Money Supply And Demand pdf

Measuring the Supply of Money• M1: Transactions Money • M1, or transactions money Money that can be directly used for transactions.. demand deposits + traveler’s checks + other checkable

MONEY SUPPLY AND

DEMAND

MONEY SUPPLY AND

DEMAND

Measuring the Supply of Money

• M1: Transactions Money

• M1, or transactions money Money that can

be directly used for transactions.

demand deposits + traveler’s checks + other checkable deposits

• M1: Transactions Money

• M1, or transactions money Money that can

be directly used for transactions.

demand deposits + traveler’s checks + other checkable deposits

M2: Broad Money

transactions money, such as savings accounts and money market accounts.

accounts, money market accounts, and other near monies.

market accounts + Other near monies

M2: Broad Money

transactions money, such as savings accounts and money market accounts.

accounts, money market accounts, and other near monies.

market accounts + Other near monies

Money Demand

• Demand for money depends on:

– Interest rates Higher interest rates raise the opportunity cost of money, which little

demanded when interest rates are high

• Demand for money depends on:

– Interest rates Higher interest rates raise the opportunity cost of money, which little

demanded when interest rates are high

Money Demand

• Demand for money depends on:

– Income Higher incomes lead to greater spending and a greater demand for money for transactions purposes

money is needed to buy the same quantity

of goods, so demand rises

• Demand for money depends on:

– Income Higher incomes lead to greater spending and a greater demand for money for transactions purposes

money is needed to buy the same quantity

of goods, so demand rises

The demand for money

• The opportunity cost of holding money

is the interest given up by holding money rather than bonds.

• People will only hold money if there is a benefit to offset that opportunity cost.

• The opportunity cost of holding money

is the interest given up by holding money rather than bonds.

• People will only hold money if there is a benefit to offset that opportunity cost.

Motives for holding money

• Transactions

– payments and receipts are not perfectly synchronized:

• so money is held to finance known transactions

• depends upon income and payment arrangements

• Precautionary

– because of uncertainty:

• people hold money to meet unforeseen contingencies

• depends upon the (nominal) interest rate

• Transactions

– payments and receipts are not perfectly synchronized:

• so money is held to finance known transactions

• depends upon income and payment arrangements

• Precautionary

– because of uncertainty:

• people hold money to meet unforeseen contingencies

• depends upon the (nominal) interest rate

Motives for holding money (2)

• Asset

– people dislike risk

– so may hold money as a low-risk component of a mixed portfolio

• depends upon opportunity cost (the nominal interest rate)

• Speculative

– people may hold money rather than bonds

– if bond prices are expected to fall

– i.e the interest rate is expected to rise

• depends upon the rate of interest and on expectations about bond prices

• Asset

– people dislike risk

– so may hold money as a low-risk component of a mixed portfolio

• depends upon opportunity cost (the nominal interest rate)

• Speculative

– people may hold money rather than bonds

– if bond prices are expected to fall

– i.e the interest rate is expected to rise

• depends upon the rate of interest and on expectations about bond prices

The Quantity Equation

M V P T   

Consumers need money to purchase

goods and services The quantity of

money is related to the number of

pounds exchanged in transactions The

link between transactions and money is

expressed in the quantity equation.

Money•Velocity = Price•Transactions

On the right hand side, “T” is

the total number of transactions during some period of time, “P”

is the price of a typical transaction, and “P•T” is the

number of pounds exchanged in

a year

On the left hand side, “M” is the

quantity of money, “V” is the

velocity of money, and “V•M” is

essentially a measure of how the

money is used to make transactions

On the right hand side, “T” is

the total number of transactions during some period of time, “P”

is the price of a typical transaction, and “P•T” is the

number of pounds exchanged in

a year

On the left hand side, “M” is the

quantity of money, “V” is the

velocity of money, and “V•M” is

essentially a measure of how the

money is used to make transactions

/

V PT M 

Rearranging the quantity equation yields

velocity to be…

Economists usually use GDP “Y” as a

The Money Demand Function and the Quantity Equation

( / ) M P d  kY

It is often useful to express the quantity of

money in terms of the quantity of good and

services it can buy This is called the real

money balances “M/P” We can use this to

construct a money demand function

( / ) M P d  kY

“k” is a constant that tells us how

much money people want to hold for

every unit of income

This equation states that the quantity of real money balances demanded is proportional to real

income

The Money Demand Function and the Quantity Equation

( / ) M P d  kY

The money demand function offers

another way to view the quantity

equation If we set money supply equal

to money demand we get…

( / ) M P  kY

(1/ )

M k  PY

A simple rearrangement of terms

changes this equation into…

Which can be written as… MV PY 

Where V=1/k

This shows the link between money

Assuming Constant Velocity and the Quantity Theory of

Money

The quantity equation is essentially a

definition If we make the assumption

that the velocity of money is constant,

then the quantity equation becomes a

theory of the effects of money, called

the quantity theory of money.

MV PY 

Because velocity is fixed, a change in

the quantity of money (M) must cause a

proportionate change in nominal GDP

(PY) So the quantity of money

determines the money value of the

economy’s output

Money, Prices, and Inflation

The quantity theory of money allows us

to explain the overall level of prices

Y PY

The production function determines

the level of output “Y”.

MV PY 

The money supply determines the

nominal value of output, “PY”.

PY P

Y



The money supply determines the

nominal value of output, “PY”.

The price level “P” is the

ratio of the nominal value

of output “PY” to the level

of output “Y”.

So, productive capacity determines

real GDP (numerator) and the quantity of money determines nominal GDP (denominator)

So if the money supply increases, nominal GDP will

Money, Prices, and Inflation

PY P

Y



This change in prices is inflation The

inflation rate is the percent change in

price level So this theory of price level

is also a theory of inflation rate

We can write the quantity equation… MV PY 

…in percent terms:

% M + % V = % P + % Y    

…in percent terms:

“M” is controlled

by the central

bank

“%ΔV” reflects shifts in

money demand (which are assumed constant)

“%ΔP” is the

rate of inflation

“%ΔY” depends on

growth in the factors of production and on technological progress (we assume this is fixed