2Chapter`s Outlines Definition of money Supply Supply of Money and Market interestThe Demand for Money, & Three motives for demand for moneyEquilibrium in Money MarketChanges in EquilibriumMoney Supply and LiquidityFriedman’s Challenge to Liquidity PreferenceTools of Monetary policy.
3Meaning of 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 countryThis is called M1 definition of supply of money and M1=Cc+ DDit means that supply of money is total quantity of money circulated in a country
4Supply of Money…..According to Keynes Ms is fixed in short run and is independent of rate of interestMs is a control variable as it is determined by central monetary authorities of a countryMs is a vertical line as Ms is independent of rate of interestIf Ms increase in a country, than Ms curve shift to the right and if Ms decrease in a country than Ms shift to the left
5Money Supply LineThe quantity of money in circulation is controlled by the central bankInterest Rate (%)Ms10580Quantity of Money
6The Supply of Money and Interest Rates….. Because the supply of money is controlled by the central bank and no one else, we assume that the money supply is invariant to the interest rate.In other words, the supply of money will stay the same regardless of whether the interest rate is 1%, 5% or even moreThus the money supply curve is a vertical line at the current money supply.
7The Market Interest Rate What determines the equilibrium interest rate in financial markets?A financial market is any market in which borrowers and lenders interactThe supply of funds being forwarded by lenders and the demand for funds by borrowers determines both the quantity of lending/borrowing and the interest rate at which these loans are made.
8The Market Interest Rate One way to analyze this market would be to directly examine the supply and demand for bonds (loans).An alternative method would be to examine the supply and demand for money
9Demand for MoneyDemand for money we mean why people keep money in their pocket or in housesWhat are the motives behind holding the moneyThree main motives of keeping moneyTransaction demand for moneyPrecautionary demand for moneySpeculative demand for money
101 Transaction demand for money Money is used as a medium of exchangePeople keep money for purpose of making daily transaction i.e. to purchase different goods and services dailyMtd depends on time intervals when a person gets income and when a person spends itThose countries where credit facilities are common, transaction demand for money is lower as compared to those countries where credit facilities are not available
11Transaction demand for money….. According to Keynes demand for money for transactary motives depends on income, it means that Mtd=f (Y)There exist a positive relationship between Mtd and income of consumerSo Mtd=kYWhere k is the proportion or percentage of income people held for transaction purpose
12Transaction demand for money…. MtdyMtdky5%1005200103001540020500252520ky15105y
132 Precautionary demand for money Both individuals and businessmen keep cash in reserve in order to meet unexpected needsIndividuals hold some cash to provide for illness, accidents, unemployment and other unforeseen contingencies while businessmen keep cash in reserve to tide over unfavorable conditionsPrecautionary demand for money depends on income level, business activity and so on
143 Speculative Demand for Money Individuals hold Money for investment in the financial marketNear money consists of non-monetary, interest-bearing assets such as stocks and bonds
15Speculative demand for money According to Keynes, individual could hold wealth in two ways i.e. in form of cash and in form of bondsPeople purchase bonds and securities for earning profit as people purchase bond at low price and sell at high priceWhenever a person keep money for purpose of purchasing bonds is known as speculative demand for money
16Speculative demand for money….. Price of bonds are linked with rate of interest and is negative related with one anotherThe formula used for finding price of bonds is PV=R/ rWhere R=return from bond, r =Market rate of interest and PV is present value of bond or price of bond
17Now if R=10 Af and r=5% then PV is 10/0.05 =200 Similarly if R=10 Af and r=10% then PV is 10/0.10 =100So it is expectation about market rate of interest which determine speculative demand for money
18Speculative demand for money…. If market rate of interest is low, bond price in market is high and at high bond price people will not purchase bond, and people will keep more money in their pocket for purpose of speculation and vice versar2r1Msd =f(r)Msd1 Msd2
19Total demand for moneyTotal demand for money is the summation of transaction demand for money, Precautionary demand for money and Speculative demand for moneyMathematically it can be shown asLT =Mtd +Msd +Mpd
20The Demand for Money and Interest Rates We assume that if you hold your wealth as money, you earn no interest, while you do earn interest if you hold your wealth as bonds.How does your demand for money change when the interest rate rises?
21The Demand for Money and Interest Rates….. The opportunity cost of each dollar held as money is the foregone interest that could have been earned, if you had held that dollar in bonds.As the interest rate rises, so does the opportunity cost of moneyThe quantity of money demanded is inversely related to the interest rate on bonds.
22Equilibrium in Money Market Through money supply and money demand we can determine equilibrium in money marketIn money market, equilibrium point is that point where demand for money is equal to supply of money
24Changes in Equilibrium Interest Rates One of the most useful features of the liquidity preference framework is that it allows us to see how changes in the demand and supply of money affect interest rates.
25Changes in Equilibrium Interest Rates….. Equilibrium interest rates will increase if there is a…Increase in money demand (+)Decrease in money supply (+)Equilibrium interest rates will decrease if there is a…Decrease in money demand (-)Increase in money supply (-)
26Shifts in Money DemandIn Keynes original analysis, two things would cause the demand for money to change:1 An Increase in Income/WealthWith more income, people would like to consume more. To increase consumption, you need more money.Money demand shifts right, causing interest rates to rise
27Interest Rates Rise when Income Rises Nominal Interest Rate (i)MS7%5%MD2MD1700900Quantity of Money ($ billions)
28Interest Rates Fall when Bonds become less Risky Nominal Interest Rate (i)MS5%3%MD1MD2400700Quantity of Money ($ billions)
292 An Increase in PricesWith higher prices, the same quantity of money held buys fewer goods and services. To maintain consumption, people need to hold more money.Several other reasons can also cause the demand curve to shifts like increase in the risk of non-monetary assets like bonds, etc
30Shifts in Money SupplySince the central bank is the sole issuer of money, any changes in the money supply must come directly from central bank policyAt its most basic level, an increase in the money supply is just the central bank printing up more money, but operationally there are various other ways to increase and decrease money supply.
31These are known as tools of Monetary policy… Operationally, the central bank changes the money supply through three channelsChanging banks reserve requirementChanging the discount rate at which banks borrow from the central bank at.Buying and selling bonds from the public in exchange for moneyThese are known as tools of Monetary policy…
32Tools of Monetary Policy 1 Reserve-deposit ratio:Ratio of cash reserves to deposits that banks are required to maintainBy lowering the ratio, banks will have more reserves to lend and invest, increasing the money supply
33Tools of Monetary Policy 2 Discount rate:rate of interest the DAB charges on loans to banksBy lowering the rate, banks encourage borrowing from the DAB and lending to the public, increasing the money supply
34Tools of Monetary Policy 3 Open Market Operations:DAB purchases and sales of government bondsBy purchasing bonds and paying the sellers, the DAB increases the money supply
35Using these tools, the central bank can lower interest rates by raising the money supply and increase rates by cutting the money supply.Note that this analysis only considers the short run and not the long term consequences of changes to the money supply.
36Friedman’s Challenge to Liquidity Preference Milton Friedman argued that while Keynes’ analysis was technically incorrect, he failed to consider the longer term effects of monetary policy.Friedman argued that increasing the money supply may actually cause interest rates to go up!An increase in the money supply will cause income to rise, spurring an increase in money demand and interest rates
37Cont`d…An increase in the money supply will stimulate spending, which will then cause prices to rise. Higher prices will increase money demand and raise interest rates.If the increase in money supply is continuous, then people will expect higher inflation. This causes the nominal interest rate to rise.
38Interest Rates and an Increase in the Money Supply Growth Rate So what happens to interest rates if the central bank increases the rate at which the money supply grows?The liquidity preference theory argues that interest rates will decrease as people will hold excess cash balancesPeople will try to convert their excess cash into bonds.Doing so will increase the number of people offering loans, which must push interest rates down.
39Cont`d….Friedman’s theory argues an increase in interest rates as the expansion in the money supply growth rate will cause income, price levels, and expected inflation all to rise.
40Expansionary Monetary Policy Increase the money supply by any one or combination of the Monetary toolsReduce the interest rate to encourage investmentIncrease employment & income
41Expansionary Monetary Policy Interest Rate (%)(M1/P)s(M2/P)s54(M/P)d8085Quantity of Money