Final answer:
The money demand function consists of several components: the quantity of money demanded, the price level, the level of real income, and the nominal interest rate. An increase in income level leads to an increase in the demand for money, assuming other factors remain constant. A decrease in the nominal interest rate leads to an increase in the demand for money as well. The impact of a decrease in the price level on the demand for money is uncertain, as other factors should be considered.
Step-by-step explanation:
a. Components of the money demand function:
The money demand function (m/p)^d = (1/2) * (y/i) includes several components:
- m: the quantity of money demanded
- p: the price level
- y: the level of real income
- i: the nominal interest rate
The economic significance of each component is as follows:
- m: the quantity of money demanded represents the desire of individuals and businesses to hold money for transactions and as a store of value.
- p: the price level affects the purchasing power of money and therefore the demand for money.
- y: the level of real income reflects the level of economic activity and influences the demand for money as people engage in more transactions.
- i: the nominal interest rate represents the opportunity cost of holding money and affects the demand for money as people compare the return on holding money versus investing or saving it.
b. Effect of income level on demand for money:
If the income level (y) in the economy increases, assuming other factors remain constant, the demand for money will also increase. This is because as income rises, individuals and businesses tend to engage in more transactions, requiring more money for payment purposes.
c. Effect of nominal interest rate on demand for money:
If the nominal interest rate (i) decreases, the demand for money will increase. This is because a lower interest rate reduces the opportunity cost of holding money, making it more attractive to hold money rather than invest or save it.
d. Impact of price level on demand for money:
If the price level (p) in the economy decreases, the impact on the demand for money is uncertain. In general, a decrease in the price level may increase the demand for money, as people need to hold more money to purchase the same quantity of goods and services. However, it is important to consider other factors that could influence the demand for money, such as changes in income or interest rates.