Chapter 5: Money Supply & Money DemandChapter 5: Money Supply & Money Demand

Chapter`s Outlines

Definition of money Supply Supply of Money and Market interestThe Demand for Money, & Three motives for demand for moneyEquilibrium in Money MarketChanges in EquilibriumMoney Supply and LiquidityFriedman’s Challenge to Liquidity PreferenceTools of Monetary policy.

Meaning of Supply of Money

According to Keynes supply of money is sum of currency issued by Central Bank of a country and demand deposits held by the commercial banks of a country

This is called M1 definition of supply of money and M1=Cc+ DD

it means that supply of money is total quantity of money circulated in a country

Supply of Money…..

According to Keynes Ms is fixed in short run and is independent of rate of interest

Ms is a control variable as it is determined by central monetary authorities of a country

Ms is a vertical line as Ms is independent of rate of interest

If Ms increase in a country, than Ms curve shift to the right and if Ms decrease in a country than Ms shift to the left

Money Supply Line

The quantity of money in circulation is controlled by the central bank

Quantity of Money

Interest Rate (%)

Ms

80

5

10

The Supply of Money and Interest Rates…..

Because the supply of money is controlled by the central bank and no one else, we assume that the money supply is invariant to the interest rate.

In other words, the supply of money will stay the same regardless of whether the interest rate is 1%, 5% or even more

Thus the money supply curve is a vertical line at the current money supply.

The Market Interest Rate

What determines the equilibrium interest rate in financial markets?

A financial market is any market in which borrowers and lenders interact

The supply of funds being forwarded by lenders and the demand for funds by borrowers determines both the quantity of lending/borrowing and the interest rate at which these loans are made.

The Market Interest Rate

One way to analyze this market would be to directly examine the supply and demand for bonds (loans).

An alternative method would be to examine the supply and demand for money

Demand for Money

Demand for money we mean why people keep money in their pocket or in housesWhat are the motives behind holding the money

Three main motives of keeping money

Transaction demand for money Precautionary demand for moneySpeculative demand for money

1 Transaction demand for money

Money is used as a medium of exchangePeople keep money for purpose of making daily transaction i.e. to purchase different goods and services daily Mtd depends on time intervals when a person gets income and when a person spends itThose countries where credit facilities are common, transaction demand for money is lower as compared to those countries where credit facilities are not available

Transaction demand for money…..

According to Keynes demand for money for transactary motives depends on income, it means that Mtd=f (Y)

There exist a positive relationship between Mtd and income of consumer

So Mtd=kY

Where k is the proportion or percentage of income people held for transaction purpose

Transaction demand for money….

y Mtd ky

0 5% 0

100 5% 5

200 5% 10

300 5% 15

400 5% 20

500 5% 25

Mtd

5

0 100 200 300 400 500

10

20

15

25

y

ky

2 Precautionary demand for money

Both individuals and businessmen keep cash in reserve in order to meet unexpected needs

Individuals hold some cash to provide for illness, accidents, unemployment and other unforeseen contingencies while businessmen keep cash in reserve to tide over unfavorable conditions

Precautionary demand for money depends on income level, business activity and so on

3 Speculative Demand for Money

Individuals hold Money for investment in the financial market

Near money consists of non-monetary, interest-bearing assets such as stocks and bonds

Speculative demand for money

According to Keynes, individual could hold wealth in two ways i.e. in form of cash and in form of bonds

People purchase bonds and securities for earning profit as people purchase bond at low price and sell at high price

Whenever a person keep money for purpose of purchasing bonds is known as speculative demand for money

Speculative demand for money…..

Price of bonds are linked with rate of interest and is negative related with one another

The formula used for finding price of bonds is PV=R/ r

Where R=return from bond, r =Market rate of interest and PV is present value of bond or price of bond

Now if R=10 Af and r=5% then PV is 10/0.05 =200

Similarly if R=10 Af and r=10% then PV is 10/0.10 =100

So it is expectation about market rate of interest which determine speculative demand for money

Speculative demand for money….

If market rate of interest is low, bond price in market is high and at high bond price people will not purchase bond, and people will keep more money in their pocket for purpose of speculation and vice versa

Msd1 Msd2

r1

r2

0

Msd =f(r)

Total demand for money

Total demand for money is the summation of transaction demand for money, Precautionary demand for money and Speculative demand for money

Mathematically it can be shown asLT =Mtd +Msd +Mpd

The Demand for Money and Interest Rates

We assume that if you hold your wealth as money, you earn no interest, while you do earn interest if you hold your wealth as bonds.

How does your demand for money change when the interest rate rises?

The Demand for Money and Interest Rates…..

The opportunity cost of each dollar held as money is the foregone interest that could have been earned, if you had held that dollar in bonds.As the interest rate rises, so does the opportunity cost of moneyThe quantity of money demanded is inversely related to the interest rate on bonds.

Equilibrium in Money Market

Through money supply and money demand we can determine equilibrium in money market

In money market, equilibrium point is that point where demand for money is equal to supply of money

The Money Market

700 1000400

3%

5%

7%

MS

MD

Quantity of Money ($ billions)

Nominal Interest Rate (i)

Money Surplus Money Shortage

Changes in Equilibrium Interest Rates

One of the most useful features of the liquidity preference framework is that it allows us to see how changes in the demand and supply of money affect interest rates.

Changes in Equilibrium Interest Rates…..

Equilibrium interest rates will increase if there is a…– Increase in money demand (+)– Decrease in money supply (+)

Equilibrium interest rates will decrease if there is a…– Decrease in money demand (-)– Increase in money supply (-)

Shifts in Money Demand

In Keynes original analysis, two things would cause the demand for money to change:

1 An Increase in Income/Wealth– With more income, people would like to consume more.

To increase consumption, you need more money.– Money demand shifts right, causing interest rates to rise

Interest Rates Rise when Income Rises

700 900

5%

7%

MS

MD2

Quantity of Money ($ billions)

Nominal Interest Rate (i)

MD1

Interest Rates Fall when Bonds become less Risky

700400

5%

3%

MS

MD2

Quantity of Money ($ billions)

Nominal Interest Rate (i)

MD1

2 An Increase in Prices– With higher prices, the same quantity of money

held buys fewer goods and services. To maintain consumption, people need to hold more money.

Several other reasons can also cause the demand curve to shifts like increase in the risk of non-monetary assets like bonds, etc

Shifts in Money Supply

Since the central bank is the sole issuer of money, any changes in the money supply must come directly from central bank policy

At its most basic level, an increase in the money supply is just the central bank printing up more money, but operationally there are various other ways to increase and decrease money supply.

Operationally, the central bank changes the money supply through three channels

1 Changing banks reserve requirement2 Changing the discount rate at which banks borrow

from the central bank at.3 Buying and selling bonds from the public in exchange

for money

These are known as tools of Monetary policy…

Tools of Monetary Policy

1 Reserve-deposit ratio:– Ratio of cash reserves to deposits that banks

are required to maintain

By lowering the ratio, banks will have more reserves to lend and invest, increasing the money supply

Tools of Monetary Policy

2 Discount rate: – rate of interest the DAB charges on loans to banks

By lowering the rate, banks encourage borrowing from the DAB and lending to the public, increasing the money supply

Tools of Monetary Policy

3 Open Market Operations: – DAB purchases and sales of government bonds

By purchasing bonds and paying the sellers, the DAB increases the money supply

Using these tools, the central bank can lower interest rates by raising the money supply and increase rates by cutting the money supply.

Note that this analysis only considers the short run and not the long term consequences of changes to the money supply.

Friedman’s Challenge to Liquidity Preference

Milton Friedman argued that while Keynes’ analysis was technically incorrect, he failed to consider the longer term effects of monetary policy.

Friedman argued that increasing the money supply may actually cause interest rates to go up!

An increase in the money supply will cause income to rise, spurring an increase in money demand and interest rates

Cont`d…

An increase in the money supply will stimulate spending, which will then cause prices to rise. Higher prices will increase money demand and raise interest rates.If the increase in money supply is continuous, then people will expect higher inflation. This causes the nominal interest rate to rise.

Interest Rates and an Increase in the Money Supply Growth Rate

So what happens to interest rates if the central bank increases the rate at which the money supply grows?

The liquidity preference theory argues that interest rates will decrease as people will hold excess cash balances– People will try to convert their excess cash into bonds.– Doing so will increase the number of people offering loans, which

must push interest rates down.

Cont`d….

Friedman’s theory argues an increase in interest rates as the expansion in the money supply growth rate will cause income, price levels, and expected inflation all to rise.

Expansionary Monetary Policy

Increase the money supply by any one or combination of the Monetary tools

Reduce the interest rate to encourage investment

Increase employment & income

Expansionary Monetary Policy

Quantity of Money

Interest Rate (%)

(M/P)d

5

80

(M1/P)s (M2/P)s

4

85

thanks