Demand and Supply of Money Week 6 Demand and Supply of Money

Outline 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

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

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

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

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

Demand for Money 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

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%

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

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.

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.

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

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

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.

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

1 Transaction demand for money What is this?

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?

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

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?

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…

2 Precautionary demand for money What is this?

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

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

3 Speculative demand for money What is this?

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

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

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

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

The Money Demand Function    

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

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

Announcements Reminder Next lectures by Dr. Priscilla Twumasi Baffour IA will be on the **** 30% of final grade Venue- **** Time- **** Format- Multiple choice questions Scope- Lectures from Weeks 1-6 Next lectures by Dr. Priscilla Twumasi Baffour Continuation of the demand for money and equilibrium in the money market