1. Demand for Money (MKM 378-79:
i -Types of Demand
There are three demands for money. First, there is a
transactional demand for example at the end of the month to pay the bills.
Between payment periods there is no transactional demand. Again, this time lag
allows banks to loan out deposits and thereby create new money. Second,
there is a precautionary demand for money. What if the banks closed and the ATM
is down? I need cash for the grocery store! For purposes of the simplified
model, however, precautionary is consider a form of transactional demand,
i.e., demand for money to meet unanticipated transactions. Third,
there is speculative demand for money.
Speculative demand for money (sometimes called asset
demand) is an original contribution of Keynes. His so-called Classical
predecessors recognized only transactional demand. They believed no
rational person would simply hold cash. Rather it would be used to buy
goods & services or invested/saved to yield income as interest. Stuffed
in a mattress it does neither. Monetarists similarly believe there
can be no hoarding of cash. In their case it is argued that if
bonds are not appealing then real estate will be and if not then artwork
or some other form of income earning asset, i.e., there will be
Keynes, on the other hand, argued that given
uncertainties about future interest rates there would be times when
individuals would hold on to cash. If you buy a bond today you are
committing part of your income to something that will pay a given rate
of interest. The price of the bond is called its yield measured by its
purchase price and its interest rate say 5%. If tomorrow the interest
rate increases to 10% to sell your bond it must yield an effective rate
of 10%. The difference between what you paid for the bond and the price
at which you must sell it to generate the 10% yield is called a capital
loss. For example, while the old bond cost you $1,000 and generates a
5% return, it must be sold tomorrow for only $500 to yield 10%.
At very lower rates speculative demand will be very high
in anticipation that interest rates must rise tomorrow. If enough
individuals and institutions hold cash rather than lend or invest it
then a liquidity trap may be created. This is the point at which the
demand for money is perfectly elastic with respect to the interest
rate. Banks, for example, will not lend because they believe interest
rates are so low that they must rise. Accordingly they will not lend to
firms for investment purposes or to consumers fearing capital loss.
ii - Factors
Four factors affect demand for money. The first
is the price level. The quantity of money measured in current dollars is
called the nominal money supply. The quantity of nominal dollars
demanded is proportional to the price level. If prices go up, the
demand for nominal money goes up. What in the end matters, however, is
not nominal but real money demanded, that is, its purchasing
power. Thus if prices go up 10% and income goes up 10%, nominal money
has increased but real money stays the same. Thus inflation tends to
lower the value of money over time. The higher the rate of inflation,
the greater will be the demand for nominal money today.
The second is interest rates. Like all
commodities, the price of money is an opportunity cost. If its price
goes up, consumers and producers will tend to substitute less expensive
alternatives. The price of money is the interest rate. The higher the
interest rate the more expensive is money and the less will be demanded.
Thus an alternative to holding money (the opportunity foregone) is to
purchase an interest-earning asset.
The third force affecting demand for money is real
GDP. In short, the higher is the level of income the greater is the
transactional demand for money, i.e., the larger the economy the
greater the number of transactions and therefore the greater the
transactional demand for money.
Fourth is financial innovation and payment
habits. Innovations like interest-earning chequing accounts, ATMs,
debit and credit cards all reduce the demand for money. Similarly if
you are paid once a year you will hang on to money increasing demand
while if you are paid weekly you know there is more coming quickly and
you spend or invest.
iii - The
Money Demand Curve (MKM C15/378-83: 354-59;
demand curve for money (R&L 13
Fig. 28-1) relates
the quantity of money demanded (transactional plus speculative or asset
demand) and its price - the interest rate. While transactional demand
is relatively inelastic with respect to the interest rate at a given
price level and GDP, speculative demand is downward sloping with respect
to interest rate, a.k.a., the price of money. The total demand
curve is therefore negatively or downward sloping from the left with
respect to the interest rate. A shift in the demand curve for money can
occur, for example, if real GDP changes, if the aggregate price level
rises, if financial innovation takes place or if payment habits change.
Supply of Money
i - Source
It is assumed for purposes of the simplified model that
the supply of money is determined by the central bank. Even super money
cannot escape the control of the central bank. If the wealth effects of
a stock market boom are big enough and money is in effect being created,
the central bank can raise interest rates and choke off the boom.
Similarly during a slump the central bank can lower interest rates and
assist recovery. The objectives and tools of the central bank will be
ii - Supply Curve
(MKM C15/377-8: 353-54;
Accordingly the supply curve (R&L 13th Ed
Fig. 28-5; MKM Fig. 15.1) for money is
vertical and perfectly inelastic. The curve will shift only on the
decision of the central bank.
4.2.3 Market Equilibrium (MKM C 15/379-383:
Money market equilibrium will occur where the vertical
supply curve intersects the downward sloping demand curve.
‘X’ marks the spot yet again
(R&L 13 Ed
Fig. 28-2; MKM Figs 11.1 & 15.4).
The connection between monetary policy and the real economy is
the interest rate. As the
interest rate goes up investment goes down shifting the aggregate demand
downward to the left.
If the interest rate goes down then investment goes up and the aggregate
demand curve shifts up to the right (R&L 13 Ed
By controlling the money supply
the central bank can thus increase or decrease the interest rate and
thereby affect investment and the real economy (R&L 13 Ed.