The demand for money is a demand for real money balances as determined by real income and interest rates. The real money supply is simply the nominal money supply M divided by the price level P, M/P, which measures its purchasing power in terms of goods and services. Real money balances measure the purchasing power of the stock of money. For example, consider an economy that produces only bread. If the quantity of money is $ 10, and the price of a loaf is $ 0.50, then real money balances are 20 loaves of bread. That is, at current prices, the stock of money in the economy is able to buy 20 loaves.

Reading: AB, chapter 7, sections 2 and 3.

The demand for money

Consumption and saving decisions indirectly involve a decision about how much money to hold

Real And Nominal Money Balances Are True

However, from 1988 to 1990, we cannot accept this restriction. The first implication of a price elasticity less than one is that the level of real money balances does not remain the same in the face of one percent increases in the price level and nominal money balances.
The demand for real money balances depends only on real income Y. Another determinant of money demand: the nominal interest rate, i. The opportunity cost of holding money (instead of bonds or other interest-earningeassets). Hence, ↑i ⇒ ↓ in money demand. CHAPTER 4 Money and Inflation slide 36 The money demand function (M/P)d = real money.

Individuals need money for transactions involving consumption goods and services. This is the transactions demand for money.
Given income, what is not consumed is saved. Individuals must then decide how divide their savings into various kinds of assets: cash, savings accounts, government bonds, stocks etc. This is the asset allocation or portfolio problem. Since money pays very little interest (has a low return) the higher the interest rate on non-money assets the higher the opportunity cost of holding money.

Simplifying assumptions

Since the general asset allocation problem involves many different kinds of assets with different risk and return characteristics we simplify this decision by assuming that there are only two kinds of financial assets in the economy.

Money assets - low return, high liquidity and low risk. i_m = nominal interest rate on money assets.
Non-money assets (bonds) - higher return than on money assets and less liquidity. We assume that the risk associated with investing in bonds is not too high (think of government bonds as the generic non-money asset). Let i denote the nominal interest rate on non-money assets. Note that, by assumption, i > i_m. Also, recall that i = r + ^e, where r denotes the real return on non-money assets and ^e denotes expected inflation.

Model for money demand

Our model for the demand for nominal money balances takes the following form:

where

M^d = demand for nominal money balances (demand for M1)

L^d = demand for liquidity function

P = aggregate price level (CPI or GDP deflator)

Y = real income (real GDP)

I = nominal interest rate on non-money assets

r = real interest rate on non-money assets

^e = expected inflation

Remarks

What Is Real Money And Nominal Money

Nominal money demand is proportional to the price level. For example, if prices go up by 10% then individuals need 10% more money for transactions.
As Y increases, desired consumption increases and so individuals need more money for the increased number of desired transactions.
As the nominal interest rate on non-money assets, i, increases the opportunity cost of holding money increases and so the demand for nominal money balances decreases.
Since i = r + ^e, we can decompose the effects on an increase in i into real interest rate increases (holding expected inflation fixed) and expected inflation increases (holding the real interest rate fixed).

The demand for real balances

Since the demand for nominal balances is proportional to the aggregate price level, we can divide both sides of the nominal money demand equation by P. This gives the liquidity demand function or the demand for real balances function:

The left-hand-side of the above equation is the demand for nominal balances divided by the aggregate price level or the demand for real balances (the real purchasing power of money). The right-hand side is the liquidity demand function. The demand for real balances is decomposed into a transactions demand for money (captured by Y) and a portfolio demand for money (captured by i).

The real money demand function is graphed below:

The demand for real balances is graphed as a function of the real interest rate holding income and expected inflation fixed. When the real interest rate is high the opportunity cost of holding money - keeping income and expected inflation fixed - is high so that real money demand is low. Conversely, when the real interest rate is low the opportunity cost of holding money is low so that money demand is high (due to the liquidity convenience of money over bonds). Whenever income or expected inflation change the real money demand curves shifts. For example, if Y increases the real money demand function shifts up and right; if expected inflation increases the real money demand function shifts down and left.

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Last updated on July 15, 1996 by Eric Zivot.

The previous article was an introduction about the two basic decisions that corporate finance helps a corporation in making. Prima-facie, these two decisions may look pretty simple. After all everyone raises money in their daily lives and puts it to productive use. Simple accounting can tell us whether or not we should make those financing and investing decisions. So, why is there a need for a complicated subject called corporate finance to make these decisions? Well, it turns out there is a need? The need arises because of this concept of nominal and real value of money. This article will explain why corporate finance is required:

The Concept of Inflation

We are all intuitively aware of the concept of inflation. We know that money loses its value every year. The same amount of money will purchase less and less every year. Let’s say that $100 is required to purchase a certain commodity of goods today. So if there is an inflation of 10%, the same goods will be available for a $110 next year.

Introduction to Nominal Value of Money

So, if we made an investment that was yielding 9% return this year, we would have a total of $109 next year from the $100 we had invested. In accounting terms we would have a profit of $9. This is because we are only considering the nominal values. Nominal values do not consider the effect of inflation, opportunity cost of capital and such other forces which cause the value of money to decrease in a given time period.

The Problem with Nominal Values to Measure a Firm’s Performance:

Real And Nominal Money Balances Definition

Nominal values present a distorted image of the firm’s performance to its shareholders and this is to say the least. Consider the case we discussed above. Here, the firm has lost 1% purchasing power. This means they were better off consuming the $100 in year 1 and could have purchased more goods with it rather than investing it and consuming $109 a year later. Thus, if nominal values are considered, firms will end up eroding their capital by investing their money in projects that offer a rate of return that is below the firm’s cost of capital.

Introduction to Real Value of Money

To offset this problem, specialists in corporate finance have come up w