What you will learn
in this Module:
268 section 5 The Financial Sector
- What the money demand
curve is - Why the liquidity preference
model determines the
interest rate in the short run
Module 28
The Money Market
The Demand for Money
Remember that M1, the most commonly used definition of the money supply, consists
of currency in circulation (cash), plus checkable bank deposits, plus traveler’s checks.
M2, a broader definition of the money supply, consists of M1 plus deposits that can
easily be transferred into checkable deposits. We also learned why people hold money—
to make it easier to purchase goods and services. Now we’ll go deeper, examining what
determines how much money individuals and firms want to hold at any given time.The Opportunity Cost of Holding Money
Most economic decisions involve trade -offs at the margin. That is, individuals decide
how much of a good to consume by determining whether the benefit they’d gain from
consuming a bit more of any given good is worth the cost. The same decision process is
used when deciding how much money to hold.
Individuals and firms find it useful to hold some of their assets in the form of
money because of the convenience money provides: money can be used to make pur-
chases directly, while other assets can’t. But there is a price to be paid (an opportunity
cost) for that convenience: money held in your wallet earns no interest.
As an example of how convenience makes it worth incurring some opportunity
costs, consider the fact that even today—with the prevalence of credit cards, debit cards,
and ATMs—people continue to keep cash in their wallets rather than leave the funds in
an interest -bearing account. They do this because they don’t want to have to go to an
ATM to withdraw money every time they want to make a small purchase. In other
words, the convenience of keeping some cash in your wallet is more valuable than the
interest you would earn by keeping that money in the bank.
Even holding money in a checking account involves a trade-off between convenience
and earning interest. That’s because you can earn a higher interest rate by putting your
money in assets other than a checking account. For example, many banks offer certifi-
cates of deposit, or CDs, which pay a higher interest rate than ordinary bank accounts.
But CDs also carry a penalty if you withdraw the funds before a certain amount of
time—say, six months—has elapsed. An individual who keeps funds in a checking ac-
count is forgoing the higher interest rate those funds would have earned if placed in a
CD in return for the convenience of having cash readily available when needed.