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The Demand for Money and Central Bank



What is money? Why does anyone want it? In economics, money = medium of exchange

What ever is accepted in exchange

Demand for money refers to the stock of assets held as cash, checking accounts, and closely related assets, specifically not generic wealth or income

Components of the Money Stock

Three main monetary aggregates: M1, M2 and M3 As liquidity of an asset decreases, the interest yield increases

A typical economic tradeoff: in order to get more liquidity, asset holders have to sacrifice yield

The Functions of Money


There are three traditional functions of money:

Medium of exchange
Money is used to pay for goods and services Eliminates the need for a double coincidence of wants


Store of value
An asset that maintains value If money were not a store of value, it would not be used as a medium of exchange


Unit of account
The unit in which prices are quoted

The Demand for Money: Theory

The demand for money is the demand for real money balances people hold money for its purchasing power

Two implications:


Real money demand is unchanged when the price level increases, and all real variables, such as the interest rate, real income, and real wealth, remain unchanged Equivalently, nominal money demand increases in proportion to the increase in the price level, given the real variables just specified

An individual is free from money illusion if a change in the level of prices, holding all real variables constant, leaves the persons real behavior, including real money demand, unchanged.

The Demand for Money: Theory

The theories covered here correspond to Keyness famous three motives for holding money:

The transactions motive, which is the demand for money arising from the use of money in making regular payments The precautionary motive, which is the demand for money to meet unforeseen contingencies The speculative motive, which arises from uncertainties about the money value of other assets that an individual can hold

Transaction Demand

The transaction demand for money arises from the lack of synchronization of receipts and disbursements

You are not likely to get paid at the exact moment you need to make a payment keep money on hand to make purchases between pay periods

There is a tradeoff between the amount of interest an individual forgoes by holding money and the costs of holding a small amount of money

Benefits of keeping small amounts of money on hand is interest earned on money left in the bank Cost of keeping small amounts of money is the cost and inconvenience of making trips to the bank to withdraw more

The Precautionary Motive

The uncertainty

People are uncertain about the payments they might want or have to make there is demand for money for these uncertain events

The more money a person holds, the less likely he or she is to incur the costs of illiquidity

The more money a person holds, the more interest he/she will give up similar tradeoff encountered with transactions demand for money

Added consideration is that greater uncertainty about receipts and expenditures increases the demand for money

Technology and the structure of the financial system are important determinants of precautionary demand

Speculative Demand for Money

Speculative demand for money focuses on the store-ofvalue function of money concentrates on role of money in the investment portfolio of an individual Wealth held in specific assets portfolio

Due to uncertainty, unwise to hold entire portfolio in a single risky asset diversify asset holdings Demand for money depends upon the expected yields and riskiness of the yields on other assets (James Tobin)
Increase in the opportunity cost of holding money lowers money demand Increase in the riskiness of the returns on other assets increases money demand

Money is a safe asset

Empirical Estimates

Empirical work establishes four essential properties of money demand:

The demand for money balances responds negatively to the rate of interest. An increase in interest rates reduces the demand for money. The demand for money increases with the level of real income. The short-run responsiveness of money demand to changes in the interest rates and income is considerably less than the longrun response. The demand for nominal money balance is proportional to the price level. There is no money illusion; in other words, the demand for money is a demand for real balances.


The Income Velocity

The income velocity of money: the number of times the stock of money is turned over per year in financing the annual flow of income.

It is equal to the ratio of nominal GDP to the nominal money stock, or: P Y Y

P can also be interpreted as the ratio of nominal income to nominal money stock OR the ratio of real income to real balances



The Quantity Theory

The quantity theory of money provides a very simple way to organize thinking about the relation between money, prices, and output: M V P Y (3)

Equation (3) is the famous quantity equation, linking the price level and the level of output to the money stock The quantity equation became the classical quantity theory of money with it was argued that both V and Y were fixed If both V and Y are fixed, it follows that the price level is proportional to the money stock


The Quantity Theory

The classical quantity theory = theory of inflation

The price level is proportional to the money stock:



If V is constant, changes in the money supply translate into proportional changes in nominal GDP With the classical case (vertical) supply function, Y is fixed, and changes in money translate into changes in the overall price level, P


Money Stock Determination

High powered money (monetary base) consists of currency and banks deposits

The part of the currency held by the public forms part of the money supply Currency in bank vaults and banks deposits at the Central Bank are used as reserves Central Bank control over the monetary base is the main route through which it determines the money supply


Money Stock Determination

The Central Bank has direct control over high powered money (H) Money supply (M) is linked to H via the money multiplier, mm Figure shows this relationship:

Top of figure is the money stock Bottom of figure is the stock of high-powered money = monetary base

Money multiplier (mm) is the ratio of the stock of money to the stock of high powered money mm > 1

The larger deposits are, as a fraction of M, the larger the multiplier

[Insert Figure 16-2 here]


Money Stock Determination

Money supply consists of currency, CU, plus deposits:



High powered money consists of currency plus reserves:

H CU reserves


Summarize the behavior of the public, the banks, and the Central Bank in the money supply process by three variables: Currency-deposit ratio: cu CU

Reserve ratio:

re reserves

Stock of high powered money: H


The Currency Deposit Ratio


payment habits of the public determine how much currency is held relative to deposits

currency deposit ratio is affected by the cost and convenience of obtaining cash Currency deposit ratio falls with shoe leather costs
Ex. If there is a cash machine nearby, individuals will on average carry less cash with them because the costs of running out are lower


The Reserve Ratio

Bank reserves = deposits banks hold at the Central Bank and vault cash, notes and coins held by banks

In the absence of regulation, banks would hold reserves to meet:

1. 2.

The demands of their customers for cash Payments their customers make by checks that are deposited in other banks


Money Stock Determination

We can rewrite equations (1) and (2) as: M (cu 1) D and H (cu re) D

allows us to express the money supply in terms of its principal determinants, re, cu, and H:

1 cu M H mm H re cu
1 cu mm re cu


where mm is the money multiplier, given by:


Money Stock Determination

Some observations of the money multiplier:

1 cu mm re cu

money multiplier is larger the smaller the reserve ratio, re