Demand & supply of money

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Demand & supply of money

  1. 1. Demand for and supplyDemand 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
  2. 2. DEFINITIONS OF MONEYDEFINITIONS OF MONEY • Money is anything that is generally accepted as aMoney is anything that is generally accepted as a medium of exchangemedium of exchange • Traditionally, money is defined as currency andTraditionally, money is defined as currency and demand deposits, and its most important function is todemand 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 plusFriedman defined money as the sum of currency plus all adjusted deposits in commercial banks. Thisall adjusted deposits in commercial banks. This includes bank deposits, non bank deposits and anyincludes bank deposits, non bank deposits and any other type of assets through which the monetaryother 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.
  3. 3. FUNCTIONS OF MONEYFUNCTIONS OF MONEY • Money serves as a means of payment, or medium ofMoney serves as a means of payment, or medium of exchange. Money eliminates the problem of barterexchange. Money eliminates the problem of barter system which requires a double coincidence of wantssystem which requires a double coincidence of wants before goods and services can be directly exchangebefore 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, itMoney serves as a store of value. In this case, it serves as an asset that can be used to transferserves 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 unitMoney serves as a unit of account, or a standard unit that provides a consistent way of measuring andthat provides a consistent way of measuring and recording economic value (e.g quoting prices)recording economic value (e.g quoting prices)
  4. 4. 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 thatCommodity monies are items used as money that also have intrinsic value in some other use. Gold isalso 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.money is money that is intrinsically worthless. Legal tender is money that a government hasLegal tender is money that a government has required to be accepted in settlement of debts.required to be accepted in settlement of debts.
  5. 5. COMPONENTS OF THE MONEYCOMPONENTS OF THE MONEY SUPPLYSUPPLY • The two most common measures of money are M1The two most common measures of money are M1 and M 2.and M 2. • M1, or Narrow money is money that can be directlyM1, or Narrow money is money that can be directly used for transactions. It includes currency heldused for transactions. It includes currency held outside banks, plus demand deposits, plus traveler’soutside 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 formoney market accounts (which allows only checks for amounts above some minimum) + other near moniesamounts above some minimum) + other near monies + fixed or time deposits, & negotiable certificates by+ fixed or time deposits, & negotiable certificates by BanksBanks
  6. 6. COMMERCIAL BANKS & PROCESSCOMMERCIAL 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 whereGoldsmiths functioned as warehouses where people stored gold for safekeeping. Upon receivingpeople stored gold for safekeeping. Upon receiving the gold, a goldsmith would issue a receipt to thethe 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 torather than the gold that they represented, began to be traded for goods. At this point, all the receiptsbe 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 oftenGoldsmiths realized that people did not come often to withdraw gold and, thus, they had a large stockto withdraw gold and, thus, they had a large stock of gold continuously on hand. They could lend outof 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.
  7. 7. CBPDC CONT’DCBPDC CONT’D • The basis of credit money is the bank deposits. TheThe 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 or1) Primary deposits arise or formed when cash or cheque is deposited by customers & the bankcheque is deposited by customers & the bank credits customers’ account. The customer cancredits customers’ account. The customer can withdraw the amount anytime by cheques. Thesewithdraw the amount anytime by cheques. These deposits are called “primary deposits” or “cashdeposits are called “primary deposits” or “cash deposits.” The bank makes loans and advances todeposits.” The bank makes loans and advances to its customers out of these primary deposits.its customers out of these primary deposits.
  8. 8. CBPDC CONT’DCBPDC CONT’D • 2) Bank deposits also arise when a loan is granted2) Bank deposits also arise when a loan is granted or when a bank discounts a bill or purchaseor when a bank discounts a bill or purchase government securities. Deposits which arise ongovernment securities. Deposits which arise on account of granting loan or purchase of assets by aaccount 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 depositsThe power of commercial banks to expand deposits through loans, advances and investments is knownthrough loans, advances and investments is known as “credit creation.” Thus, credit creation impliesas “credit creation.” Thus, credit creation implies multiplication of bank deposits. Credit creation maymultiplication of bank deposits. Credit creation may be defined as “the expansion of bank depositsbe defined as “the expansion of bank deposits through the process of more loans and advancesthrough the process of more loans and advances and investments.and investments.
  9. 9. CBPDC CONT’DCBPDC CONT’D • An important aspect of the credit creating functionAn 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 creditThe banking system as a whole can create credit which is several times more than the originalwhich is several times more than the original increase in the deposits of a bank. This process isincrease in the deposits of a bank. This process is called the multiple-expansion or multiple-creationcalled 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 ofit leads to the process of multiple-contraction of credit.credit.
  10. 10. CBPDC CONT’DCBPDC CONT’D • The process of multiple credit-expansion can beThe process of multiple credit-expansion can be illustrated by assumingillustrated 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 withBankIslam, 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.
  11. 11. CBPDC CONT’DCBPDC CONT’D • Suppose, Mr Jones deposits RM1,000 cashSuppose, Mr Jones deposits RM1,000 cash in BankIslam. As a result, the deposits ofin BankIslam. As a result, the deposits of BankIslam increase by RM1,000 and cashBankIslam increase by RM1,000 and cash also increases by RM1,000. The balancealso increases by RM1,000. The balance sheet of the BankIslam is as fallows:sheet of the BankIslam is as fallows: BALANCE SHEET OF BANKISLAM Liabilities RM Assets RM Primary Demand Deposit 1,000 Cash received 1,000 Cash reserved 200 Excess reserve 800
  12. 12. CBPDC CONT’DCBPDC CONT’D • The deposit of RM1,000 is a liability for BankIslamThe deposit of RM1,000 is a liability for BankIslam and it is also its asset. BankIslam has to keep onlyand it is also its asset. BankIslam has to keep only 20% cash reserve, i.e., RM200 out of its new20% cash reserve, i.e., RM200 out of its new deposit and it has a surplus of RM 800 which it candeposit 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 theSuppose BankIslam gives a loan to Mr Pat, and the amount of loan is withdrawn & used by Mr Pat toamount of loan is withdrawn & used by Mr Pat to pay off his creditors. After that, the balance sheet ofpay off his creditors. After that, the balance sheet of BankIslam will be as follows:BankIslam will be as follows:
  13. 13. CBPDC CONT’DCBPDC CONT’D BALANCE SHEET OF BANKISLAM Liabilities 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.
  14. 14. CBPDC CONT’DCBPDC CONT’D • After keeping a cash reserve of RM160, CIMB isAfter 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, whoSuppose CIMB lends RM640 to Mr. Kay, who uses the amount to pay off his creditors. Theuses 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 Demand Deposit 800 Cash reserve 160 Loan 640 Total 800 800
  15. 15. CBPDC CONT’DCBPDC CONT’D • Suppose Mr. Kay purchases goods valued atSuppose 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) andMayBank now keeps 20% as reserve (RM128) and lends RM512 to a merchant. The balance sheet oflends RM512 to a merchant. The balance sheet of MayBank will be as follows:MayBank will be as follows: BALANCE SHEET OF CIMB BANK Liabilities RM Asset RM Primary Demand Deposit 640 Cash Reserve 128 Loans 512 Total 640 640
  16. 16. CBPDC CONT’DCBPDC CONT’D • Looking at the banking system as a whole, the positionLooking 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
  17. 17. CBPDC CONT’DCBPDC CONT’D • 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 thebank advanced RM800 as a loan. It formed the primary deposit of the second bank, CIMB, which inprimary deposit of the second bank, CIMB, which in turn advanced RM640 as loan. This sum againturn 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 resultedThus, 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 thethere will be many banks in the country and the above process of credit expansion will continue andabove process of credit expansion will continue and come to an end when no bank has an excesscome to an end when no bank has an excess reserve to lend again.reserve to lend again.
  18. 18. CBPDC CONT’DCBPDC CONT’D • When the banking system receives an additionalWhen the banking system receives an additional primary deposit, there will be multiple expansionprimary deposit, there will be multiple expansion of credit.of credit. • When the banking system loses cash, there willWhen 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 creditThe extent to which the banks can create credit together could be found out with the help of thetogether could be found out with the help of the credit multiplier formula given as: K=1/rcredit multiplier formula given as: K=1/r
  19. 19. CBPDC CONT’DCBPDC CONT’D • Where K is the credit multiplier, and r, theWhere K is the credit multiplier, and r, the required reserves.required reserves. • If the reserve ratio is 20% the size ofIf 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 canIt means that the banking system can create credit together to the amount whichcreate credit together to the amount which is five times more than the originalis five times more than the original increase in the deposits.increase in the deposits.
  20. 20. CBPDC CONT’DCBPDC CONT’D • Note that the size of credit multiplier isNote that the size of credit multiplier is inversely related to the percentage of cashinversely related to the percentage of cash reserves the banks have to maintain.reserves the banks have to maintain. • Thus, If the reserve ratio increases, theThus, If the reserve ratio increases, the size of credit multiplier is reduced and if thesize of credit multiplier is reduced and if the reserve ratio is reduced, the size of creditreserve ratio is reduced, the size of credit multiplier will increasemultiplier will increase
  21. 21. CBPDC CONT’DCBPDC CONT’D • In general, increase in reserve, ∆R causesIn general, increase in reserve, ∆R causes deposits increase, ∆D until requireddeposits 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) asWe can define deposit multiplier (K) as increase in deposits per unit increase inincrease in deposits per unit increase in bank reserves as: ∆D/ ∆R = 1/r = Kbank reserves as: ∆D/ ∆R = 1/r = K
  22. 22. LIMITATION TO COMM.BANKLIMITATION TO COMM.BANK DEPOSIT CREATIONDEPOSIT CREATION • The commercial banks do not have unlimited power ofThe commercial banks do not have unlimited power of credit creation. The following factors limit their power tocredit creation. The following factors limit their power to create credit:create credit: • I) Amount of Cash: If banks receive more cash, they canI) Amount of Cash: If banks receive more cash, they can create more credit and vice versa. Cash supply iscreate 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 certainII) Cash Reserve Ratio: Banks must keep certain percentage of deposits in cash as reserve as directed bypercentage of deposits in cash as reserve as directed by Central Bank. If the cash reserve ratio is increased, theCentral Bank. If the cash reserve ratio is increased, the volume of credit that the banks can create will fall andvolume of credit that the banks can create will fall and vice versa.vice versa.
  23. 23. LIMITATION CONT’DLIMITATION CONT’D • III) Banking Habits of the People: There can beIII) Banking Habits of the People: There can be multiple expansion only when people form the bankingmultiple expansion only when people form the banking habit & keep their money in the banks as deposits andhabit & 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 ofCredit creation will be large during a period of prosperity bcos more demand for loans and advancesprosperity bcos more demand for loans and advances for investment purposes, thus, the volume of bankfor investment purposes, thus, the volume of bank credit will be high. Opposite is the case during acredit will be high. Opposite is the case during a depression period.depression period.
  24. 24. LIMITATION CONT’DLIMITATION CONT’D • V) Leakages in Credit-Creation: Leakages in theV) Leakages in Credit-Creation: Leakages in the process of credit creation where people keep aprocess of credit creation where people keep a portion of their amount as idle cash instead ofportion 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 holdVi) Liquidity Preference: If people desire to hold more cash, the power of banks to create credit ismore cash, the power of banks to create credit is reduced.reduced. • Vii) Monetary Policy of the Central Bank: TheVii) 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 expansionopen market operations to control the expansion and contraction of credit by the commercial bank.and contraction of credit by the commercial bank.
  25. 25. CENTRAL BANK & THE SUPPLY OFCENTRAL 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 toThe required reserve ratio: If the CB wants to increase the MS, it creates more reserves, therebyincrease the MS, it creates more reserves, thereby freeing banks to create additional deposits byfreeing 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 CBThe 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 ofThe 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.
  26. 26. CB & MSCB & MS • In practice, discount rate are not often used byIn practice, discount rate are not often used by CB to control the MS with great precision, bcosCB to control the MS with great precision, bcos its effects on banks’ demand for reserves areits effects on banks’ demand for reserves are uncertain.uncertain. • Moral suasion: This is the pressure exerted byMoral suasion: This is the pressure exerted by the CB on member banks to discourage themthe CB on member banks to discourage them from borrowing heavily from the CB.from 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 openor sale of govt. securities by the CB in the open market in order to (expand) or contract themarket in order to (expand) or contract the amount of reserves in the system and thus, theamount of reserves in the system and thus, the MS.MS.
  27. 27. CB & MSCB & MS • An open market purchase of securities by the CBAn open market purchase of securities by the CB results in an increase in reserves and an increaseresults in an increase in reserves and an increase in the supply of money by an amount equal to thein the supply of money by an amount equal to the money multiplier times the change in reserves.money multiplier times the change in reserves. • An open market sale of securities by the FedAn open market sale of securities by the Fed results in a decrease in reserves and a decreaseresults in a decrease in reserves and a decrease in the supply of money by an amount equal to thein the supply of money by an amount equal to the money multiplier times the change in reserves.money multiplier times the change in reserves. • OMOs are the CB’s preferred means of controllingOMOs are the CB’s preferred means of controlling MS bcos they can be used with some precision,MS bcos they can be used with some precision, are extremely flexible, and are fairly predictable.are extremely flexible, and are fairly predictable.
  28. 28. MONEY DEMANDMONEY DEMAND • Keynesian Theory: According to Keynes, thereKeynesian Theory: According to Keynes, there three motives for holding money. These arethree motives for holding money. These are • Transaction MotivesTransaction 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:
  29. 29. MONEY DEMANDMONEY 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 interestbond at mkt price (PB) of RM1,000, at interest rate (r) of 5% and entitlement or coupon paymentrate (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 nopast). 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.ePB now at CP of RM50 gives RM500 [ i.e (50x100)/10]. Thus, capital loss of RM500.(50x100)/10]. Thus, capital loss of RM500.
  30. 30. MONEY DEMANDMONEY DEMAND -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.ePB 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 subjectbcos 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 anyon bond equals int. return plus or minus any expected gain or loss.expected gain or loss.
  31. 31. MONEY DEMANDMONEY DEMAND -Therefore, If investor expects int. rate to fall,-Therefore, If investor expects int. rate to fall, bonds have higher expected return and yield abonds 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 bondspossible that the expected capital loss on bonds will outweigh the interest earnings. The expectedwill outweigh the interest earnings. The expected return on bonds would be negative and thereturn 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, thenexpected to fall & capital loss expected, then money is demand for as an asset now.money is demand for as an asset now.
  32. 32. MONEY DEMANDMONEY DEMAND -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 tonormal rate, investors expect the int. rate to fall. Conversely, when the int. rate is below thefall. 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.
  33. 33. MONEY DEMANDMONEY DEMAND Fig.1: Individual speculative demand for moneyFig.1: Individual speculative demand for money Int. rate. rInt. rate. r nrnr crcr MM2i2i (Whi-M(Whi-M1i1i)) Speculative demand for moneySpeculative demand for money
  34. 34. MONEY DEMANDMONEY DEMAND Fig 2: Agg. speculative demand for MoneyFig 2: Agg. speculative demand for Money Int. rate. rInt. rate. r MM22 Speculative demand for moneySpeculative demand for money
  35. 35. MONEY DEMANDMONEY DEMAND • MM1i1i + M+ M2i2i ≡ M≡ Mii wherewhere MM2i2i is the speculative dd for money, andis the speculative dd for money, and MM1i1i is the transactions dd for money by individual.is the transactions dd for money by individual. • MMii + B+ Bii ≡ Wh≡ Whii where Mwhere Mi ,i , BBii ,Wh,Whii are individual’s total moneyare 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, criticalare interest rate, normal interest rate, critical interest rate, and bond holding respectively.interest rate, and bond holding respectively.
  36. 36. MONEY DEMANDMONEY DEMAND • Fig 1 shows the individual’s speculative dd forFig 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 thethe 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 moneyFig 2 shows the agg. speculative dd for money schedule. As the interest rate becomes lower, itschedule. As the interest rate becomes lower, it fall below the critical rate for more individualsfall 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 speculativeThis situation at a very low r where speculative dd for money schedule becomes nearlydd for money schedule becomes nearly horizontal is known as the liquidity Trap.horizontal is known as the liquidity Trap.
  37. 37. EQUILIBRIUM INTEREST RATESEQUILIBRIUM INTEREST RATES int. rate r Equilibrium in the moneyint. rate r Equilibrium in the money MsMs00 marketmarket r*r* MdMd00 M* MM* M FIG. 1 Quantity of moneyFIG. 1 Quantity of money
  38. 38. EQUILIBRIUM INTEREST RATESEQUILIBRIUM INTEREST RATES Int. rate r Effects of a shift in MoneyInt. rate r Effects of a shift in Money MsMs00 MsMs11 DemandDemand r1r1 r*r* r2 Mdr2 Md22 Md* MdMd* Md11 FIG.2 Qty of money M* MFIG.2 Qty of money M* M11 MM
  39. 39. EQUILIBRIUM INTEREST RATESEQUILIBRIUM INTEREST RATES • Fig.1 shows the intersection of money demandFig.1 shows the intersection of money demand and supply schedules (Md & Ms) to determine theand supply schedules (Md & Ms) to determine the equilibrium interest rate r*.equilibrium interest rate r*. • Ms is assumed to be exogenous and the MsMs is assumed to be exogenous and the Ms target M* is achieved by Central Bank usingtarget M* is achieved by Central Bank using monetary base to control it.monetary base to control it. • Also, equilibrium interest rate r* is considered theAlso, equilibrium interest rate r* is considered the desired level by the Central Bank.desired level by the Central Bank.
  40. 40. EQUILIBRIUM INTEREST RATESEQUILIBRIUM INTEREST RATES • Consider the effects of shifts in Money demandConsider the effects of shifts in Money demand schedule in Fig 2schedule 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 functionOr due to the effects of actual shifts in Md function i.e changes in the amount of money demandedi.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 Md22 (a decline in(a decline in money demand).money demand).
  41. 41. EQUILIBRIUM INTEREST RATESEQUILIBRIUM INTEREST RATES • What will the Central Bank (CB) do in response toWhat will the Central Bank (CB) do in response to the shifts?the shifts? • If CB maintains the Ms at M* which is CB MsIf CB maintains the Ms at M* which is CB Ms target, the desired level of CB’s int. rate, r* will nottarget, the desired level of CB’s int. rate, r* will not be achieved as it will move away from the positionbe 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 declineleads 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 Md11 leads to anleads to an undesirable rise in the r from r* to rundesirable rise in the r from r* to r1.1.
  42. 42. EQUILIBRIUM INTEREST RATESEQUILIBRIUM INTEREST RATES • The CB can prevent or mitigate theseThe CB can prevent or mitigate these movements in the r only by changing themovements in the r only by changing the monetary base & hence the money supply.monetary base & hence the money supply. • In the case of an increase in Md, CB could moveIn the case of an increase in Md, CB could move the money supply to the level Msthe money supply to the level Ms11 schedule soschedule so as to have equilb. in money market at the desiredas 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 targetBy so doing, CB would not achieve the Ms target as the money supply would be Mas the money supply would be M11 above M*. Inabove M*. In this case, the increase in demand for money bythis case, the increase in demand for money by public is accommodated by the CB.public is accommodated by the CB.
  43. 43. EQUILIBRIUM INTEREST RATESEQUILIBRIUM INTEREST RATES • In this scenario, the monetary base and moneyIn this scenario, the monetary base and money supply are not determined exogenously butsupply 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 atIn an extreme case where int. rate is pegged at a fixed level for a long time by the CB, thea fixed level for a long time by the CB, the monetary authority have no choice in the moneymonetary authority have no choice in the money supply process than to supply the requiredsupply process than to supply the required amount of money to maintain the desiredamount of money to maintain the desired interest rate.interest rate.

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