function the nominal interest rate will increase from  i_$′ to i_$″.

So we find a positive realtion between price level and nominal interest rate. As the price level increases it leads to increase in the nominal interest rate.

The demand for money is affected by several factors but the three important independent factors are income, inflation and interest rate. The way by which these three factors affect the demand for money are usually explained with three motives od money demand, which are- transaction motive, precautionary motive and the speculative motive.

Transaction motive arises because people need money in order to exchange good and services. As money is required to buy good and services so people hold money and this is called transaction motive for demand for money. It is related with income. As income or GDP increases the transaction demand for money increases.

Precationary motive implies the motive of holding money for uncertain incidences. People hold money in order to cover some uncertain or unexpected payments. The need to hold money for uncertain and unexpected situation is refered to as precationary motive.

Speculative motive depends on the rate of interest. Money like other store of value is an asset. The demand for an asset basically depnds on its rate of return and opportunty cost. Generally money holding provides no rate of retun and decreciate its value due to inflation. The opportuniy cost of money is the rate of interest that could be earned by lending the money to someone. The speculative demand for money arises when holding money in hand is less risky than the other opportunity cost. So if the rate of interest is very low the speculative demand for money increases.