MODULE: MACROECONOMICS

BB106
Unit 7: Demand For
Money
TUTORIAL
7

Short-answer Problems

1. What are the two types of demand for money?

Answer:
The two types of demand for money are transaction motive and asset motive.

2. Explain how the GDP and the interest rate are related to the transactions and asset demands for money.

Answer:
The transactions demand for money is believed to have a direct relationship with GDP and the level of
income but is through to be largely independent of interest rate fluctuations. The asset demand for money
is believed to be largely independent of the level of GDP but is inversely related to the interest rate.

3. Suppose that a bond having no expiration date has a face value of $10,000 and pays a fixed amount of
interest of $1000 annually. Compute and enter in the spaces provided either the effective interest rate
which a bond buyer could receive at the new price or the bond price (rounded to the nearest
$1000) required to receive the interest rate shown.

Bond price Interest rate

(%)

$ 8,000

11.1

10,000

12,000

6.67
Answer:
Bond price Interest rate (%)
$8,000 (i) 12.5
(ii) 9,009 11.1
10,000 (iii) 10.0
12,000 (iv) 8.3
(v) 14,993 6.67
Calculation:
1,000
(i) IR= ×100=12.5
8,000
1,000
(ii) 11.1= ×100=9,009
BP
1,000
(iii) IR= ×100=10
10,000
1,000
(iv) IR= ×100=8.3
12,000
1,000
(v) 6.67= ×100=14,993
BP

4. The total demand for money is equal to the transactions demand plus the asset demand for money.
(a) Assume that each dollar held for transactions purposes is spent on the average five times per year
to buy final goods and services. If the nominal GDP is $5000 billion ($5 trillion), what is the
transaction demand?

(b) The table below shows the asset demand at certain rates of interest. Using your answer to part
(a), complete the table to show the total demand for money at various rates of interest.

Interest Asset Total

rate demand demand

(in (billions) (billions)

%)

10 $ 40 $

8 80

6 120

4 160

(c) If the money supply is $1,080 billion, what will be the equilibrium rate of interest?

(d) If the money supply rises, will the equilibrium rate of interest rise or fall?

(e) If GDP rises, will the equilibrium rate of interest rise or fall?
Answer:
$ 5,000 billion
(a) Transaction demand= =$ 1,000 billion
5
(b)
Interest rate (%) Asset demand Total demand
(billions) (billions)
10 $40 $1,040
8 80 1,080
6 120 1,120
4 160 1,160

(c) When money supply is equal to total demand at 8%.

(d) If the money supply increases, the rate will fall.

(e) The rate will rise because transaction demand, hance, total demand, will rise and interest supply at a
new higher rate of interest.

5. Explain how the money market responds to a shortage of money or to a surplus of money.

Answer:
In the money market, the demand for money and the supply of money determine the interest rate.
Graphically, the demand for money is a down sloping line and the supply of money is a vertical line, and
their intersection determines the interest rate. Disequilibrium in this market (a shortage or a surplus of
money) is corrected by changes in bond prices and their inverse relationship with interest rates.

If there is a shortage of money, bonds will be sold. The increase in supply of bonds will drive down bond
prices causing interest rates to rise until the shortage is eliminated.

If there is a surplus of money, bonds will be bought. The increased demand for bonds will drive up bond
prices causing interest rates to fall until the surplus is eliminated.