Demand curve for money in the money market | AP Macroeconomics | Khan Academy

What we're going to do in this video is talk a lot about money, and in particular, we're going to talk about the market for money. 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? 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 one hundred and one 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. In one month, it costs a hundred dollars; it costs 100, and in one month the government will pay back. The government pays back 101.

So my question to you is, what if you decide instead of buying 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 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 the month, or if you think about it in terms of how much money this is, you have a one percent opportunity cost. Opportunity, opportunity cost.

As we are about to see, we think about the opportunity cost of holding the money as its cost in the money market. So let me draw some axes here to start thinking about this money market. All right, so let's call this vertical axis the nominal interest rate—nominal, nominal interest rate. Sometimes you'll see NIR; it's abbreviated, but let's just write it out: the nominal interest rate in that axis. 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." A month later, get a hundred and one dollars. So we're going to have the nominal interest rate on this axis right over here.

Then in the horizontal axis, I am going to have the quantity of money, quantity of money. There are multiple ways of thinking about which measure of money supply, and we're going to 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 and one dollars back after a month, if you were to get, I'll say something extreme, if you were to get 200 back in a month, would 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, if the nominal interest rate is quite high, then people will perhaps choose to forego holding the money. 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 a hundred dollars right now, in a month I will give you a hundred dollars 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 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 MD, so this is the demand curve for money is downward sloping.

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. 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, a reason, a motivation to hold money. But once again, the reason why we have this downward sloping curve, 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."

Likewise, if nominal interest rates go really down, you're saying, "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." And 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. 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 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 nominal interest rates are low, you're like, "You know, it's not worth it. I'd rather keep some more money." 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. 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 an even 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 going to keep my cash for now because there's not a lot to be gained by lending that money."