NSS Exploring Economics 6

Chapter 9

Money demand and money market equilibrium

Questions
p.72
Think it over
1.
How much money do you keep in your purse?
2.
Why do you hold cash?
3.
If you have a large amount of unspent income, would you save the money at home or put it
into a bank? Why?
p.73
Discuss
9.1
a. Can consumption expenditure exceed disposable income? Why?
b. Can savings exceed disposable income? Why?
p.76
Test yourself
9.1
Ben bought 1,000 shares of China Life Insurance (Overseas) Company Limited at $20 per
share in January 2007. He received a dividend of $0.47 per share in June and sold the shares
at $40 per share in December 2007.
Assuming there are no transaction costs, what was the actual nominal rate of return in the
specified period?
Fig. 9.5
Is there any risk of saving money in a bank?
Discuss
9.2
What are the risks of holding money?
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p.77
Test yourself
9.2
Suppose Asset A gives a higher expected rate of return than Asset B.
Determine which asset is more desirable if:
a. Asset A is a share while Asset B is a bond;
b. Asset A is a time deposit while Asset B is a savings deposit.
9.3
Rank the following assets in descending order according to their riskiness and liquidity,
respectively.
Cash Demand deposit Saving deposit
Bond Share Time deposit
p.79
Discuss
9.3
Young children are consumers too but they seldom hold money. Why?
p.83
Discuss
9.4
How would the following events affect the transactions demand for money curve?
a. Many firms have engaged in vertical integration. As a result, there are more internal
transactions but fewer market transactions among firms.
b. The nominal interest rate decreases.
p. 87
Discuss
9.5
How would the following events affect the asset demand for money curve?
a. Due to technological and institutional changes, income-earning assets become more
liquid.
b. People expect that stock prices will rise significantly in the near future.

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p.91
Test yourself
9.4
What is the effect of a decrease in money demand on the nominal interest rate? Explain with
the help of a diagram.
9.5
What is the effect of a decrease in money supply on the nominal interest rate? Explain with
the help of a diagram.
pp.95-96
Exercises
Multiple Choice Questions
1.
Suppose you bought a flat for $3 million at the beginning of last year. If the flat yielded an
annual rent of $120,000 and its price rose from $3 million to $4 million in the year, what was
the actual rate of return on your flat last year?
A. 3%
B. 4%
C. 33%
D. 37%
2.
Which of the following assets is the least risky?
A. Hong Kong dollar savings deposits
B. Shares
C. Bonds
D. Foreign currencies
3.
Which of the following statements about money is INCORRECT?
A. Holding money yields no nominal income.
B. Holding money brings no capital gain or loss in nominal terms.
C. Holding money bears no risk.
D. Money is the most liquid asset.

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4.
Suppose the nominal interest rate and the expected real interest rate are 10% and 7%,
respectively. If the actual inflation rate turns out to be 6%, then the nominal rate of return and
the cost of holding money are
, respectively.
A. 0% and 10%
B. -6% and 7%
C. 0% and -6%
D. -6% and -10%
5*.
People hold cash for transactions purposes because
A. we live in a monetary economy.
B. money is a commonly accepted medium of exchange.
C. money receipts and expenditures are not perfectly synchronised.
D. money is the least risky asset.
6.
The transactions demand for money increases when
A. there is an increase in household savings.
B. the price level rises.
C. many companies change their wage payment method from monthly to daily.
D. the risk of holding income-earning assets increases.
7.
Which of the following statements CANNOT explain why people hold money rather than
income-earning assets for storing wealth?
A. People expect that prices of income-earning assets will fall soon.
B. People hold some money to minimise the risk of liquidating assets when asset prices
fall.
C. Returns on income-earning assets cannot cover the cost of switching assets.
D. People become wealthier.
8.
Which of the following factors is negatively related to asset demand for money?
A. Expected inflation rate
B. Risk of holding income-earning assets
C. Cost of switching assets
D. Wealth
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9.
The nominal interest rate falls when there is
(1) an increase in money demand.
(2) a decrease in money demand.
(3) an increase in money supply.
(4) a decrease in money supply.
A. (1) or (3)
B. (1) or (4)
C. (2) or (3)
D. (2) or (4)
10.
If the money demand increases but the money supply decreases,
A. the interest rate must rise.
B. the interest rate must fall.
C. the effect on the interest rate is indeterminate.
D. the interest rate increases and then decreases.
Short Questions
1.
Are money demand, money supply and the nominal interest rate stocks or flows? Explain.
(6 marks)
2.
Compare money and gold in terms of the following aspects:
a. Nominal returns
b. Liquidity
c. Risk
3.
a.
b.

(2 marks)
(2 marks)
(2 marks)

What are the transactions demand for money and asset demand for money?
(4 marks)
Suggest ONE factor which is positively related to and ONE factor which is negatively
related to them.
(4 marks)

4*.
Briefly explain why an increase in the purchase price of an asset will lead to a fall in the
nominal interest rate.
(4 marks)

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5.
How will the following events affect money demand and/or money supply?
a. People expect a rise in bond prices.
b. Commercial banks lend out all their excess reserves.
c. People make more extensive use of credit cards.
d. People expect a higher inflation rate.

(2 marks)
(2 marks)
(2 marks)
(2 marks)

Structured Questions
1.
a. What is the difference between expected nominal interest rate and actual nominal
interest rate?
(3 marks)
b. What is the relation between the nominal interest rate and the real interest rate? (3 marks)
c. What are the nominal and the real rates of return of holding money?
(6 marks)
d. The cost of holding money is the real interest rate. Do you agree? Explain.
(4 marks)
2.
a.
b.

Predict the change in the nominal interest rate with the help of separate diagrams in each
of the following situations.
Due to stock market fluctuations, income-earning assets become riskier. Moreover, the
central bank raises money supply.
(8 marks)
The average time interval between two successive income receipts decreases and the
central bank raises money supply.
(5 marks)

Answers
P.72
Think it over
1. Free answer
2. To finance anticipated and unanticipated expenditures and to store wealth
3. Free answer. Saving money at home would mean forgoing deposit interest. Saving
money at a bank may be inconvenient as we may not be able to use the deposited money
immediately.

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P.73
Discuss 9.1
a. Consumption expenditure can exceed disposable income. The excess amount can be
financed by past savings (wealth) or borrowing.
b. Savings cannot exceed disposable income. People seldom create extra savings in a bank
by withdrawing other savings from another bank (total savings remain unchanged) or
finance extra savings by borrowing (the interest rate on savings is generally lower than
the interest rate on borrowed money).
P.76
Test Yourself 9.1
Actual nominal rate of return
Actual net income
receipts
=

Actual change in
asset price
100%

Amount of money invested

[$0.47 + ($40
$20)]1,000
$201,000

100%

= 102.35%
Fig 9.5
The following are some of the risks of saving money in a bank. Firstly, the nominal interest
rate on bank deposits may change. Secondly, the general price level may change and affect
the real interest rate on bank deposits. Thirdly, there is a risk of bank runs and deposit
defaults.
Discuss 9.2
Although the face value of money is fixed, money is not a 100% risk-free asset. The risks of
holding money include the following, which can cause losses to money holders.

Inflation risk: If the general price level increases, the real value or purchasing power of
money decreases.

Exchange rate risk: If the exchange rates of foreign currencies rise, the value of
domestic currency falls as it can buy fewer foreign goods.

Bank-run risk: If there is a bank run or a default on deposits, depositors may lose their
money.

Political or country risk: Legal tender issued by a government may not be accepted as
the medium of exchange in the event of foreign invasion or revolution.
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P.77
Test Yourself 9.2
The desirability of an asset is determined by its expected rate of return, risk and liquidity.
a. Although Asset A gives a higher expected rate of return than Asset B, Asset A (a share)
is riskier than Asset B (a bond). Which one is more desirable depends on peoples
preference and the difference in their rates of return relative to the difference in their
risks. As a result, some people may prefer to hold shares while some may prefer to hold
bonds.
b. Although Asset A gives a higher expected rate of return than Asset B, Asset A (a time
deposit) is less liquid than Asset B (a savings deposit). Which one is more desirable
depends on peoples preference and the difference in their rates of return relative to the
difference in their liquidity. As a result, some people may prefer to hold time deposits
while some may prefer to hold savings deposits.
Test Yourself 9.3

Riskiness of assets in descending order:

Share, bond, time deposit, savings deposit, demand deposit, cash

Liquidity of assets in descending order:
Cash, demand deposit (cashing a cheque involves costs), savings deposit, time deposit,
share and bond (both share and bond are transacted in a securities market)

P.79
Discuss 9.3
Young children are not independent. Whenever they want to consume, they usually need to
seek the permission and support of their parents or elders. Hence, they have no need to hold
money as their money expenditures and receipts (given by their parents or elders) most likely
occur at the same time.
P.83
Discuss 9.4
a. Since there are fewer market transactions among firms, the quantity of money demanded
for transactions purpose drops at the same nominal interest rate. The Mt curve shifts
leftwards.
b. Since the Mt curve shows the quantity of money demanded for transactions
purpose at every nominal interest rate, the fall in the nominal interest rate brings no
change to the Mt curve but a downward movement along it.

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P.87
Discuss 9.5
a. When income-earning assets become more liquid, they become more desirable. Hence,
the quantity of money demanded as an asset drops at the same nominal interest rate. The
Ma curve shifts leftwards.
b. When people expect stock prices to rise significantly in the near future, stocks become
more desirable.
Hence, the quantity of money demanded as an asset drops at the same nominal interest
rate. The Ma curve shifts leftwards.
P.91
Test Yourself 9.4
A decrease in money demand shifts the Md curve leftwards. Hence, the nominal interest rate
drops.

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Test Yourself 9.5

A decrease in money supply shifts the MS curve leftwards. Hence, the nominal interest rate
rises.

P.95-96
Exercises
Multiple Choice Questions
1. D. The actual rate of return
=

Net income receipts + Change in asset price

100%
Purchase price of the asset

= $120,000 + $1,000,000 100%

$3,000,000
= 37%
2.
3.

4.

Option D is incorrect. The money values of foreign currencies in HKD fluctuate with
their exchange rates.
Although the face value of money is fixed, money is not a 100% risk-free asset. Its real
value (purchasing power) may fluctuate as the general price level or the exchange rate
changes. Defaults of deposit money or legal tender may occur if there is a bank run,
foreign invasion or revolution.
The nominal rate of return on money is 0% and the cost of holding money is the nominal
interest rate (10%).

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5.

Option C is correct. If money receipts and expenditures are perfectly synchronised, there
is no need for people to hold cash for transactions purposes.
Option D is incorrect. That money is the least risky asset is the reason for asset demand
for money, not transactions demand.
6. Options A and C are incorrect. They reduce the transactions demand for money.
Option D is incorrect. This raises the asset demand for money instead of the transactions
demand.
7. When people become wealthier, people hold more money as well as more incomeearning assets.
8. Option A is correct. A rise in the expected inflation rate would raise the nominal interest
rate and reduce the asset demand for money.
Options B, C and D are incorrect. They are positively related to the asset demand for
money.
9. C
10. A
P. 96
Short Questions
1. Money demand is a stock as it measures the total quantity of money that all economic
agents of an economy desire to hold at a certain moment. The addition of a period is
meaningless. For example, saying that money demand in Jan 2010 was $100 billion per
year is pointless. (2 marks)
Money supply is also a stock as it measures the quantity of money available in an
economy at a certain moment. The addition of a period is meaningless. For example,
saying that money supply in Jan 2010 was $100 billion per year is pointless. (2 marks)
Nominal interest rate is a flow as it measures the rate of return of holding an asset in a
period of time. The specification of the period concerned is necessary because periods of
different lengths imply a different magnitude. For example, a nominal interest rate of 3%
a month is larger than a nominal interest rate of 3% a year. (2 marks)
2.

a. Money has zero nominal return while gold has a nominal return equal to the
change in its price, which can be positive or negative. (2 marks)
b. Money is more liquid than gold. Money is already a medium of exchange but
gold has to be sold in the market to become a medium of exchange. (2 marks)
c. Money is less risky than gold as the expected and the actual nominal returns of
money are certain to be zero, but the expected and actual nominal returns of gold may
not be equal as its market value may fluctuate unexpectedly. (2 marks)

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3.

4.

a. Transactions demand for money is the total amount of money that an economy
desires to hold as a medium of exchange in conducting transactions. Asset demand for
money is the total amount of money that an economy desires to hold as an asset to
store wealth. (4 marks)
b. Factors positively related to Mt include real national income, the price level and time
interval between two successive income receipts. Factors negatively related to Mt
include savings and technological factors.
Factors positively related to Ma include the risk of holding income-earning assets, the
cost of switching assets and wealth.
Factors negatively related to Ma include the nominal interest rate, expected real
interest rate and expected inflation rate.
(Mark the first factor suggested. 1 mark each.)

Nominal interest rate or nominal rate of return on an asset

=

Net income receipts + Change in asset price

100% (1 mark)
Principal or purchase price of the asset

When the purchase price rises, net income receipts remain unchanged but the value of
change in asset price drops (elaborated in the note below) and hence the value of the
numerator falls. On the other hand, the value of the denominator rises. Hence, the
nominal interest rate declines. (3 marks)
Note: Suppose the asset price was originally expected to rise from $80 (at present) to
$120 (in future). The capital gain is $40 (= $120 $80). If the purchase price (at
present) rises from $80 to $100, based on the same expectation, the capital gain is
$20 (= $120 $100). The return on the asset drops.
If the asset price was originally expected to fall from $80 (at present) to $40 (in
future), the capital loss is $40 (= $40 $80).
If the purchase price (at present) rises from $80 to $100, based on the same
expectation, the capital loss is $60 (= $40 $100). The return on the asset drops.

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5.

a. When people expect a rise in bond prices, people prefer to sell their bonds later or
hold more bonds to earn a higher return. Then, the asset demand for money falls.
(2 marks)
b. When commercial banks lend out all their excess reserves, more loans are created.
Money supply increases. (2 marks)
c. When people use credit cards more extensively, people can hold less money to
conduct transactions. Transactions demand for money drops. (2 marks)
d. When people expect a higher inflation rate, the nominal interest rate
[= real interest rate + (expected) inflation rate] rises and the cost of holding money
increases. Consequently, the asset demand for money declines. (2 marks)

Structured Questions
1.
a. The expected nominal interest rate is the estimated one because the future event has not
occurred or people do not have information about it. The actual nominal interest rate is
the realised one because the past event has occurred and people have information about
it. Therefore, the expected rate may not be equal to the actual rate. (3 marks)
b. Nominal interest rate = Real interest rate + Inflation rate. When there is inflation
(deflation), the nominal interest rate is larger (smaller) than the real interest rate.
(3 marks)
c. Since money does not bear interest and the face value of money does not change, the
nominal rate of return of holding money is zero. (3 marks)
Real rate of return = Nominal rate of return Inflation rate
Since the nominal rate of return on money is zero, the real rate of return on money = 0
Inflation rate = -Inflation rate (3 marks)
d. When people hold money, one cannot hold the income-earning asset which yields the
(highest) nominal interest rate. Hence, the cost of holding money is the (highest)
nominal interest rate (forgone). The statement is wrong. (3 marks)
Since the nominal interest rate is equal to the real interest rate plus the inflation rate, the
cost of holding money may be equal to the real interest rate only when the inflation rate
is equal to zero. (1 mark)

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2.
a.

When income-earning assets become riskier, the asset demand for money increases. The
money demand curve shifts rightwards. (1 mark)
When the central bank increases the money supply, the money supply curve shifts
rightwards. (1 mark)
As a result, the change in the nominal interest rate is uncertain, depending on the extent
of the shift in both curves. If the increase in money demand is larger than (equal to /
smaller than) the increase in the money supply, the nominal interest rate increases
(remains unchanged / decreases). (3 marks)

(Each case, 1 mark.) (3 marks)

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b.

When the average time interval between two successive income receipts decreases, the
transaction demand for money drops. The money demand curve shifts leftwards.
(1 mark)
When the central bank raises money supply, the money supply curve shifts rightwards.
(1 mark)
As a result, the nominal interest rate must drop. (1 mark)

(2 marks)

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