BOX 18.5 CALCULATING THE MONEY MULTIPLIER ECONOMICS EXPLORING
18.4 THE DEMAND FOR MONEY
• Increases in money supply may occur as a result of banks expanding credit in response to the demand for credit. This assumes that banks have surplus liquidity in the first place, or are happy to operate with lower liquid- ity, or can increase liquidity through secondary market- ing of otherwise illiquid assets, or can obtain liquidity from the central bank through repos. Higher demand for credit will drive up interest rates, making it more profitable for banks to supply more credit.
• Higher interest rates may encourage depositors to switch their deposits from sight accounts (earning little or no interest) to time accounts. Since money is less likely to be withdrawn quickly from time accounts, banks may feel the need to hold less liquidity, and therefore may
decide to increase credit, thus expanding the money supply.
• Higher interest rates attract deposits from overseas. This increases the money supply to the extent that the Bank of England does not allow the exchange rate to appreci- ate in response.
To summarise: an increase in demand for money raises interest rates, which in turn increases the quantity of money supplied (see sections 18.4 and 18.5): a movement along an upward-sloping money supply curve.
Some economists go further still. They argue that not only is money supply endogenous, but the ‘curve’ is effectively horizontal; money supply expands passively to match the demand for money.
The speculative or assets motive
Certain firms and individuals who wish to purchase finan- cial assets, such as bonds, shares or other securities, may prefer to wait if they feel that their price is likely to fall.
In the meantime, they will hold money balances instead.
This speculative demand can be quite high when the price of securities is considered certain to fall. Money when used for this purpose is a means of temporarily storing wealth.
Similarly, people who will require foreign currency at some time in the future (people such as importers, holiday- makers, or those thinking of investing abroad or in foreign securities) may prefer to wait before exchanging pounds into the relevant foreign currencies if they believe that the sterling price of these currencies is likely to fall (the pound is likely to appreciate).
The transactions plus precautionary demand for money: L1
The transactions plus precautionary demand for money is termed L1. ‘L’ stands for liquidity preference: that is, the desire to hold assets in liquid form. Money balances held for these two purposes are called active balances: money to be used as a medium of exchange. What determines the size of L1?
The major determinant of L1is nominal national income (i.e. national income at current prices). The bigger people’s
money income, the greater their expenditure and the big- ger their demand for active balances. The frequency with which people are paidalso affects L1. The less frequently they are paid, the greater the level of money balances they will require to tide them over until the next payment.
Will students in receipt of a grant or an allowance who are paid once per term have a high or a low transactions demand for money relative to their income?
The rate of interest has some effect on L1, albeit rather small (see Figure 18.5). At high rates of interest, people may choose to spend less and save more of their income, e.g. by buying shares. The effect is likely to be bigger on the pre- cautionary demand: a higher interest rate may encourage people to risk tying up their money. Firms’ active balances are more likely to be sensitive to changes in rthan those of individuals.
Other determinants of L1 include the season of the year: people require more money balances at Christmas, for
?
BOX 18.6 ARE THE DAYS OF CASH NUMBERED?
EFTPOS versus ATMs
CASE STUDIES AND APPLICATIONS
technical innovation is moving us in the direction of using morecash, not less! This is the cash machine – or ATM (automated teller machine), to give it its official title.
The spread of cash machines to virtually every bank and building society branch and to many larger stores and supermarkets has been rapid in recent years. The sheer simplicity of obtaining cash at all hours from these machines, not only from current accounts but also on credit cards, is obviously a huge encouragement to the use of cash.
So are we using more cash or less cash? The evidence suggests that, until recent years, there was a gradual decline in cash in circulation as a proportion of GDP. It fell from just over 5 per cent of GDP in 1980 to just over 3 per cent in the mid 1990s. Since then it has risen slightly.
Between 2000 and 2008 it varied between 3.3 and 3.5 per cent.
But although the effects of EFTPOS and ATMs may be quite different in terms of the use of cash, they both have the same advantage to banks: they reduce the need for bank staff and thereby reduce costs.
Under what circumstances are cheques more efficient than cash and vice versa? Would you get the same answer from everyone involved in transactions: individuals, firms and banks?
?
Banking is becoming increasingly automated, with computer debiting and crediting of accounts replacing the moving around of pieces of paper. What was once done by a bank clerk is often now done by computer.
One possible outcome of this replacement of labour by computers is the gradual elimination of cash from the economy – or so some commentators have claimed.
The most dramatic example of computerisation in recent years has been EFTPOS (electronic funds transfer at the point of sale). This is where you pay for goods in the shops by means of a credit or debit card. When the card is swiped across the machine and the amount entered, your card is then automatically debited and the shop’s account credited.
The advantage of this system is that it does away with the processing by hand of pieces of paper. In particular, it does away with the need for (a) credit-card slips when used in conjunction with credit cards and (b) cheques.
Both cheques and credit-card slips have to be physically moved around and then read and processed by people.
If cards were to become more extensively used for small transactions, they could well reduce the need for cash.
So are we moving towards a cashless society?
Probably not. Cash is still the simplest and most efficient way of paying for a host of items, from a bus ticket to a newspaper to a packet of mints. What is more, another
Liquidity preferenceThe demand for holding assets in the form of money.
Active balancesMoney held for transactions and precautionary purposes.
Definitions
TC 9 p105
KI 11 p75
KI 10 p71
TC 1 p8
example. Also, any other factors that affect consumption will affect L1.
The increased use of credit cards in recent years has reduced both the transactions and precautionary demands.
Paying once a month for goods requires less money on average than paying separately for each item purchased.
Moreover, the possession of a credit card reduces or even eliminates the need to hold precautionary balances for many people. On the other hand, the increased availability of cash machines, the convenience of debit cards and the ability to earn interest on current accounts have all encour- aged people to hold more money in bank accounts. The net effect has been an increase in the demand for (broad) money.
The speculative (or assets) demand for money: L2
The speculative demand for money balances is termed L2. Money balances held for this purpose are called idle balances.
People who possess wealth, whether they are wealthy or simply small savers, have to decide the best form in which to hold that wealth. Do they keep it in cash in a piggy bank, or in a current account in a real bank; or do they put it in some interest-bearing time account; or do they buy stocks and shares or government bonds; or do they buy some physical asset such as a car or property?
In making these decisions, people will have to weigh up the relative advantages and disadvantages of the various alternative assets. Assets can be compared according to two criteria: liquidityand the possibility of earning income. Just as
we saw in the case of a bank’s assets, these two criteria tend to conflict. The more liquid an asset is, the lower is likely to be the income earned from holding it. Thus cash is totally liquid to the holder: it can be used to buy other assets (or spent on goods) instantly, but it earns no interest. Stocks and shares, on the other hand, are not very liquid since they cannot be sold instantly at a guaranteed price. (They can be sold pretty well instantly, but if share prices are depressed, a considerable loss may be incurred in so doing.
In other words, they are a riskymeans of holding wealth.) But stocks and shares have the potentialof earning quite a high income for the holder, not only in terms of the divi- dends paid out of the firms’ profits, but also in terms of the capital gain from any increase in the shares’ prices.
Buying something like a car is at the other end of the spectrum from holding cash. A car is highly illiquid, but yields a high return to the owner. In what form is this ‘return’?
There are three major determinants of the speculative demand for money. Let us examine each in turn.
The rate of interest (or rate of return) on assets
The higher the rate of return on assets, such as shares and bonds, the greater the opportunity cost of holding money and therefore the lower the speculative demand for money.
The rate of return on assets varies inversely with their price. Take the case of a government bond (which pays a fixed sum of money throughout its life). Assume that the government issued a £100 bond at a time when interest rates were 10 per cent. Thus the bond must pay £10 per year. Although the government will not redeem bonds until their maturity date, which could well be 20 years from when they were issued, holders can sell bonds at any time on the stock market. Their market price will reflect market rates of interest. Assume, for example, that interest rates fall to 5 per cent. What will happen to the market price of the bond paying £10 per year? It will be driven up to £200.
At that price, the £10 per year is worth the current market rate of 5 per cent. Thus the market price of bonds varies inversely with the rate of interest.
Expectations of changes in the prices of securities and other assets
If people believe that share prices are about to rise rapidly on the stock market, they will buy shares and hold smaller speculative balances of money. If they think that share prices will fall, they will sell them and hold money instead.
Some clever (or lucky) individuals anticipated the 2000–3 stock market decline. They sold shares and ‘went liquid’.
Some people made a similar move in the stock market decline of 2007– 8.
As we have just seen, if the market price of securities is high, the rate of interest (i.e. the rate of return) on these securities will be low. Potential purchasers of these secur- ities will probably wait until their prices fall and the rate of interest rises. Similarly, existing holders of securities will
?
Figure 18.5 The demand for money
Idle balancesMoney held for speculative purposes:
money held in anticipation of a fall in asset prices.
Definition
probably sell them while the price is high, hoping to buy them back again when the price falls, thus making a capital gain. In the meantime, therefore, large speculative balances of money will be held. L2is high.
If, on the other hand, the rate of interest is high, then L2is likely to be low. To take advantage of the high rate of return on securities, people buy them now instead of hold- ing on to their money.
Would the demand for securities be low if their price was high, but was expected to go on rising?
The relationship between L2and the rate of interest (r) is again shown in Figure 18.4. The inverse relationship between rand L2gives a downward-sloping curve.
Speculative demand and the exchange rate
In an open economy like the UK where large-scale move- ments of currencies across the foreign exchanges take place, expectations about changes in the exchange rate are a major determinant of the speculative demand for money.
If people believe that the pound is likely to appreciate, they will want to hold sterling until it does appreciate. For example, if the current exchange rate is £1 =$1.50 and speculators believe that it will shortly rise to £1 =$1.75, then if they are correct they will make a 25c per £1 profit by holding sterling. The more quickly is the exchange rate expected to rise, the more will people want to hold sterling (as money). If, however, people believe that it will be a slow rise over time, they will want to buy sterling assets (such as UK government bonds) rather than money, since such assets will also earn the holder a rate of interest.
Conversely, if people believe that the exchange rate is likely to fall in the near future, they will economise on their holdings of sterling, preferring to hold their liquid assets in some other currency – the one most likely to appreciate against other currencies.
Graphically, changes in expectations about the ex- change rate will have the effect of shifting the L2curve in Figure 18.5.
There is a further complication here. Expectations about changes in the exchange rate will themselves be influenced by the interest rate (relative to overseas interest rates). If the UK rate of interest goes up, people will want to deposit their money in the UK. This will increase the demand for sterling on the foreign exchange market: there will be a short-term financial inflow into the UK (the financial account of the balance of payments will go into surplus). The effect will be to drive up the exchange rate. Thus if people believe that the UK rate of interest will rise, they will alsobelieve that the rate of exchange will appreciate, and they will want to hold larger speculative balances of sterling.
The introduction of the ‘foreign exchange dimension’
into our analysis will have two effects on the L2curve. First, the curve will become more elastic. If the rate of interest is
?
low and is thought likely to rise, the speculative demand is likely to be veryhigh. Not only will people hold money in anticipation of a fall in security prices, but they will also hold money (sterling) in anticipation of an appreciation of the exchange rate.
Second, the curve will become more unstable. Expecta- tions of changes in the exchange rate do not just depend on current domestic interest rates. They depend on the cur- rent and anticipated future state of the balance of trade, the rate of inflation, the current and anticipated levels of inter- est rates in other major trading countries, the price of oil, and so on. If any of these cause people to expect a lower exchange rate, the speculative demand for money will fall:
L2will shift to the left.
Which way is the L2curve likely to shift in the following cases?
(a) The balance of trade moves into deficit.
(b) People anticipate that foreign interest rates are likely to rise substantially relative to domestic ones.
(c) The domestic rate of inflation falls below that of other major trading countries.
(d) People believe that the pound is about to depreciate.
The total demand for money: L1++ L2
Figure 18.5 also shows the total demand for money bal- ances (L). This is found by the horizontal addition of curves L1and L2. This curve is known as the ‘liquidity preference curve’ or simply the demand for money curve.
Any factor, other than a change in interest rates, that causes the demand for money to rise will shift the Lcurve to the right. For example, a rise in national income will cause L1to increase, and thus Lwill shift to the right.
Additional effects of expectations
We have talked about expectations and their importance in determining the speculative demand for money. In particular, we have looked at (a) the effect of interest rates on people’s anticipations of future security prices and (b) the effect of expectations about exchange rate move- ments. There are two other ways in which expectations can influence the demand for money, and make it more unstable.
Expectations about prices. If people expect prices to rise, they may reduce their money balances and purchase goods and assets now, before prices do rise. This will tend to shift Lto the left. (Note, though, that once prices haverisen, people will need more money to conduct the same amount of transactions.)
Expectations of interest rate levels over the longer term. If people come to expect that interest rates will normally be higher than they used to be, then any given interest rate will seem lower relative to the ‘normal’ rate than it used to be. People will be more inclined to hold speculative bal- ances of money in anticipation of a rise in interest rates.
This will tend to shift Lupwards.
?
KI 10 p71
itself will be hard to predict and will be subject to consider- able shifts. Generally, it is likely that the greater the uncer- tainty, the greater will be the preference for liquidity, and the greater the risk of tying wealth up in illiquid assets.
In an era of uncertainty about inflation, interest rates and exchange rates, people’s expectations will be hard to predict. They will be volatile and susceptible to rumours and political events. In such circumstances, the L curve
Section summary
1. The three motives for holding money are the transactions, precautionary and speculative (or assets) motives.
2. The transactions-plus-precautionary demand for money (L1) depends primarily on the level of nominal national income, the frequency with which people are paid and institutional arrangements (such as the use of credit or debit cards). It also depends to some degree on the rate of interest.
3. The speculative demand for money (L2) depends on the rate of return on assets and on anticipations about future movements in security prices (and hence their rate of return) and future movements in exchange rates. If security prices are anticipated to fall or the exchange rate to rise, people will hold more money balances.
4. The demand for money is also influenced by expectations of price changes and the levels of interest rates over the longer term.
TC 4 p44
Equilibrium in the money market
Equilibrium in the money market is where the demand for money (L) is equal to the supply of money (Ms). This equi- librium is achieved through changes in the rate of interest.
In Figure 18.6, equilibrium is achieved with a rate of interest reand a quantity of money Me. If the rate of interest were above re, people would have money balances surplus to their needs. They would use these to buy shares, bonds and other assets. This would drive up the price of these assets and drive down the rate of interest.
As the rate of interest fell, so there would be a contrac- tion of the money supply (a movement down along the Ms
curve) and an increase in the demand for money balances, especially speculative balances (a movement down along the liquidity preference curve). The interest rate would go on falling until it reached re. Equilibrium would then be achieved.
Similarly, if the rate of interest were below re, people would have insufficient money balances. They would sell securities, thus lowering their prices and raising the rate of interest until it reached re.
A shift in either the Msor the Lcurve will lead to a new equilibrium quantity of money and rate of interest at the new intersection of the curves. For example, a rise in the supply of money will cause the rate of interest to fall.