Why Is the Relationship Between the Supply and Demand for Money s...

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Why Is the Relationship Between the Supply and Demand for Money so Important to an Economy

By | August 2013
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2.Why is the relationship between the supply and demand for money so important to an economy? Money, as a medium of exchange, needs to be usable for exchanging goods or services rendered. It should be able to transport purchasing power and store wealth over time. It is also the use of the monetary unit as a yardstick for measuring the relative worth of heterogeneous goods and resources (Jackson, J et al, 2007). Therefore, the demand for money is use to exchange goods and services and store wealth. In the money market, the combination of the money demand and money supply determines the equilibrium interest rate. The interest rate change represents the opportunity cost of holding money balances. Figure 1

Figure 1

From the figure 1, if the interest rate is higher than ie, then there is an excess supply of money that indicates a surplus gap in money market. An excess supply of money can increase consumption as well as investment (Boyes, W et al, 2011). This means people have more money than the desire, and also the opportunity cost of holding money in interest earning deposit will decrease and people will sell assets and immigrate to higher interest earning deposit. That is why most people will save money in banks rather than invest to the market. By managing the interest rate, inflation will be controlled in most situations and prevent real asset from devaluing through financial bubble. On the other hand, if the interest rate is lower than ie, then there is a shortage supply of money gap in money market. An excess of demand for money can decrease consumption as well as investment. It means people desire for more money, and also the opportunity cost of holding money in interest earning deposit will increase and people will buy other assets, such as bonds, to earn a better return. People will invest more in the market instead of saving too much money in banks. It is also used to settle the impact of deflation. Meanwhile, interest rate also affect people’s...
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