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Current time:0:00Total duration:8:15

Demand curve for money in the money market

AP.MACRO:
MKT‑3 (EU)
,
MKT‑3.A (LO)
,
MKT‑3.A.1 (EK)

Video transcript

what we're going to do in this video is talk a lot about money and in particular we're gonna talk about the market for money and this might seem a little bit counterintuitive because we're used to thinking about the market in other things and we use money as a way to think about price we use money as a way to facilitate transactions but now the market is money itself so the first question is how do we somehow come up with a cost of money and to help us with that I'll give you a little bit of a thought experiment let's say that we had a very very simple world where you had two options you could have your cash money you could have a hundred dollars in cash just like that or you could lend that hundred dollars to the government and the government would pay you back in a month 101 dollars so your other option we'll call that a bond a bond which is really your lending in this situation you are lending this money to the government let's assume that it is risk-free that the government is good for the money you can also have bonds where you're lending to other entities like States or to corporations but let's say that this is a federal government bond and in one month it costs $100 it costs $100 and in one month in one month the government will pay back government pays back 101 dollars so my question to you is what if you decide instead of buying in this bond and then having the government pay you back in a month for $101 instead of that if you decide hey you know what that sounds interesting but I just like the feel of of cash what is the opportunity cost of holding the cash pause the video and think about that well if you decide to hold this cash instead of buying this government bond instead of lending it to the government for that month you are foregoing one dollar so your opportunity cost right over here you could view it as one dollar over over the month or if you think about it in term of how much money this is you have a 1% opportunity cost opportunity opportunity cost and as we are about to see we think about the opportunity cost of holding the money as it's cost in the money market so let me draw some axes here to start thinking about this this this money market all right so let's call this vertical axis the nominal interest rate nominal nominal interest rate sometimes you'll see and IR it's abbreviated but let's we'll just write it out the nominal interest rate in that in that axis and the reason why I'm focusing on the nominal interest rate is we don't know in this situation what inflation is we don't know how to calculate the real interest rate in this situation and that's what people look at when they're making these decisions people aren't constantly calculating the real interest rate because they know exactly what inflation is in exactly that moment they can just see hey I could either keep this hundred dollars in my pocket or I could lend it to the government and a month later get 101 dollars so we're gonna have the nominal interest rate on this axis right over here and then in the horizontal axis I am going to have the quantity of money quantity of money and there's multiple ways of thinking about which measure of money supply and we're gonna think about that in future videos but we'll get to that in a second the first thing I want to do is construct a demand curve for money so let me ask you a question if nominal interest rates are really high so instead of getting a hundred $1.00 back after a month if you were to get I'll say something extreme if you were to get $200 back in a month with that would you want to keep a lot of money or would you say hey no I would rather lend that money to the government well yes common sense would tell you is if the nominal interest rate is quite high then people will perhaps choose to forego holding the money and so the quantity of money might be lower so we might be in a situation like this high nominal interest rate hey that's a high opportunity cost from holding this cash I might want to lend it to the government or to somebody else now what if the nominal interest rate were really low let's say the government says hey you let me borrow $100 right now in a month I will give you $100 and a tenth of a penny well then you're like gee that doesn't make a lot of sense I would really like to keep my hundred dollars I might need it I might need to do some transactions with it I might want it to be around in case the ATM system goes out whatever you know there's there's a hurricane whatever it might be and so at a low nominal interest rate it makes sense that people would want to hold or more likely to hold their cash and so you would have a higher quantity of money and so that explains why economists assume often abbreviated as M D so this is the demand curve for money is downward sloping and if we wanted to get a little bit more technical some terms that you might see in an economics class the famous economist John Maynard Keynes came up with three particular motives for this downward sloping curve some of which I've already talked about the first he calls the transactions motive transactions and that's the idea that one of the primary reasons you would want to keep cash is well you might need to use it if you want to go buy a candy bar or buy a pet iguana that you want that money around if you have it lent to the government and then all of a sudden you see your dream iguana then you have to wait a month in order to do it so that would be your transactions motive the reason a motivation to hold money but once again the reason why we have this downward sloping curve if if nominal interest rates are really high if the government is willing to pay you a lot back in a month then you might say you know what I'm willing to take the risk even if I see that dream iguana if I lend the money to the government now in a month I might be able to buy two iguanas even if they aren't quite my dream iguana and likewise if nominal interest rates go really down because then you know it's not worth it for me to risk not being able to buy that perfect iguana when it shows up so I'm not going to lend it to the government so the overall quantity of money more people are going to keep cash in their pockets now another motive that Keynes talks about is the precautionary motive and this is the idea that you might want to just keep cash around in case there's an emergency let's say the lights go out there's an earthquake there's a hurricane the ATM system goes out maybe there's a banking holiday for some reason and you're going to need some of that cash for transactions but once again it's more of precautionary for that rainy day for that bad situation and once again if nominal interest rates are high then you might say well yeah I want to be cautious but boy I could get a lot back if I lend that money but if a nominal interest rates are low you're like you know it's not worth it I'd rather keep some more money and a lot of people do this and so that's why in general in that economy you're going to have a high quantity of money now the last motive that Keynes talked about is the speculative motive and speculation in general is this idea of buying something or selling something or waiting to buy something based on some speculation you have about whether the price will go up or down and so for example you might say hey if I wait a couple of days or if I might wait a week the government might give me even a better deal so let me hold on to this and in aggregate when interest rates are high nominal interest rates are high people might be willing to forego the ability to speculate and when interest rates are low they might say you know what I'm just gonna keep my cash for now because there's not a lot to be gained by lending that money
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