Chapter 5: Money Supply
& Money Demand
Chapter`s Outlines
Definition of money Supply
Supply of Money and Market interest
The Demand for Money, & Three motives for demand for money
Equilibrium in Money Market
Changes in Equilibrium
Money Supply and Liquidity
Friedman’s Challenge to Liquidity Preference
Tools 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
Interest Rate (%)
Ms
10
5
80
Quantity of Money
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 houses
What are the motives behind holding the money
Three main motives of keeping money
Transaction demand for money
Precautionary demand for money
Speculative demand for money
1
Transaction demand for money
Money is used as a medium of exchange
People 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 it
Those 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
25
100
5%
5
20
200
5%
10
300
5%
15
10
400
5%
20
5
500
5%
25
Mtd
ky
15
0
100 200 300 400
y
500
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, interestbearing 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
r2
people will keep more money
in their pocket for purpose of r1
speculation and vice versa
Msd =f(r)
0
Msd1
Msd2
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 as
LT =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 money
The 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
Nominal
Interest Rate
(i)
MS
7%
5%
3%
MD
400
Money Surplus
700
1000
Money Shortage
Quantity of Money ($
billions)
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
Nominal
Interest Rate
(i)
MS
7%
5%
MD2
700
900
MD1
Quantity of Money ($
billions)
Interest Rates Fall when Bonds become less Risky
Nominal
Interest Rate
(i)
MS
5%
3%
MD2
400
700
MD1
Quantity of Money ($
billions)
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 nonmonetary 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
2
3
Changing banks reserve requirement
Changing the discount rate at which banks borrow
from the central bank at.
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
Interest Rate (%)
(M1/P)s
(M2/P)s
5
4
(M/P)d
80 85
Quantity of Money
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