Aggregate Money Demand
Our discussion of how individual households and firms determine their demands for
money can now be applied to derive the determinants of aggregate money demand, the
total demand for money by all households and firms in the economy. Aggregate money demand
is just the sum of all the economy’s individual money demands.
Three main factors determine aggregate money demand:
1. The interest rate. A rise in the interest rate causes each individual in the economy
to reduce her demand for money. All else equal, aggregate money demand therefore
falls when the interest rate rises.
2. The price level. The economy’s price level is the price of a broad reference basket
of goods and services in terms of currency. Generally the reference basket includes
the standard, everyday consumption items such as food, clothing, and housing, but
also less routine purchases such as medical care and legal fees. If the price level rises,
individual households and firms must spend more money than before to purchase their
usual weekly baskets of goods and services. To maintain the same level of liquidity as
before the price level increase, they will therefore have to hold more money.
3. Real national income. When real national income (GNP) rises, more goods and
services are being sold in the economy. This increase in the real value of transactions
raises the demand for money, given the price level.
CHAPTER 15 Money, Interest Rates, and Exchange Rates 359
If P is the price level, R is the interest rate, and Y is real GNP, the aggregate demand for
money, can be expressed as
(15-1)
where the value of falls when R rises, and rises when Y rises.3 To see why we have
specified that aggregate money demand is proportional to the price level, imagine that all
prices doubled but the interest rate and everyone’s real incomes remained unchanged. The
money value of each individual’s average daily transactions would then simply double, as
would the amount of money each wished to hold.
We usually write the aggregate money demand relation (15-1) in the equivalent form
(15-2)
and call aggregate real money demand. This way of expressing money demand shows
that the aggregate demand for liquidity, , is not a demand for a certain number of currency
units but is instead a demand to hold a certain amount of real purchasing power in liquid
form. The ratio —that is, desired money holdings measured in terms of a typical reference
basket of commodities—equals the amount of real purchasing power people would like
to hold in liquid form. For example, if people wished to hold in cash at a price level
of per commodity basket, their real money holdings would be equivalent to
. If the price level doubled (to per basket), the purchasing
power of their in cash would be halved, since it would now be worth only 5 baskets.
Figure 15-1 shows how aggregate real money demand is affected by the interest rate for
a fixed level of real income, Y. The aggregate real money demand schedule L(R, Y) slopes
downward because a fall in the interest rate raises the desired real money holdings of each
household and firm in the economy.
For a given level of real GNP, changes in the interest rate cause movements along
the L(R, Y) schedule. Changes in real GNP, however, cause the schedule itself to shift.
$1,000
($100 per basket) = 10 baskets $200
$100 $1,000/
$1,000
Md/P
L(R, Y)
L(R, Y)
Md/P = L(R, Y),
L(R, Y)
Md = P * L(R, Y),
Md,
3 Naturally, L(R, Y) rises when R falls, and falls when Y falls.
Interest
rate, R
L(R, Y)
Aggregate real
money demand
Figure 15-1
Aggregate Real Money Demand
and the Interest Rate
The downward-sloping real
money demand schedule shows
that for a given real income level
Y, real money demand rises as the
interest rate falls.
360 PART THREE Exchange Rates and Open-Economy Macroeconomics
Figure 15-2 shows how a rise in real GNP from to affects the position of the aggregate
real money demand schedule. Because a rise in real GNP raises aggregate real money
demand for a given interest rate, the schedule lies to the right of when
is greater than .
Our discussion of how individual households and firms determine their demands for
money can now be applied to derive the determinants of aggregate money demand, the
total demand for money by all households and firms in the economy. Aggregate money demand
is just the sum of all the economy’s individual money demands.
Three main factors determine aggregate money demand:
1. The interest rate. A rise in the interest rate causes each individual in the economy
to reduce her demand for money. All else equal, aggregate money demand therefore
falls when the interest rate rises.
2. The price level. The economy’s price level is the price of a broad reference basket
of goods and services in terms of currency. Generally the reference basket includes
the standard, everyday consumption items such as food, clothing, and housing, but
also less routine purchases such as medical care and legal fees. If the price level rises,
individual households and firms must spend more money than before to purchase their
usual weekly baskets of goods and services. To maintain the same level of liquidity as
before the price level increase, they will therefore have to hold more money.
3. Real national income. When real national income (GNP) rises, more goods and
services are being sold in the economy. This increase in the real value of transactions
raises the demand for money, given the price level.
CHAPTER 15 Money, Interest Rates, and Exchange Rates 359
If P is the price level, R is the interest rate, and Y is real GNP, the aggregate demand for
money, can be expressed as
(15-1)
where the value of falls when R rises, and rises when Y rises.3 To see why we have
specified that aggregate money demand is proportional to the price level, imagine that all
prices doubled but the interest rate and everyone’s real incomes remained unchanged. The
money value of each individual’s average daily transactions would then simply double, as
would the amount of money each wished to hold.
We usually write the aggregate money demand relation (15-1) in the equivalent form
(15-2)
and call aggregate real money demand. This way of expressing money demand shows
that the aggregate demand for liquidity, , is not a demand for a certain number of currency
units but is instead a demand to hold a certain amount of real purchasing power in liquid
form. The ratio —that is, desired money holdings measured in terms of a typical reference
basket of commodities—equals the amount of real purchasing power people would like
to hold in liquid form. For example, if people wished to hold in cash at a price level
of per commodity basket, their real money holdings would be equivalent to
. If the price level doubled (to per basket), the purchasing
power of their in cash would be halved, since it would now be worth only 5 baskets.
Figure 15-1 shows how aggregate real money demand is affected by the interest rate for
a fixed level of real income, Y. The aggregate real money demand schedule L(R, Y) slopes
downward because a fall in the interest rate raises the desired real money holdings of each
household and firm in the economy.
For a given level of real GNP, changes in the interest rate cause movements along
the L(R, Y) schedule. Changes in real GNP, however, cause the schedule itself to shift.
$1,000
($100 per basket) = 10 baskets $200
$100 $1,000/
$1,000
Md/P
L(R, Y)
L(R, Y)
Md/P = L(R, Y),
L(R, Y)
Md = P * L(R, Y),
Md,
3 Naturally, L(R, Y) rises when R falls, and falls when Y falls.
Interest
rate, R
L(R, Y)
Aggregate real
money demand
Figure 15-1
Aggregate Real Money Demand
and the Interest Rate
The downward-sloping real
money demand schedule shows
that for a given real income level
Y, real money demand rises as the
interest rate falls.
360 PART THREE Exchange Rates and Open-Economy Macroeconomics
Figure 15-2 shows how a rise in real GNP from to affects the position of the aggregate
real money demand schedule. Because a rise in real GNP raises aggregate real money
demand for a given interest rate, the schedule lies to the right of when
is greater than .
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