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Money Demand and Money Supply

2) Precautionary Demand for Money / Precautionary Motive


(I) Money Demand (Mp)
A. Keynes Approach to the Demand for Money This is the demand for money to protect against
1) Transactions Demand for Money / Transaction Motive (Mt) unforeseen fluctuations in expenditures and receipts.
This is the demand for money to finance day-to-day
Precautionary demand for money depends on:
transactions. When people do not receive money at precisely the a. The level of income: the higher the level of income, the larger
time when they want to spend, they must hold transaction
the amount of money is needed for precautionary motives.
balances to bridge the gap. b. Interest rate: the lower the market interest rate, the lower the
Transaction demand for money depends on: cost of holding money and people will hold more precautionary
a. The level of income: the higher the level of income, more balances.
money is needed for transactions: Mt = f (Y).
To conclude, precautionary demand for money is
b. Other factors: positively related to income and negatively related with
i. Pay period: The transaction demand for money increases interest rate: Mp = f (Y,r)
as the pay period become longer, and vice versa, holding
income constant.
Points to be Noted:
ii. The use of credit cards: If more people use credit cards, 1. Cost of holding money is the nominal interest rate.
the transaction demand for money will increase, and vice 2. Real cost of holding money is the real interest rate.
versa, holding income constant. 3. Nominal return of holding money is zero.
iii. Liquidity preference: If people have stronger preference 4. Real return of holding money is negative inflation rate.
towards liquidity, the transaction demand for money
increases, holding income constant.
iv. Vertical integration: If firms are vertically integrated, there 3) Speculative Demand for Money / Speculative Motive (Msp)
will be more internal transactions and fewer market Speculative demand for money is d ue to speculation about
transactions. Hence, the transaction demand for money will possible changes in the bonds price. People hold their assets
decrease, holding income constant. either as money or bonds. Money is defined as any asset that
is non-interest bearing while bonds refer to all interest
bearing assets.

Notes on A-Level Macroeconomics P.1


Money Demand and Money Supply

Since bond price is the discounted present value of its 3) The demand curve for money
future interest earning. So, bond price and interest rate is The total demand for money is therefore, positively
negatively related. When current interest is relatively low, related to income and negatively related with interest rate:
people are more likely to expect the interest rate to rise and bond Md = f (Y,r)
prices to fall in the future, and people will consequently hold less It is more common to plot the demand for money against
bonds and more speculative balances. interest rate:
Thus, speculative demand for money is negatively
Interest Mt Ma Md
related with interest rate:
rate (r)
Msp = f (r).

4) The Total demand for money :


The total demand for money is the sum of the demand for
money of the three motives mentioned above. Under the
Keynesian approach of money demand, the total demand for
money is positively related with the level of income (Y) and
Ma Md
negatively related with interest rate (r): Md = f (Y,r)
Quantity of money
demanded
B. New Approach to the Demand for Money
Thus when interest rate changes, it will cause a
1) Transactions Demand for Money
movement along the same demand curve.
As discussed in the above section, transaction demand
for money is positively related with income: Mt = f (Y)
Factors other than interest rate will cause the money
demand curve to shift. Money demand curve shifts to the right as
2) Asset Demand for Money
the transaction demand for money increases, which, in turns,
Holding money as an asset provides its owner with liquidity,
depends on income, pay period, etc.
safety and reduced risk, but it involves the opportunity cost of
forgone interest income. Thus, asset demand for money is
negatively related with interest rate: Ma = f (r)

Notes on A-Level Macroeconomics P.2


Money Demand and Money Supply

4) Liquidity Trap
(II) Money Supply
According to Keynes, if the current rate of interest is very
low, people will believe that it is the minimum rate of interest, and (A) Factors affecting money supply
they would hold all their assets in money rather than bonds. In In the HKAL syllabus, money supply is assumed to be
other words, at a very low interest rate, people would expect the independent on interest rate and income.
interest rate will rise sooner or later and bond price will fall
sooner or later and nobody would buy bonds to avoid a capital Interest Ms
loss. Therefore, at a very low interest rate, the demand curve for rate (r)
money becomes perfectly elastic.
The perfectly elastic portion of the demand curve is
called the liquidity trap. It represents a situation in which an
increase in the money supply does not result in a fall in the
interest rate, but merely in an addition to speculative balances.

Quantity of money supplied


Interest
rate (r) Md
(B) How does Central Bank Control the Money Supply?
a. Monetary Policy: is the control of money supply by the
monetary authority to achieve certain economic goals, such as
GNP growth, high employment, price stability, etc.
Liquidity Trap
b. Monetary Tools:
Md 1) Varying the required cash / liquidity reserve ratio
An increase (decrease) in the reserve ratio will initiate a
Quantity of money multiple contraction (expansion) of money supply.
demanded
2) Varying the discount rate / rediscount rate
The discount rate (or the rediscount) rate is the rate of
interest which the central bank charges on its loans to the
commercial banks. This is also the rate at which bills of exchange
are discounted by a central bank.

Notes on A-Level Macroeconomics P.3


Money Demand and Money Supply

An increase (decrease) in the discount rate will make 5) Printing Money


commercial banks more (less) costly to borrow from the central The central bank may increase the money supply simply
bank and then lend it to the public, and thereby, lead to decrease by printing money. It should noted that this tool is not available in
(increase) in money supply. Hong Kong since when the three note issuing banks want to print
In Hong Kong, there is no central bank. The Hong Kong money, they must put same value of US dollars to the Exchange
interbank borrowing rate (HKIBR) acts similarly as the discount Fund.
rate. However, the government (or the HKMA) cannot adjust the
rate directly. However, the HKMA can affect the rate indirectly by (C) Effectiveness of Monetary Policy :
injecting (withdrawing) funds to (from) the banking system 1) The existence of excess reserves
The banks may change their excess reserve to rise or fall
3) Open Market Operations (OMO) the money supply, which may reinforce or counteract the central
Open market operations refer to the central bank’s buying bank or monetary authority’s monetary policy such that the
and selling of government bonds in the open market. central bank does have a full control of the money supply.
When the central bank sells bonds to the public, It is said that the central bank would have a better central
buyers will withdraw cash from banks to pay for the bonds of the money supply if the reserve ratio were 100%. It is
causing a reduction in the cash reserve of the banking system because with 100% reserve ratio, there is no room for deposit
and leads to multiple contraction of money supply. creation. Thus, banks have no tool to affect the effect of the
On the other hand, when the central bank buys bonds monetary policy. Therefore, although the central bank cannot
from the public, it will lead to an increase in the cash holdings of change the money supply through adjusting the reserve ratio
the public. They will deposit cash into the banking system and when reserve ratio were 100%, it has a better control of the
lead to an increase in the cash reserves of the banking system money supply as it can sure the direction and magnitude of
causing a multiple expansion in money supply. change in money supply when it use other monetary tools (e.g.
OMO) to affect the money supply.
4) Moral suasion
The central bank (or the monetary authority) exerts 2) The problem of liquid assets
pressure on the commercial banks by using oral and written If the monetary authority allows holding liquid assets rather
requests to expand or contract credit. than cash as their reserves, then banks may hold a large portion
of these reserves in interest earning assets (e.g. bonds). When
the government try to alter the money supply by altering the

Notes on A-Level Macroeconomics P.4


Money Demand and Money Supply

reserve ratio, banks may continue to lend out money (through ,


(III) Quantity Theory of Money
for example, acquiring more bonds). Thus, changing reserve ratio
may not have the effect as expected. a. Irving Fisher’s equation of exchange
Mv η PT , where M = money stock
3) Borrowing from other countries v = the velocity of circulation
In an international financial center, change in discount rate P = price level
T = number of transaction
may not be an effective way to alter the money supply since
banks can borrow from other countries.
b. The quantity equation of money
Mv η PQ , where M = money stock
4) Moral suasion may not be effective
v = the velocity of circulation
The primary aim of commercial banks is profit making, and P = price level
they are not required by law to follow moral suasion. They may Q = real income / real output
ignore the advice of the monetary authority.
The velocity of circulation (v) measures the speed at
5) Capital Inflows and Outflows which a given sum of money circulates in the economy. The
An inflow and outflow of foreign currency will affect the velocity of circulation is the average number of times a unit of
amount of deposits in banks. This will result in an expansion or money changes hands in one year.
contraction of the money supply, which may be in contraction to
the government's monetary policy. The quantity equation of money is an identity (N.B. It is
also called quantity identity) which is true by definition since the
6) Time lags
total amount of money spent (Mv) must always be equal to the
There needs time to recognize the need of the economy
total value of goods and services exchanged (PQ).
and decide an optimal monetary policy. This is called decision
lag.
c. The Classical / Long run quantity theory of money
There also needs time to have an actual effect after the
Assumptions:
policy is implemented. This is called execution lag.
1) v is constant as it is determined by habits, customs,
Because of the decision lag and execution lag, there
institutional and technological factors.
needs some time for monetary policy to have effect on the
2) Q is constant since to classical economists, output is always in
economy. The economic situation may have changed in that time
the full-employment level.
and the initial monetary policy may be inappropriate.

Notes on A-Level Macroeconomics P.5


Money Demand and Money Supply

With v and Q being assumed to be a constant, the quantity f. Inflation as a monetary phenomenon
identity becomes an equation: Mv = PQ, which only holds for From the quantity identity, Mv≡PQ
some values of M and P. It becomes a theory that can Taking derivative with respect to time, we have :
generate some refutable predictions. & + v& = p + q&
m
The prediction:
Any change in money stock will lead to a proportionate , where m & = rate of change of money supply
change in the price level. [i.e. < M = <P] (or the money supply growth rate)
v& = rate of change of the velocity of circulation
p = rate of change of price level (or the inflation rate)
d. Short run quantity theory of money q& =
In the short run (it is not classical), output (Q) is allowed to
change. That means only the velocity of circulation is being held In the classical model, since v and Q are assumed to be
constant. constant, v& and q& will be 0. Thus m & = p . In words, the
The prediction: money supply growth rate must equal to the rate of inflation.
Any change in money stock will lead to a proportionate That means, inflation must be sustained by money supply
change in nominal income. [i.e. < M = <(PQ)] growth. In other words, inflation cannot be sustained without a
The change in nominal income (PQ) may due to change in Price continuous increase in money. Thus inflation is therefore a
(P), change in output (Q) or a combination of both. monetary phenomenon.

e. The Cambridge k version


This version assumes that the demand for money
depends solely on the transactions motive. The demand for
money balances (Md) is assumed to be a factor (k, where 0 < k <
1) of the nominal income. [i.e. Md = kPQ], where k can be
viewed as the reciprocal of v (i.e. k = 1/v).
Assuming k and Q to be constant, the prediction is the
same as the classical version. Any change in money stock will
lead to a proportionate change in the price level.

Notes on A-Level Macroeconomics P.6