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

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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 behavior for loan and credit card. Higher interest rate will make loan and credit card usage relatively expensive, and then consumer spending will decline. Lower interest rate will make this cost-efficiency, and consumer will definitely increase their spending through that. From the analysis above, the relationship between the supply and demand for money will influence interest rate. And then, influence the trend and expectation of buying bonds and other assets, saving money at banks and investment. Therefore, economy will change due to the relationship and situation of money supply and money demand.

3. Explain the connection between rising unemployment and falling inflation using an AD/AS model to assist your answer. In the business cycle, unemployment, inflation and economic growth tend to change cyclically over time. Unemployment increases during business cycle recessions and decreases during business cycle expansions. Inflation decreases during recessions and increases during expansions. Therefor, there is an inverse relationship between rate of inflation and the rate of unemployment in an economy.When there is inflation in the economy, the general price level of goods and services is rising. Then the currency purchasing power and financial assets held by public will fall. Real value of assets and cash will have a loss. It means the opportunity cost of holding money will be increased through inflation occurs. The positive effect of inflation is that RBA can adjust interest rate to encouraging investment and stimulate economy. The increase in price level cause higher nominal interest rates, which causes reduction in certain kinds of consumption and investment spending. In a word, inflation will cause lenders to lose as their real interest rates fall. Higher domestic price level will cause the relative price of foreign good to decrease and local goods to increase, which relate to net export fall. The relationship between inflation and unemployment can be illustrated...
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