Demand and Supply of Money

1. Demand and Supply of Money

2. Outline • The Central Bank and its Functions • The Supply of Money, The Demand for Money, and Equilibrium In The Money Market • The supply of money • Temporary assumption of fixed money supply • Meaning of demand for money • Factors affecting the demand for money • Transaction demand for money • Precautionary demand for money • Speculative demand for money • Money demand as a function of nominal interest rate and income

3. The Basics: How Central Banks Originated and Their Role Today • The central bank started out as the government’s bank and over the years added various other functions. • A modern central bank not only manages the government’s finances but provides an array of services to commercial banks.

4. The Government’s Bank • As the government’s bank, the central bank has a privileged position: • It has the monopoly on the issuance of currency. • The central bank creates money. • The primary reason for a country to create its own central bank, then, is to ensure control over its currency. • Giving the currency-printing monopoly to someone else could be disastrous. • At its most basic level, printing money is a very profitable business. • A bill only costs a few cents to print. • Government officials also know that losing control of the printing presses means losing control of inflation. • A high rate of money growth creates a high inflation rate.

5. The Government’s Bank • The central bank can control the availability of money and credit in a country's economy. • Most central banks go about this by adjusting short-term interest rates: monetary policy. • They use it to stabilize economic growth and information.

6. The Banker’s Bank • As the banker’s bank, the central bank took on the roles it plays today: • To provide loans during times of financial stress, • To manage the payments system, and • To oversee commercial banks and the financial system. • The ability to create money means that the central bank can make loans even when no one else can.

7. Other Functions • Supervising and Regulating Banks • Sets rules and enforces reserve requirements • Sets standards for establishing new banks • Determines what kinds of loans and investments banks are allowed to make etc • Clearing Cheques

8. The Market Interest Rate • What determines the equilibrium interest rate in financial markets? • A financial market is any market in which borrowers and lenders of money interact • Forces of demand and supply for money determine both the quantity of lending/borrowing and the interest rate at which these loans are made. • To analyze this market, we focus on the demand and supply of money

9. 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 the M1 definition of supply of money • M1=Currency (Cc)+ Demand Deposits (DD) • It means that supply of money is the total quantity of money circulated in a country

10. Supply of Money, Ms • Ms is determined by central monetary authorities of a country • We assume that the Central Bank has printed enough money as deems prudent, and the commercial banks have created enough money (demand deposits) as they can • Ms is therefore fixed in short run and is independent of rate of interest • Graphical illustration • Ms is a vertical line as it is independent of rate of interest • If Ms increases in a country, then the Ms curve shifts to the right • And if Ms decreases in a country than Ms curve shift to the left

11. Money Supply Line • The quantity of money in circulation is controlled by the central bank Interest Rate (%) Ms 10 5 80 Quantity of Money

12. Demand for Money • Money is one form of wealth • Other forms include bonds stocks etc. • Assume: wealth is fixed and can be in bonds or money • Bonds pay interest, money doesn’t ( opportunity cost) • If people desire to hold money, there is a demand for money. • To use money, one must hold money. • The quantity of money people hold depends on: • 1) The price level • 2) The interest rate • 3) Real GDP • 4) Financial innovation

13. Demand for Money • The Price Level • Nominal money is the quantity of money measured in Ghana cedis. • The quantity of nominal money demanded is proportional to the price level. • If price increases by 10%, people will hold 10% more of money to buy the same bundle of goods. • For example, if you spent Ghc20 to buy a pair of shoes before, now you need to hold Ghc2 more to buy the same bundle if prices increase by 10%

14. Demand for Money • The Interest Rate • The opportunity cost of holding money is the interest rate a person could earn on assets they could hold instead of money. • Higher interest rate (higher opportunity cost) causes lower money demand, and v. versa

15. Demand for Money • Real GDP • Money holdings depend upon planned spending. • The quantity of money demanded in the economy as whole depends on Real GDP. • Higher income leads to higher expenditure. • People hold more money to finance the higher volume of expenditure.

16. Demand for Money • Financial Innovation • Changing technologies affect the quantity of money held. • These include: • Automatic transfers between checking and savings deposits • Automatic teller machines (ATMs) • Credit cards • In general, the above innovation reduces the demand for money.

17. Demand for Money • The Demand for Money Curve • The demand for money is the relationship between the quantity of real money demanded and the interest rate. • Graphical Illustration

18. Demand for Money • The Demand for Money Curve • Changes in the interest rate lead to shifts along the demand for money curve

19. Demand for Money • Shifts in the Demand Curve for Real Money • Changes in prices, real GDP or financial innovation changes the demand for money and shifts the demand curve for real money.

20. Demand for Money • What are the motives behind holding the money? • Three main motives of keeping money • Transactions demand for money • Precautionary demand for money • Speculative demand for money

21. 1 Transaction demand for money • What is this?

22. 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 • The transactions demand for money depends on time intervals when a person gets income and when a person spends it • If the duration is shorter, individuals demand less money • People who are paid less frequently (e.g. monthly vs weekly or daily) tend to hold more transactions balances • In those countries where credit facilities are common, transaction demand for money is lower as compared to those countries where credit facilities are not available • Why?

23. The Transactions Demand for Money • According to Keynes, the demand for money for transactions motives depends on income • i.e. the higher the income, the greater the amount of money that will be held for transactions purposes

24. The Transactions Demand for Money • According to the modern view, also depends on interest rates • Rationale • More interest could be earned on money if it was invested in bonds, rather than held as money • Because money has an opportunity cost, therefore, people keep money held for Mtd to a minimum • Make frequent switches between money and other assets • Is this practical? Factors to consider?

25. The Transactions Demand for Money • According to the modern view, Mtd also depends on interest rates • Rationale • More interest could be earned on money if it was invested in bonds, rather than held as money • Because money has an opportunity cost, therefore, people keep money held for Mtd to a minimum • Make frequent switches between money and other assets • Is this practical? Factors to consider? • How much interest can be earned, compared to cost of switching assets • E.g. time spent making trips to banks, inconvenience, cost of buying and selling assets, etc • The higher the rate of interest, the lower the Mtd • Explain…

26. 2 Precautionary demand for money • What is this?

27. 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 • Alternative? Borrow at high interest costs to meet temporary cash shortages • Uncertainty plays a very important role in the precautionary demand for money, MpD

28. Precautionary Demand for Money • Total precautionary demand for money is positively associated with nominal income, PY • Firms/ individuals will hold more funds the higher the nominal national income • It is however negatively related with the interest rate • The firm/individual will hold more funds, the lower the opportunity cost of holding such funds (i.e. the lower the interest rate) • The introduction of credit cards led to a reduction in the precautionary demand for money

29. 3 Speculative demand for money • What is this?

30. 3 Speculative demand for money • This is when individuals hold Money for investment in the financial market • According to Keynes, individuals 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 • 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

31. Speculative demand for money • The speculative demand for money is negatively related with interest rates • When the interest rate falls, the cost of holding money falls and more money is held for speculative reasons • When the interest rate rises, the cost of holding money rises and more money is held for speculative reasons • The speculative demand for money is positively related with the national income or wealth • The greater one’s income, the more money is held for speculative purposes

32. 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 Where Mtd is the transactions demand for money Msd is the speculative demand for money Mpd is the precautionary demand for money

33. What Influences Aggregate Money Demand (MD)? (Summary)

34. The Money Demand Function

35. A Model of Aggregate Money Demand For a given level of income, real money demand decreases as the interest rate increases.

36. A Model of Aggregate MD (cont.) When income increases, real money demand increases at every interest rate.

37. Next Class… • Equilibrium in the money market • Financial assets • The price of bonds and the interest rate • Monetary equilibrium and the equilibrium interest rate • Monetary Policy and Interest Rates