Ch 7---Money Demand & Money Supply
In Microeconomics, we study Fisher's theory of capital and interest. According to classical economists, the market interest rate is determined by real force (like productivity, thriftiness or time preference), that means the demand for and supply of loanable funds. We now consider the Keynesian theory of money demand.
Keynesian economists, unlike classical economists, argue that the monetary force of demand and supply determines the equilibrium rate of interest. There are various motives of money demand, and we study how the monetary authority can use monetary policy to influence the money supply.
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Index:
Why is there a demand for money: The Classical Approach: The amount of money held for transaction purpose depends very much on the institutional arrangement ...
Why is there a demand for money: The Keynesian Approach: Money and Bonds; the price of an asset
Keynes recognized motives for holding money...
1. Transactions demand/transactions motive (Mt)...
2. Asset Demand for Money(Ma) or Speculative demand...
Supply of Money: (1) Exogenous Ms ¡@¡@(2) Endogenous Ms
equilibrium in money market...
(1) Expansionary monetary policy...
(2) Contractionary monetary policy...
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Why is there a demand for money:
The Classical Approach:
The transaction demand for money: Classical economists' analysis is based on the view that money is a medium of exchange. People keep transaction balance of money because of payments and receipts do not perfectly synchronize. The holding of money is to bridge the time gap between receipt and expenditure.
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The amount of money held for transaction purpose depends very much on the institutional arrangement ----
1. the frequency of receipt of income by households (Pay period): reducing(increasing) the frequency of income receipt means longer(shorter) time lag between income inflows. Thus increases (decreases) the amount of money needed for transaction purposes; (Refer to Txtbk P. 128)
2. the expenditure pattern of household; and;
3. The degree of vertical integration among firms and;
4. the extensive use of credit, e.g. the use of credit cards; and
5. The liquidity preference that the interest rate is a factor which affects the demand for money.
Therefore, the amount of money a person demands is positively related to his income and the transaction demand for will be in direction proportion to the level of real national income.
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Why is there a demand for money: The Keynesian Approach:--- In the Keynesian Theory of Money Demand, it is assumed that there exist only two types of financial asset: money and bonds.
Money: is a perfectly liquid financial asset, but earns no interest. In his model, all non-interest earning financial assets are regarded as money.
Bonds: include all interest-earning financial assets. They are less liquid but earn interest returns. Therefore the cost of holding money is the amount of interest that could have been earned if the money had been used to purchase bonds. All bonds are assumed to be perpetual (they pay interest forever and never repay the principal).
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The price of an asset is its future income discounted. It reflects the value of income received by the owner.
The price of bond: Pb=I /r .Where I is the interest income and r is the interest rate per annum.
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The Demand for Money: Keynes recognized the following motives for holding money:
1. Transactions demand/transactions motive (Mt) which also incorporates with precautionary demand/precautionary motive : Mt is comprised of the collective demand of money for transactions by individuals, household, firms and the government. People must hold transactions balances to bridge the gap between receipts of money. It is also comprised of the collective demand for money by individuals, households, firms and the government as a contingency against unforeseen fluctuations in expenditures and receipts. Precautionary money balances are held because of uncertainty about the receipts and expenditure of future income.
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2. Asset Demand for Money(Ma) or Speculative demand / speculative motive : when the current rate of interest is relatively low, people are likely to expect the interest rate to rise and bond prices to fall in the future. They therefore believe that negative returns will be earned from holding bonds, and will consequently hold larger money balances. Speculative demand for money is money demand due to speculation about possible changes in the bond price. Therefore, the asset function of money provides its owners with liquidity but involves the opportunity cost of sacrificed interest income. The higher the interests rate the lower the amount of asset demand for money. The total amount of money balances that people wish to hold for all purposes is called Money Demand and price level is assumed to be constant in Keynesian model.
(Refer to your textbook the Demand Curve for Money on P.127 Fig. 4 and Fig. 5)
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According to Keynes, bondholders have a fair idea of the normal rate of interest. If the current rate of interest is very low, people will believe that it is the minimum rate of interest and they would all hold assets in money rather than bonds. Nobody would buy bonds at this rate in order to avoid capital loss that is greater than the interest returns in the future. Therefore, the demand curve for money may be perfectly elastic at a certain low interest rate. The perfectly elastic portion of the demand curve for money is called the liquidity trap. (Refer to your book P.130 Fig. 9)
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There are two basic assumptions that govern the determination of money supply (Ms):
(1) Exogenous money supply : The money supply may be determined by the monetary authority or central bank. I.e. disregarding the interest rate the money supply is fixed.
(2) Endogenous money supply : The money supply may be also determined by forces such the level of interest rate. I.e. the Ms and the interest rate is positively related as the financial agents will find it profitable to expand the volume of loans. It is a function of interest rate.
In practice, the money supply is partly endogenous and partly exogenous. However, to make thing simple, we assume the Ms as exogenous (I.e. in accordance with the change in central monetary authority's policy).
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Equilibrium in the money market :
In the money market, rate of interest (in equilibrium) is determined by the intersection of the money demand and supply. (It is in accordance with the Keynsian thought.)
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Either an excess in money demand or an excess in money supply will move the market interest rate back to equilibrium.
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A monetary policy is the control of money supply and interest rates by the central monetary authority or central bank to achieve so-called desired goals in the economy such as low unemployment and stable level of general price.
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(1) Expansionary monetary policy: Whenever the unemployment is high, the central bank can either increase the money supply or reduce interest rate, or both. In the short run, since price is fixed, people will increase their aggregate demand with their extra balance of money. Hence consumption and investment will be raised and higher level of national output will be resulted.
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(2) Contractionary monetary policy: Whenever there is high inflation, the central bank can either reduce the money supply or increase interest rate, or both. In the short run, since price is fixed, people will reduce their aggregate demand. The resulting fall in AD will lower the inflationary pressure on the economy. Hence consumption and investment will be reduced as the costs of borrowing are increased.
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----Varying the required cash/liquidity reserve ratio: A decrease/increase in the ratio will permit a multiple expansion/contraction of deposit money through credit creation/contraction process assuming the banks adhere to the minimum required reserve ratio;
---- Varying the discount rate and inter-bank rate: I.e. the change in interest rate;
---- Open market operations: It refers to the buying and selling government bonds in order to control the money supply;
---- Moral suasion: Government exerts pressure on the banks to expand or contract credit, which is the least effectiveness;
---- Issuing more money notes (non-convertible money), which the most effective way. However, it exerts inflationary pressure on the economy.