MONEY SUPPLY AND DEMAND 8/1/2011 B01012-Money supply&demand 1 MONEY SUPPLY AND DEMAND Measuring the Supply of Money • M1: Transactions Money • M1, or transactions money Money that can be directly used for transactions. M1 ≡ currency held outside banks + demand deposits + traveler’s checks + other checkable deposits 8/1/2011 B01012-Money supply&demand 2 • M1: Transactions Money • M1, or transactions money Money that can be directly used for transactions. M1 ≡ currency held outside banks + demand deposits + traveler’s checks + other checkable deposits M2: Broad Money near monies Close substitutes for transactions money, such as savings accounts and money market accounts. M2, or broad money M1 plus savings accounts, money market accounts, and other near monies. M2 ≡ M1 + Savings accounts + Money market accounts + Other near monies M2: Broad Money near monies Close substitutes for transactions money, such as savings accounts and money market accounts. M2, or broad money M1 plus savings accounts, money market accounts, and other near monies. M2 ≡ M1 + Savings accounts + Money market accounts + Other near monies 8/1/2011 B01012-Money supply&demand 3 Money Demand • Demand for money depends on: – Interest rates. Higher interest rates raise the opportunity cost of money, which little or no interest. Hence less money is demanded when interest rates are high • Demand for money depends on: – Interest rates. Higher interest rates raise the opportunity cost of money, which little or no interest. Hence less money is demanded when interest rates are high 8/1/2011 4B01012-Money supply&demand Money Demand • Demand for money depends on: – Income. Higher incomes lead to greater spending and a greater demand for money for transactions purposes – Prices. When prices are higher more 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 – Prices. When prices are higher more money is needed to buy the same quantity of goods, so demand rises 8/1/2011 5B01012-Money supply&demand 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. 6 • 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. 8/1/2011 B01012-Money supply&demand 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 7 • 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 8/1/2011 B01012-Money supply&demand 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 8 • 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 8/1/2011 B01012-Money supply&demand 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 M V P Y   Rearranging the quantity equation yields velocity to be… Economists usually use GDP “Y” as a proxy for “T” since data on the number of transactions is difficult to obtain. 8/1/2011 9B01012-Money supply&demand The Money Demand Function and the Quantity Equation ( / ) d M P 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. ( / ) d M P 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. 8/1/2011 10B01012-Money supply&demand . MONEY SUPPLY AND DEMAND 8/1/2011 B01012 -Money supply& amp ;demand 1 MONEY SUPPLY AND DEMAND Measuring the Supply of Money • M1: Transactions Money • M1, or transactions money Money that. is demanded when interest rates are high 8/1/2011 4B01012 -Money supply& amp ;demand Money Demand • Demand for money depends on: – Income. Higher incomes lead to greater spending and a greater demand. of real money balances demanded is proportional to real income. 8/1/2011 10B01012 -Money supply& amp ;demand The Money Demand Function and the Quantity Equation ( / ) d M P kY The money demand function