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Chapter 5: Money Supply & Money Demand. Chapter`s Outlines. Definition of money Supply Supply of Money and Market interest The Demand for Money, & Three motives for demand for money Equilibrium in Money Market Changes in Equilibrium Money Supply and Liquidity

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chapter s outlines
Chapter`s Outlines
  • Definition of money Supply
  • Supply of Money and Market interest
  • The Demand for Money, & Three motives for demand for money
  • Equilibrium in Money Market
  • Changes in Equilibrium
  • Money Supply and Liquidity
  • Friedman’s Challenge to Liquidity Preference
  • Tools of Monetary policy.
meaning of supply of money
Meaning 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 country
  • This is called M1 definition of supply of money and M1=Cc+ DD
  • it means that supply of money is total quantity of money circulated in a country
supply of money
Supply of Money…..
  • According to Keynes Ms is fixed in short run and is independent of rate of interest
  • Ms is a control variable as it is determined by central monetary authorities of a country
  • Ms is a vertical line as Ms is independent of rate of interest
  • If 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
money supply line
Money Supply Line
  • The quantity of money in circulation is controlled by the central bank

Interest Rate (%)

Ms

10

5

80

Quantity of Money

the supply of money and interest rates
The 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 more
  • Thus the money supply curve is a vertical line at the current money supply.
the market interest rate
The Market Interest Rate
  • What determines the equilibrium interest rate in financial markets?
  • A financial market is any market in which borrowers and lenders interact
  • The 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.
the market interest rate8
The 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
demand for money
Demand for Money
  • Demand for money we mean why people keep money in their pocket or in houses
  • What are the motives behind holding the money
  • Three main motives of keeping money
  • Transaction demand for money
  • Precautionary demand for money
  • Speculative demand for money
1 transaction demand for money
1 Transaction demand for money
  • Money is used as a medium of exchange
  • People keep money for purpose of making daily transaction i.e. to purchase different goods and services daily
  • Mtd depends on time intervals when a person gets income and when a person spends it
  • Those countries where credit facilities are common, transaction demand for money is lower as compared to those countries where credit facilities are not available
transaction demand for money
Transaction 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 consumer
  • So Mtd=kY
  • Where k is the proportion or percentage of income people held for transaction purpose
transaction demand for money12
Transaction demand for money….

Mtd

25

20

ky

15

10

5

0

100 200 300 400 500

y

2 precautionary demand for money
2 Precautionary demand for money
  • Both individuals and businessmen keep cash in reserve in order to meet unexpected needs
  • Individuals hold some cash to provide for illness, accidents, unemployment and other unforeseen contingencies while businessmen keep cash in reserve to tide over unfavorable conditions
  • Precautionary demand for money depends on income level, business activity and so on
3 speculative demand for money
3 Speculative Demand for Money
  • Individuals hold Money for investment in the financial market
  • Near money consists of non-monetary, interest-bearing assets such as stocks and bonds
speculative demand for money
Speculative demand for money
  • According to Keynes, individual could hold wealth in two ways i.e. in form of cash and in form of bonds
  • People purchase bonds and securities for earning profit as people purchase bond at low price and sell at high price
  • Whenever a person keep money for purpose of purchasing bonds is known as speculative demand for money
speculative demand for money16
Speculative demand for money…..
  • Price of bonds are linked with rate of interest and is negative related with one another
  • The formula used for finding price of bonds is PV=R/ r
  • Where R=return from bond, r =Market rate of interest and PV is present value of bond or price of bond
slide17

Now 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 =100
  • So it is expectation about market rate of interest which determine speculative demand for money
speculative demand for money18
Speculative 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 versa

r2

Msd =f(r)

r1

0

Msd1 Msd2

total demand for money
Total demand for money
  • Total demand for money is the summation of transaction demand for money, Precautionary demand for money and Speculative demand for money
  • Mathematically it can be shown as
  • LT =Mtd +Msd +Mpd
the demand for money and interest rates
The 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?
the demand for money and interest rates21
The 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 money
  • The quantity of money demanded is inversely related to the interest rate on bonds.
equilibrium in money market
Equilibrium in Money Market
  • Through money supply and money demand we can determine equilibrium in money market
  • In money market, equilibrium point is that point where demand for money is equal to supply of money
the money market
The Money Market

Nominal Interest Rate (i)

MS

7%

5%

3%

MD

400

1000

Quantity of Money ($ billions)

700

Money Shortage

Money Surplus

changes in equilibrium interest rates
Changes 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.
changes in equilibrium interest rates25
Changes 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 (-)
shifts in money demand
Shifts in Money Demand
  • In Keynes original analysis, two things would cause the demand for money to change:

1 An Increase in Income/Wealth

    • With more income, people would like to consume more. To increase consumption, you need more money.
    • Money demand shifts right, causing interest rates to rise
interest rates rise when income rises
Interest Rates Rise when Income Rises

Nominal Interest Rate (i)

MS

7%

5%

MD2

MD1

900

Quantity of Money ($ billions)

700

interest rates fall when bonds become less risky
Interest Rates Fall when Bonds become less Risky

Nominal Interest Rate (i)

MS

5%

3%

MD1

MD2

Quantity of Money ($ billions)

400

700

slide29

2 An Increase in Prices

    • With 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
shifts in money supply
Shifts in Money Supply
  • Since the central bank is the sole issuer of money, any changes in the money supply must come directly from central bank policy
  • At 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.
slide31

Operationally, the central bank changes the money supply through three channels

    • Changing banks reserve requirement
    • Changing the discount rate at which banks borrow from the central bank at.
    • Buying and selling bonds from the public in exchange for money

These are known as tools of Monetary policy…

tools of monetary policy
Tools of Monetary Policy

1 Reserve-deposit ratio:

    • Ratio of cash reserves to deposits that banks are required to maintain
  • By lowering the ratio, banks will have more reserves to lend and invest, increasing the money supply
tools of monetary policy33
Tools of Monetary Policy

2 Discount rate:

    • rate of interest the DAB charges on loans to banks
  • By lowering the rate, banks encourage borrowing from the DAB and lending to the public, increasing the money supply
tools of monetary policy34
Tools of Monetary Policy

3 Open Market Operations:

    • DAB purchases and sales of government bonds
  • By purchasing bonds and paying the sellers, the DAB increases the money supply
slide35

Using 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.
friedman s challenge to liquidity preference
Friedman’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
cont d
Cont`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.
interest rates and an increase in the money supply growth rate
Interest 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 balances
    • People 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.
cont d39
Cont`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.
expansionary monetary policy
Expansionary Monetary Policy
  • Increase the money supply by any one or combination of the Monetary tools
  • Reduce the interest rate to encourage investment
  • Increase employment & income
expansionary monetary policy41
Expansionary Monetary Policy

Interest Rate (%)

(M2/P)s

(M1/P)s

5

4

(M/P)d

85

80

Quantity of Money