Demand & supply of money

Demand for and supply Demand for and supply of moneyof money

-Money: Definitions, functions & Components of money supply-Money: Definitions, functions & Components of money supply-Commercial Banks & Process of Deposit Creation-Commercial Banks & Process of Deposit Creation

-Central Bank & the Supply of Money-Central Bank & the Supply of Money-Money Demand-Money Demand

-Equilibrium Interest Rates-Equilibrium Interest Rates

DEFINITIONS OF MONEYDEFINITIONS OF MONEY

• Money is anything that is generally accepted as a Money is anything that is generally accepted as a medium of exchangemedium of exchange

• Traditionally, money is defined as currency and Traditionally, money is defined as currency and demand deposits, and its most important function is to demand deposits, and its most important function is to act as a medium of exchange.act as a medium of exchange.

• Friedman defined money as the sum of currency plus Friedman defined money as the sum of currency plus all adjusted deposits in commercial banks. This all adjusted deposits in commercial banks. This includes bank deposits, non bank deposits and any includes bank deposits, non bank deposits and any other type of assets through which the monetary other type of assets through which the monetary authority influence the level of income, prices, authority influence the level of income, prices, employment or any other macro economic variable.employment or any other macro economic variable.

FUNCTIONS OF MONEYFUNCTIONS OF MONEY

• Money serves as a means of payment, or medium of Money serves as a means of payment, or medium of exchange. Money eliminates the problem of barter exchange. Money eliminates the problem of barter system which requires a double coincidence of wants system which requires a double coincidence of wants before goods and services can be directly exchange before goods and services can be directly exchange for other goods and services.for other goods and services.

• Money serves as a store of value. In this case, it Money serves as a store of value. In this case, it serves as an asset that can be used to transfer serves as an asset that can be used to transfer purchasing power from one time period to another.purchasing power from one time period to another.

• Money serves as a unit of account, or a standard unit Money serves as a unit of account, or a standard unit that provides a consistent way of measuring and that provides a consistent way of measuring and recording economic value (e.g quoting prices)recording economic value (e.g quoting prices)

TYPES OF MONEYTYPES OF MONEY

• The following are the types of money: The following are the types of money: • commodity money • commodity money • fiat money • fiat money • legal tender • legal tender • token money • token money • demand deposit • demand deposit

• Commodity monies are items used as money that Commodity monies are items used as money that also have intrinsic value in some other use. Gold is also have intrinsic value in some other use. Gold is one form of commodity money. Fiat, or token, one form of commodity money. Fiat, or token, money is money that is intrinsically worthless. Legal money is money that is intrinsically worthless. Legal tender is money that a government has required to tender is money that a government has required to be accepted in settlement of debts.be accepted in settlement of debts.

COMPONENTS OF THE MONEY COMPONENTS OF THE MONEY SUPPLYSUPPLY

• The two most common measures of money are M1 The two most common measures of money are M1 and M 2.and M 2.

• M1, or Narrow money is money that can be directly M1, or Narrow money is money that can be directly used for transactions. It includes currency held used for transactions. It includes currency held outside banks, plus demand deposits, plus traveler’s outside banks, plus demand deposits, plus traveler’s checks, plus other checkable deposits.checks, plus other checkable deposits.

• M2, or Broad money is M1 + savings accounts + M2, or Broad money is M1 + savings accounts + money market accounts (which allows only checks for money market accounts (which allows only checks for amounts above some minimum) + other near monies amounts above some minimum) + other near monies + fixed or time deposits, & negotiable certificates by + fixed or time deposits, & negotiable certificates by BanksBanks

COMMERCIAL BANKS & PROCESS COMMERCIAL BANKS & PROCESS OF DEPOSIT CREATIONOF DEPOSIT CREATION

• The origins of the modern banking system: The origins of the modern banking system: Goldsmiths functioned as warehouses where people Goldsmiths functioned as warehouses where people stored gold for safekeeping. Upon receiving the stored gold for safekeeping. Upon receiving the gold, a goldsmith would issue a receipt to the gold, a goldsmith would issue a receipt to the depositor. After a time, these receipts themselves, depositor. After a time, these receipts themselves, rather than the gold that they represented, began to rather than the gold that they represented, began to be traded for goods. At this point, all the receipts be traded for goods. At this point, all the receipts issued were backed 100 percent by gold.issued were backed 100 percent by gold.

• Goldsmiths realized that people did not come often Goldsmiths realized that people did not come often to withdraw gold and, thus, they had a large stock of to withdraw gold and, thus, they had a large stock of gold continuously on hand. They could lend out gold continuously on hand. They could lend out some of this gold without any fear of running out.some of this gold without any fear of running out.

CBPDC CONT’DCBPDC CONT’D

• The basis of credit money is the bank deposits. The The basis of credit money is the bank deposits. The bank deposits are of two kinds namely, bank deposits are of two kinds namely, (1)Primary deposits, and (2)Derivative deposits.(1)Primary deposits, and (2)Derivative deposits.

• 1) Primary deposits arise or formed when cash or 1) Primary deposits arise or formed when cash or cheque is deposited by customers & the bank cheque is deposited by customers & the bank credits customers’ account. The customer can credits customers’ account. The customer can withdraw the amount anytime by cheques. These withdraw the amount anytime by cheques. These deposits are called “primary deposits” or “cash deposits are called “primary deposits” or “cash deposits.” The bank makes loans and advances to deposits.” The bank makes loans and advances to its customers out of these primary deposits.its customers out of these primary deposits.


• 2) Bank deposits also arise when a loan is granted 2) Bank deposits also arise when a loan is granted or when a bank discounts a bill or purchase or when a bank discounts a bill or purchase government securities. Deposits which arise on government securities. Deposits which arise on account of granting loan or purchase of assets by a account of granting loan or purchase of assets by a bank are called “derivative deposits.”bank are called “derivative deposits.”

• The power of commercial banks to expand deposits The power of commercial banks to expand deposits through loans, advances and investments is known through loans, advances and investments is known as “credit creation.” Thus, credit creation implies as “credit creation.” Thus, credit creation implies multiplication of bank deposits. Credit creation may multiplication of bank deposits. Credit creation may be defined as “the expansion of bank deposits be defined as “the expansion of bank deposits through the process of more loans and advances through the process of more loans and advances and investments.and investments.


• An important aspect of the credit creating function An important aspect of the credit creating function of the commercial banks is the process of multiple-of the commercial banks is the process of multiple-expansion of credit.expansion of credit.

• The banking system as a whole can create credit The banking system as a whole can create credit which is several times more than the original which is several times more than the original increase in the deposits of a bank. This process is increase in the deposits of a bank. This process is called the multiple-expansion or multiple-creation called the multiple-expansion or multiple-creation of credit. of credit.

• Similarly, if there is withdrawal from any one bank, Similarly, if there is withdrawal from any one bank, it leads to the process of multiple-contraction of it leads to the process of multiple-contraction of credit.credit.


• The process of multiple credit-expansion can be The process of multiple credit-expansion can be illustrated by assuming illustrated by assuming

• (a) The existence of a number of banks, e.g (a) The existence of a number of banks, e.g BankIslam, CIMB, Maybank, etc., each with BankIslam, CIMB, Maybank, etc., each with different sets of depositors.different sets of depositors.

• (b) Every bank has to keep 20% of cash reserves, (b) Every bank has to keep 20% of cash reserves, according to law, and, according to law, and,

• (c) To start with, let a new deposit of RM1,000 be (c) To start with, let a new deposit of RM1,000 be made with bankIslam by Mr Jones.made with bankIslam by Mr Jones.

CBPDC CONT’D CBPDC CONT’D

• Suppose, Mr Jones deposits RM1,000 cash Suppose, Mr Jones deposits RM1,000 cash in BankIslam. As a result, the deposits of in BankIslam. As a result, the deposits of BankIslam increase by RM1,000 and cash BankIslam increase by RM1,000 and cash also increases by RM1,000. The balance also increases by RM1,000. The balance sheet of the BankIslam is as fallows: sheet of the BankIslam is as fallows:

BALANCE SHEET OF BANKISLAMLiabilities RM Assets RM

Primary Demand Deposit

1,000 Cash received 1,000

Cash reserved 200

Excess reserve 800


• The deposit of RM1,000 is a liability for BankIslam The deposit of RM1,000 is a liability for BankIslam and it is also its asset. BankIslam has to keep only and it is also its asset. BankIslam has to keep only 20% cash reserve, i.e., RM200 out of its new 20% cash reserve, i.e., RM200 out of its new deposit and it has a surplus of RM 800 which it can deposit and it has a surplus of RM 800 which it can use as loans. use as loans.

• Suppose BankIslam gives a loan to Mr Pat, and the Suppose BankIslam gives a loan to Mr Pat, and the amount of loan is withdrawn & used by Mr Pat to amount of loan is withdrawn & used by Mr Pat to pay off his creditors. After that, the balance sheet of pay off his creditors. After that, the balance sheet of BankIslam will be as follows:BankIslam will be as follows:


BALANCE SHEET OF BANKISLAMLiabilities RM Assets RM

Primary Demand Deposit

1,000 Cash Received 1,000

Derivative Demand Deposit

800 Loan to Mr. Pat 800

•Suppose Mr. Pat purchases goods valued at RM800 from Mrs. Mary and pays cash. Mrs. Mary collects the amount & deposits it with CIMB. The deposits of CIMB now increase by RM800 and its cash also increases by RM800.


• After keeping a cash reserve of RM160, CIMB is After keeping a cash reserve of RM160, CIMB is free to lend the balance of RM640 to any one. free to lend the balance of RM640 to any one. Suppose CIMB lends RM640 to Mr. Kay, who Suppose CIMB lends RM640 to Mr. Kay, who uses the amount to pay off his creditors. The uses the amount to pay off his creditors. The balance sheet of CIMB will be as follows:balance sheet of CIMB will be as follows:

BALANCE SHEET OF CIMB BANK

Liabilities RM Asset RM

Primary DemandDeposit

800 Cash reserve 160

Loan 640

Total 800 800


• Suppose Mr. Kay purchases goods valued at Suppose Mr. Kay purchases goods valued at RM640 from Mrs. Janet and pays the amount. Mrs. RM640 from Mrs. Janet and pays the amount. Mrs. Janet deposits the amount, RM640 in MayBank. Janet deposits the amount, RM640 in MayBank. MayBank now keeps 20% as reserve (RM128) and MayBank now keeps 20% as reserve (RM128) and lends RM512 to a merchant. The balance sheet of lends RM512 to a merchant. The balance sheet of MayBank will be as follows:MayBank will be as follows:

BALANCE SHEET OF CIMB BANKLiabilities RM Asset RM

Primary DemandDeposit

640 Cash Reserve 128

Loans 512

Total 640 640


• Looking at the banking system as a whole, the position Looking at the banking system as a whole, the position will be as follow:will be as follow:

Name of Banks Deposits (RM) Cash reserve(RM) Loans(RM)BankIslam 1,000 200 800

CIMB 8,00 160 640

MayBank 640 128 512

Total 2,440 488 1952


• From the above, out of the initial primary deposit, From the above, out of the initial primary deposit, bank advanced RM800 as a loan. It formed the bank advanced RM800 as a loan. It formed the primary deposit of the second bank, CIMB, which in primary deposit of the second bank, CIMB, which in turn advanced RM640 as loan. This sum again turn advanced RM640 as loan. This sum again formed the primary deposit of the third bank, formed the primary deposit of the third bank, MayBank, which in turn advanced RM512 as loan. MayBank, which in turn advanced RM512 as loan. Thus, the initial primary deposit of RM1,000 resulted Thus, the initial primary deposit of RM1,000 resulted in bank credit of RM1952 in three banks. Of course, in bank credit of RM1952 in three banks. Of course, there will be many banks in the country and the there will be many banks in the country and the above process of credit expansion will continue and above process of credit expansion will continue and come to an end when no bank has an excess come to an end when no bank has an excess reserve to lend again.reserve to lend again.


• When the banking system receives an additional When the banking system receives an additional primary deposit, there will be multiple expansion primary deposit, there will be multiple expansion of credit.of credit.

• When the banking system loses cash, there will When the banking system loses cash, there will be multiple contraction of credit.be multiple contraction of credit.

• The extent to which the banks can create credit The extent to which the banks can create credit together could be found out with the help of the together could be found out with the help of the credit multiplier formula given as: K=1/r credit multiplier formula given as: K=1/r


• Where K is the credit multiplier, and r, the Where K is the credit multiplier, and r, the required reserves. required reserves.

• If the reserve ratio is 20% the size of If the reserve ratio is 20% the size of credit multiplier will be: K=1/r =1/0.2 = 5credit multiplier will be: K=1/r =1/0.2 = 5

• It means that the banking system can It means that the banking system can create credit together to the amount which create credit together to the amount which is five times more than the original is five times more than the original increase in the deposits.increase in the deposits.


• Note that the size of credit multiplier is Note that the size of credit multiplier is inversely related to the percentage of cash inversely related to the percentage of cash reserves the banks have to maintain. reserves the banks have to maintain.

• Thus, If the reserve ratio increases, the Thus, If the reserve ratio increases, the size of credit multiplier is reduced and if the size of credit multiplier is reduced and if the reserve ratio is reduced, the size of credit reserve ratio is reduced, the size of credit multiplier will increasemultiplier will increase


• In general, increase in reserve, ∆R causes In general, increase in reserve, ∆R causes deposits increase, ∆D until required deposits increase, ∆D until required reserves increase, r∆D equalizes it (∆R).reserves increase, r∆D equalizes it (∆R).

• Thus, ∆R = r∆D) Thus, ∆R = r∆D)

• ∆ ∆D = 1/r ∆RD = 1/r ∆R

• We can define deposit multiplier (K) as We can define deposit multiplier (K) as increase in deposits per unit increase in increase in deposits per unit increase in bank reserves as: ∆D/ ∆R = 1/r = Kbank reserves as: ∆D/ ∆R = 1/r = K

LIMITATION TO COMM.BANK LIMITATION TO COMM.BANK DEPOSIT CREATIONDEPOSIT CREATION

• The commercial banks do not have unlimited power of The commercial banks do not have unlimited power of credit creation. The following factors limit their power to credit creation. The following factors limit their power to create credit:create credit:

• I) Amount of Cash: If banks receive more cash, they can I) Amount of Cash: If banks receive more cash, they can create more credit and vice versa. Cash supply is create more credit and vice versa. Cash supply is controlled by the central bank of the countrycontrolled by the central bank of the country

• II) Cash Reserve Ratio: Banks must keep certain II) Cash Reserve Ratio: Banks must keep certain percentage of deposits in cash as reserve as directed by percentage of deposits in cash as reserve as directed by Central Bank. If the cash reserve ratio is increased, the Central Bank. If the cash reserve ratio is increased, the volume of credit that the banks can create will fall and volume of credit that the banks can create will fall and vice versa. vice versa.

LIMITATION CONT’DLIMITATION CONT’D

• III) Banking Habits of the People: There can be III) Banking Habits of the People: There can be multiple expansion only when people form the banking multiple expansion only when people form the banking habit & keep their money in the banks as deposits and habit & keep their money in the banks as deposits and use cheques for the settlement of transactions.use cheques for the settlement of transactions.

• Iv) Nature of Business Conditions in the Economy: Iv) Nature of Business Conditions in the Economy: Credit creation will be large during a period of Credit creation will be large during a period of prosperity bcos more demand for loans and advances prosperity bcos more demand for loans and advances for investment purposes, thus, the volume of bank for investment purposes, thus, the volume of bank credit will be high. Opposite is the case during a credit will be high. Opposite is the case during a depression period.depression period.

LIMITATION CONT’D LIMITATION CONT’D

• V) Leakages in Credit-Creation: Leakages in the V) Leakages in Credit-Creation: Leakages in the process of credit creation where people keep a process of credit creation where people keep a portion of their amount as idle cash instead of portion of their amount as idle cash instead of keeping it in Banks limits credit creation. keeping it in Banks limits credit creation.

• Vi) Liquidity Preference: If people desire to hold Vi) Liquidity Preference: If people desire to hold more cash, the power of banks to create credit is more cash, the power of banks to create credit is reduced.reduced.

• Vii) Monetary Policy of the Central Bank: The Vii) Monetary Policy of the Central Bank: The Central Bank has powerful tools such as bank rate, Central Bank has powerful tools such as bank rate, open market operations to control the expansion open market operations to control the expansion and contraction of credit by the commercial bank. and contraction of credit by the commercial bank.

CENTRAL BANK & THE SUPPLY OF CENTRAL BANK & THE SUPPLY OF MONEYMONEY

• Central bank (CB) Controls the Money Supply (MS) Central bank (CB) Controls the Money Supply (MS) In many ways:In many ways:

• The required reserve ratio: If the CB wants to The required reserve ratio: If the CB wants to increase the MS, it creates more reserves, thereby increase the MS, it creates more reserves, thereby freeing banks to create additional deposits by freeing banks to create additional deposits by making more loans. If it wants to decrease the MS, making more loans. If it wants to decrease the MS, it reduces reserves.it reduces reserves.

• The Discount Rate: Banks may borrow from the CB The Discount Rate: Banks may borrow from the CB & charged interest rate known as discount rate. & charged interest rate known as discount rate. The higher the discount rate, the higher the cost of The higher the discount rate, the higher the cost of borrowing, and the lower the MS and vice versa. borrowing, and the lower the MS and vice versa.

CB & MS CB & MS

• In practice, discount rate are not often used by CB In practice, discount rate are not often used by CB to control the MS with great precision, bcos its to control the MS with great precision, bcos its effects on banks’ demand for reserves are effects on banks’ demand for reserves are uncertain.uncertain.

• Moral suasion: This is the pressure exerted by the Moral suasion: This is the pressure exerted by the CB on member banks to discourage them from CB on member banks to discourage them from borrowing heavily from the CB.borrowing heavily from the CB.

• Open Market Operations: OMO is the (purchase) Open Market Operations: OMO is the (purchase) or sale of govt. securities by the CB in the open or sale of govt. securities by the CB in the open market in order to (expand) or contract the amount market in order to (expand) or contract the amount of reserves in the system and thus, the MS. of reserves in the system and thus, the MS.

CB & MS CB & MS

• An open market purchase of securities by the CB results An open market purchase of securities by the CB results in an increase in reserves and an increase in the supply in an increase in reserves and an increase in the supply of money by an amount equal to the money multiplier of money by an amount equal to the money multiplier times the change in reserves. times the change in reserves.

• An open market sale of securities by the Fed results in a An open market sale of securities by the Fed results in a decrease in reserves and a decrease in the supply of decrease in reserves and a decrease in the supply of money by an amount equal to the money multiplier times money by an amount equal to the money multiplier times the change in reserves.the change in reserves.

• OMOs are the CB’s preferred means of controlling MS OMOs are the CB’s preferred means of controlling MS bcos they can be used with some precision, are bcos they can be used with some precision, are extremely flexible, and are fairly predictable.extremely flexible, and are fairly predictable.

MONEY DEMANDMONEY DEMAND

• Keynesian Theory: According to Keynes, there Keynesian Theory: According to Keynes, there three motives for holding money. These arethree motives for holding money. These are

• Transaction Motives Transaction Motives

• Precautionary MotivesPrecautionary Motives

• Speculative Motive: Speculative Motive:

- Uncertainty about future interest rates & rxp btw - Uncertainty about future interest rates & rxp btw changes in the interest rate and the price of bonds. changes in the interest rate and the price of bonds.

– –The illustrations are provided belows: The illustrations are provided belows:

MONEY DEMAND MONEY DEMAND

-Suppose in the past an investor bought govt. -Suppose in the past an investor bought govt. bond at mkt price (PB) of RM1,000, at interest bond at mkt price (PB) of RM1,000, at interest rate (r) of 5% and entitlement or coupon payment rate (r) of 5% and entitlement or coupon payment (CP) of RM50 per yr. Thus, [ PB= {CP x 100}/r ] (CP) of RM50 per yr. Thus, [ PB= {CP x 100}/r ] gives RM1,000.gives RM1,000.

-Suppose today, mkt int. rate, r = 5% (same as -Suppose today, mkt int. rate, r = 5% (same as past). The price of bond is still RM1,000 and no past). The price of bond is still RM1,000 and no capital gain or loss.capital gain or loss.

-If the mkt. int. rate, r has risen to 10%, then the -If the mkt. int. rate, r has risen to 10%, then the PB now at CP of RM50 gives RM500 [ i.e PB now at CP of RM50 gives RM500 [ i.e (50x100)/10]. Thus, capital loss of RM500. (50x100)/10]. Thus, capital loss of RM500.


-If the mkt. int. rate, r has declined to 2%, then the -If the mkt. int. rate, r has declined to 2%, then the PB now at CP of RM50 gives RM2500 [ i.e PB now at CP of RM50 gives RM2500 [ i.e (50x100)/2]. Thus, capital gain of RM1500. (50x100)/2]. Thus, capital gain of RM1500.

- Given the assmptn, the return on money is zero - Given the assmptn, the return on money is zero bcos it earns no interest & its value is not subject bcos it earns no interest & its value is not subject to capital loss or gain as the int. rate changes. to capital loss or gain as the int. rate changes.

-Bond will pay an int. rate of r. the expected return -Bond will pay an int. rate of r. the expected return on bond equals int. return plus or minus any on bond equals int. return plus or minus any expected gain or loss.expected gain or loss.


-Therefore, If investor expects int. rate to fall, -Therefore, If investor expects int. rate to fall, bonds have higher expected return and yield a bonds have higher expected return and yield a capital gain.capital gain.

-Conversely, If investor expects int. rate to rise, it is -Conversely, If investor expects int. rate to rise, it is possible that the expected capital loss on bonds possible that the expected capital loss on bonds will outweigh the interest earnings. The expected will outweigh the interest earnings. The expected return on bonds would be negative and the return on bonds would be negative and the preferred asset would be money.preferred asset would be money.

-Thus, if r is expected to rise, the price of bonds is -Thus, if r is expected to rise, the price of bonds is expected to fall & capital loss expected, then expected to fall & capital loss expected, then money is demand for as an asset now.money is demand for as an asset now.


-Keynes assumes that investors have a -Keynes assumes that investors have a relatively fixed conception of the normal int. relatively fixed conception of the normal int. rate. rate.

-Thus, when the actual int. rate is above the -Thus, when the actual int. rate is above the normal rate, investors expect the int. rate to normal rate, investors expect the int. rate to fall. Conversely, when the int. rate is below the fall. Conversely, when the int. rate is below the normal rate, they expect it to rise.normal rate, they expect it to rise.

-Based on this assmptn, a rxp btw the level of -Based on this assmptn, a rxp btw the level of the speculative demand for money and int. the speculative demand for money and int. rate can be developed.rate can be developed.


Fig.1: Individual speculative demand for money Fig.1: Individual speculative demand for money Int. rate. r Int. rate. r

nrnr

crcr

MM2i2i

(Whi-M(Whi-M1i1i))

Speculative demand for moneySpeculative demand for money


Fig 2: Agg. speculative demand for Money Fig 2: Agg. speculative demand for Money

Int. rate. rInt. rate. r

MM22

Speculative demand for moneySpeculative demand for money


• MM1i1i + M + M2i2i ≡ M ≡ Mi i

wherewhere MM2i 2i is the speculative dd for money, and is the speculative dd for money, and MM1i 1i is the transactions dd for money by individual.is the transactions dd for money by individual.

• MMi i + B+ Bii ≡ Wh ≡ Whi i

where Mwhere Mi , i , BBii ,Wh ,Whi i are individual’s total money are individual’s total money holdings, bond holdings and wealth, respectivelyholdings, bond holdings and wealth, respectively

• r, nr, cr, and (Whi-Mr, nr, cr, and (Whi-M1i1i) ) are interest rate, normal interest rate, critical are interest rate, normal interest rate, critical interest rate, and bond holding respectively.interest rate, and bond holding respectively.


• Fig 1 shows the individual’s speculative dd for Fig 1 shows the individual’s speculative dd for money. At any int. rate above the critical rate, money. At any int. rate above the critical rate, the speculative dd for money is zero. Below the the speculative dd for money is zero. Below the critical interest rate, individual shifts to money.critical interest rate, individual shifts to money.

• Fig 2 shows the agg. speculative dd for money Fig 2 shows the agg. speculative dd for money schedule. As the interest rate becomes lower, it schedule. As the interest rate becomes lower, it fall below the critical rate for more individuals fall below the critical rate for more individuals and the speculative demand for money rises.and the speculative demand for money rises.

• This situation at a very low r where speculative This situation at a very low r where speculative dd for money schedule becomes nearly dd for money schedule becomes nearly horizontal is known as the liquidity Trap. horizontal is known as the liquidity Trap.

EQUILIBRIUM INTEREST RATESEQUILIBRIUM INTEREST RATES

int. rate r Equilibrium in the money int. rate r Equilibrium in the money Ms Ms00 market market

r* r*

MdMd00

M* MM* M

FIG. 1 Quantity of moneyFIG. 1 Quantity of money


Int. rate r Effects of a shift in Money Int. rate r Effects of a shift in Money Ms Ms0 0

MsMs1 1 DemandDemand

r1r1

r*r*

r2 Mdr2 Md22 Md* Md Md* Md11

FIG.2 Qty of money M* MFIG.2 Qty of money M* M1 1 MM


• Fig.1 shows the intersection of money demand Fig.1 shows the intersection of money demand and supply schedules (Md & Ms) to determine the and supply schedules (Md & Ms) to determine the equilibrium interest rate r*. equilibrium interest rate r*.

• Ms is assumed to be exogenous and the Ms Ms is assumed to be exogenous and the Ms target M* is achieved by Central Bank using target M* is achieved by Central Bank using monetary base to control it.monetary base to control it.

• Also, equilibrium interest rate r* is considered the Also, equilibrium interest rate r* is considered the desired level by the Central Bank.desired level by the Central Bank.


• Consider the effects of shifts in Money demand Consider the effects of shifts in Money demand schedule in Fig 2 schedule in Fig 2

• The shifts could be due to changes in income (∆ Y) The shifts could be due to changes in income (∆ Y) which change money demand for a given int. rate.which change money demand for a given int. rate.

• Or due to the effects of actual shifts in Md function Or due to the effects of actual shifts in Md function i.e changes in the amount of money demanded i.e changes in the amount of money demanded (∆Md) at a given levels of both Y and the int. rate.(∆Md) at a given levels of both Y and the int. rate.

• ∆∆Md could shift the Md schedule to say MdMd could shift the Md schedule to say Md11 (an (an increase in money demand) or Mdincrease in money demand) or Md2 2 (a decline in (a decline in money demand). money demand).


• What will the Central Bank (CB) do in response to What will the Central Bank (CB) do in response to the shifts?the shifts?

• If CB maintains the Ms at M* which is CB Ms If CB maintains the Ms at M* which is CB Ms target, the desired level of CB’s int. rate, r* will not target, the desired level of CB’s int. rate, r* will not be achieved as it will move away from the position be achieved as it will move away from the position r*. r*.

• A decline in Md from Md* to MdA decline in Md from Md* to Md22 leads r to decline leads r to decline from r* to rfrom r* to r2. 2.

• An increase in Md from Md* to MdAn increase in Md from Md* to Md1 1 leads to an leads to an undesirable rise in the r from r* to rundesirable rise in the r from r* to r1.1.


• The CB can prevent or mitigate these movements The CB can prevent or mitigate these movements in the r only by changing the monetary base & in the r only by changing the monetary base & hence the money supply.hence the money supply.

• In the case of an increase in Md, CB could move In the case of an increase in Md, CB could move the money supply to the level Msthe money supply to the level Ms11 schedule so schedule so as to have equilb. in money market at the desired as to have equilb. in money market at the desired int. rate, r* by increasing the monetary base.int. rate, r* by increasing the monetary base.

• By so doing, CB would not achieve the Ms target By so doing, CB would not achieve the Ms target as the money supply would be Mas the money supply would be M1 1 above M*. In above M*. In this case, the increase in demand for money by this case, the increase in demand for money by public is accommodated by the CB. public is accommodated by the CB.


• In this scenario, the monetary base and money In this scenario, the monetary base and money supply are not determined exogenously but supply are not determined exogenously but rather respond to the behaviour of the public.rather respond to the behaviour of the public.

• In an extreme case where int. rate is pegged at In an extreme case where int. rate is pegged at a fixed level for a long time by the CB, the a fixed level for a long time by the CB, the monetary authority have no choice in the money monetary authority have no choice in the money supply process than to supply the required supply process than to supply the required amount of money to maintain the desired amount of money to maintain the desired interest rate. interest rate.

Education

Demand & supply of money