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The Money Market, Supply & Demand

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Instructor: Kevin Newton

Kevin has edited encyclopedias, taught history, and has an MA in Islamic law/finance. He has since founded his own financial advice firm, Newton Analytical.

So much of the economy hinges on money. But this medium of exchange is actually a good, just like butter or books. This lesson explains money as a good, as well as how economists describe money.

How Does the Money Market Work?

While it may sound strange to think about money being subject to supply and demand, it actually makes quite a bit of sense. For starters, very few people would go as far to say that they couldn't use more money if it were available to them. Also, people pay a price for money, although we tend to call it an interest rate instead. With that in mind, let's try to draw a supply and demand graph for money. Start with the x-axis and y-axis. The x-axis, where quantity supplied normally is, would stay the same - after all, we're talking about the quantity of money supplied. For the y-axis, we'd normally put price, but to make things easier, we'll just call that axis the interest rate axis.

But what about the actual lines? The demand line for money looks like any other demand line - it has a positive slope that starts low and rises. The supply curve for money, on the other hand, looks different. It's a straight vertical line. This is because there is only one supplier for money in the United States, and that's the Federal Reserve Bank. It is up to the Fed, as it is commonly called, to decide when it's time to make new money. Okay, fine, so it's not a perfect straight line, as there are counterfeiters, but you get the idea.

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Coming up next: Fractional Reserve System: Required and Excess Reserves

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Demand for Money

Like I said earlier, just about everyone could use more money if they had access to it. But why? Remember, money is ideally only good as a medium of exchange - you shouldn't be able to turn the physical pieces of money into anything more valuable than the face value of the note or coin. So what do people use money for? Economists characterize the way that people use money in one of four large umbrellas.

Transactional demand refers to needing money to buy and sell things. That 10-dollar bill in your wallet for lunch satisfies this demand.

Precautionary demand is having money in case of emergencies. If you have a couple of 100-dollar bills tucked away someplace no one else knows about, then that money goes towards precautionary demand.

Speculative demand is money you hold onto because you think the money itself will be worth more money later. That sounds confusing, but remember there are multiple currencies - if you think that Euros will rise in value and buy a $100 worth hoping to sell them for more later, then your $100 went towards speculative demand.

Finally, there is the portfolio demand of money, which largely is held by investors to balance out their portfolios. Investors don't just plan for the future 20 or 30 years from now, but also have to have resources that allow relatively quick access.

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