1. Demand for and supplyDemand for and supply
of moneyof money
-Money: Definitions, functions & Components of money supply-Money: Definitions, functions & Components of money supply
-Commercial Banks & Process of Deposit Creation-Commercial Banks & Process of Deposit Creation
-Central Bank & the Supply of Money-Central Bank & the Supply of Money
-Money Demand-Money Demand
-Equilibrium Interest Rates-Equilibrium Interest Rates

2. DEFINITIONS OF MONEYDEFINITIONS OF MONEY
• Money is anything that is generally accepted as aMoney is anything that is generally accepted as a
medium of exchangemedium of exchange
• Traditionally, money is defined as currency andTraditionally, money is defined as currency and
demand deposits, and its most important function is todemand deposits, and its most important function is to
act as a medium of exchange.act as a medium of exchange.
• Friedman defined money as the sum of currency plusFriedman defined money as the sum of currency plus
all adjusted deposits in commercial banks. Thisall adjusted deposits in commercial banks. This
includes bank deposits, non bank deposits and anyincludes bank deposits, non bank deposits and any
other type of assets through which the monetaryother type of assets through which the monetary
authority influence the level of income, prices,authority influence the level of income, prices,
employment or any other macro economic variable.employment or any other macro economic variable.

3. FUNCTIONS OF MONEYFUNCTIONS OF MONEY
• Money serves as a means of payment, or medium ofMoney serves as a means of payment, or medium of
exchange. Money eliminates the problem of barterexchange. Money eliminates the problem of barter
system which requires a double coincidence of wantssystem which requires a double coincidence of wants
before goods and services can be directly exchangebefore goods and services can be directly exchange
for other goods and services.for other goods and services.
• Money serves as a store of value. In this case, itMoney serves as a store of value. In this case, it
serves as an asset that can be used to transferserves as an asset that can be used to transfer
purchasing power from one time period to another.purchasing power from one time period to another.
• Money serves as a unit of account, or a standard unitMoney serves as a unit of account, or a standard unit
that provides a consistent way of measuring andthat provides a consistent way of measuring and
recording economic value (e.g quoting prices)recording economic value (e.g quoting prices)

4. TYPES OF MONEYTYPES OF MONEY
• The following are the types of money:The following are the types of money:
• commodity money• commodity money
• fiat money• fiat money
• legal tender• legal tender
• token money• token money
• demand deposit• demand deposit
• Commodity monies are items used as money thatCommodity monies are items used as money that
also have intrinsic value in some other use. Gold isalso have intrinsic value in some other use. Gold is
one form of commodity money. Fiat, or token,one form of commodity money. Fiat, or token,
money is money that is intrinsically worthless.money is money that is intrinsically worthless.
Legal tender is money that a government hasLegal tender is money that a government has
required to be accepted in settlement of debts.required to be accepted in settlement of debts.

5. COMPONENTS OF THE MONEYCOMPONENTS OF THE MONEY
SUPPLYSUPPLY
• The two most common measures of money are M1The two most common measures of money are M1
and M 2.and M 2.
• M1, or Narrow money is money that can be directlyM1, or Narrow money is money that can be directly
used for transactions. It includes currency heldused for transactions. It includes currency held
outside banks, plus demand deposits, plus traveler’soutside banks, plus demand deposits, plus traveler’s
checks, plus other checkable deposits.checks, plus other checkable deposits.
• M2, or Broad money is M1 + savings accounts +M2, or Broad money is M1 + savings accounts +
money market accounts (which allows only checks formoney market accounts (which allows only checks for
amounts above some minimum) + other near moniesamounts above some minimum) + other near monies
+ fixed or time deposits, & negotiable certificates by+ fixed or time deposits, & negotiable certificates by
BanksBanks

6. COMMERCIAL BANKS & PROCESSCOMMERCIAL BANKS & PROCESS
OF DEPOSIT CREATIONOF DEPOSIT CREATION
• The origins of the modern banking system:The origins of the modern banking system:
Goldsmiths functioned as warehouses whereGoldsmiths functioned as warehouses where
people stored gold for safekeeping. Upon receivingpeople stored gold for safekeeping. Upon receiving
the gold, a goldsmith would issue a receipt to thethe gold, a goldsmith would issue a receipt to the
depositor. After a time, these receipts themselves,depositor. After a time, these receipts themselves,
rather than the gold that they represented, began torather than the gold that they represented, began to
be traded for goods. At this point, all the receiptsbe traded for goods. At this point, all the receipts
issued were backed 100 percent by gold.issued were backed 100 percent by gold.
• Goldsmiths realized that people did not come oftenGoldsmiths realized that people did not come often
to withdraw gold and, thus, they had a large stockto withdraw gold and, thus, they had a large stock
of gold continuously on hand. They could lend outof gold continuously on hand. They could lend out
some of this gold without any fear of running out.some of this gold without any fear of running out.

7. CBPDC CONT’DCBPDC CONT’D
• The basis of credit money is the bank deposits. TheThe basis of credit money is the bank deposits. The
bank deposits are of two kinds namely,bank deposits are of two kinds namely,
(1)Primary deposits, and (2)Derivative deposits.(1)Primary deposits, and (2)Derivative deposits.
• 1) Primary deposits arise or formed when cash or1) Primary deposits arise or formed when cash or
cheque is deposited by customers & the bankcheque is deposited by customers & the bank
credits customers’ account. The customer cancredits customers’ account. The customer can
withdraw the amount anytime by cheques. Thesewithdraw the amount anytime by cheques. These
deposits are called “primary deposits” or “cashdeposits are called “primary deposits” or “cash
deposits.” The bank makes loans and advances todeposits.” The bank makes loans and advances to
its customers out of these primary deposits.its customers out of these primary deposits.

8. CBPDC CONT’DCBPDC CONT’D
• 2) Bank deposits also arise when a loan is granted2) Bank deposits also arise when a loan is granted
or when a bank discounts a bill or purchaseor when a bank discounts a bill or purchase
government securities. Deposits which arise ongovernment securities. Deposits which arise on
account of granting loan or purchase of assets by aaccount of granting loan or purchase of assets by a
bank are called “derivative deposits.”bank are called “derivative deposits.”
• The power of commercial banks to expand depositsThe power of commercial banks to expand deposits
through loans, advances and investments is knownthrough loans, advances and investments is known
as “credit creation.” Thus, credit creation impliesas “credit creation.” Thus, credit creation implies
multiplication of bank deposits. Credit creation maymultiplication of bank deposits. Credit creation may
be defined as “the expansion of bank depositsbe defined as “the expansion of bank deposits
through the process of more loans and advancesthrough the process of more loans and advances
and investments.and investments.

9. CBPDC CONT’DCBPDC CONT’D
• An important aspect of the credit creating functionAn important aspect of the credit creating function
of the commercial banks is the process of multiple-of the commercial banks is the process of multiple-
expansion of credit.expansion of credit.
• The banking system as a whole can create creditThe banking system as a whole can create credit
which is several times more than the originalwhich is several times more than the original
increase in the deposits of a bank. This process isincrease in the deposits of a bank. This process is
called the multiple-expansion or multiple-creationcalled the multiple-expansion or multiple-creation
of credit.of credit.
• Similarly, if there is withdrawal from any one bank,Similarly, if there is withdrawal from any one bank,
it leads to the process of multiple-contraction ofit leads to the process of multiple-contraction of
credit.credit.

10. CBPDC CONT’DCBPDC CONT’D
• The process of multiple credit-expansion can beThe process of multiple credit-expansion can be
illustrated by assumingillustrated by assuming
• (a) The existence of a number of banks, e.g(a) The existence of a number of banks, e.g
BankIslam, CIMB, Maybank, etc., each withBankIslam, CIMB, Maybank, etc., each with
different sets of depositors.different sets of depositors.
• (b) Every bank has to keep 20% of cash reserves,(b) Every bank has to keep 20% of cash reserves,
according to law, and,according to law, and,
• (c) To start with, let a new deposit of RM1,000 be(c) To start with, let a new deposit of RM1,000 be
made with bankIslam by Mr Jones.made with bankIslam by Mr Jones.

11. CBPDC CONT’DCBPDC CONT’D
• Suppose, Mr Jones deposits RM1,000 cashSuppose, Mr Jones deposits RM1,000 cash
in BankIslam. As a result, the deposits ofin BankIslam. As a result, the deposits of
BankIslam increase by RM1,000 and cashBankIslam increase by RM1,000 and cash
also increases by RM1,000. The balancealso increases by RM1,000. The balance
sheet of the BankIslam is as fallows:sheet of the BankIslam is as fallows:
BALANCE SHEET OF BANKISLAM
Liabilities RM Assets RM
Primary Demand
Deposit
1,000 Cash received 1,000
Cash reserved 200
Excess reserve 800

12. CBPDC CONT’DCBPDC CONT’D
• The deposit of RM1,000 is a liability for BankIslamThe deposit of RM1,000 is a liability for BankIslam
and it is also its asset. BankIslam has to keep onlyand it is also its asset. BankIslam has to keep only
20% cash reserve, i.e., RM200 out of its new20% cash reserve, i.e., RM200 out of its new
deposit and it has a surplus of RM 800 which it candeposit and it has a surplus of RM 800 which it can
use as loans.use as loans.
• Suppose BankIslam gives a loan to Mr Pat, and theSuppose BankIslam gives a loan to Mr Pat, and the
amount of loan is withdrawn & used by Mr Pat toamount of loan is withdrawn & used by Mr Pat to
pay off his creditors. After that, the balance sheet ofpay off his creditors. After that, the balance sheet of
BankIslam will be as follows:BankIslam will be as follows:

13. CBPDC CONT’DCBPDC CONT’D
BALANCE SHEET OF BANKISLAM
Liabilities RM Assets RM
Primary Demand
Deposit
1,000 Cash Received 1,000
Derivative
Demand Deposit
800 Loan to Mr. Pat 800
•Suppose Mr. Pat purchases goods valued at
RM800 from Mrs. Mary and pays cash. Mrs.
Mary collects the amount & deposits it with
CIMB. The deposits of CIMB now increase by
RM800 and its cash also increases by RM800.

14. CBPDC CONT’DCBPDC CONT’D
• After keeping a cash reserve of RM160, CIMB isAfter keeping a cash reserve of RM160, CIMB is
free to lend the balance of RM640 to any one.free to lend the balance of RM640 to any one.
Suppose CIMB lends RM640 to Mr. Kay, whoSuppose CIMB lends RM640 to Mr. Kay, who
uses the amount to pay off his creditors. Theuses the amount to pay off his creditors. The
balance sheet of CIMB will be as follows:balance sheet of CIMB will be as follows:
BALANCE SHEET OF CIMB BANK
Liabilities RM Asset RM
Primary Demand
Deposit
800 Cash reserve 160
Loan 640
Total 800 800

15. CBPDC CONT’DCBPDC CONT’D
• Suppose Mr. Kay purchases goods valued atSuppose Mr. Kay purchases goods valued at
RM640 from Mrs. Janet and pays the amount. Mrs.RM640 from Mrs. Janet and pays the amount. Mrs.
Janet deposits the amount, RM640 in MayBank.Janet deposits the amount, RM640 in MayBank.
MayBank now keeps 20% as reserve (RM128) andMayBank now keeps 20% as reserve (RM128) and
lends RM512 to a merchant. The balance sheet oflends RM512 to a merchant. The balance sheet of
MayBank will be as follows:MayBank will be as follows:
BALANCE SHEET OF CIMB BANK
Liabilities RM Asset RM
Primary Demand
Deposit
640 Cash Reserve 128
Loans 512
Total 640 640

16. CBPDC CONT’DCBPDC CONT’D
• Looking at the banking system as a whole, the positionLooking at the banking system as a whole, the position
will be as follow:will be as follow:
Name of Banks Deposits (RM) Cash reserve(RM) Loans(RM)
BankIslam 1,000 200 800
CIMB 8,00 160 640
MayBank 640 128 512
Total 2,440 488 1952

17. CBPDC CONT’DCBPDC CONT’D
• From the above, out of the initial primary deposit,From the above, out of the initial primary deposit,
bank advanced RM800 as a loan. It formed thebank advanced RM800 as a loan. It formed the
primary deposit of the second bank, CIMB, which inprimary deposit of the second bank, CIMB, which in
turn advanced RM640 as loan. This sum againturn advanced RM640 as loan. This sum again
formed the primary deposit of the third bank,formed the primary deposit of the third bank,
MayBank, which in turn advanced RM512 as loan.MayBank, which in turn advanced RM512 as loan.
Thus, the initial primary deposit of RM1,000 resultedThus, the initial primary deposit of RM1,000 resulted
in bank credit of RM1952 in three banks. Of course,in bank credit of RM1952 in three banks. Of course,
there will be many banks in the country and thethere will be many banks in the country and the
above process of credit expansion will continue andabove process of credit expansion will continue and
come to an end when no bank has an excesscome to an end when no bank has an excess
reserve to lend again.reserve to lend again.

18. CBPDC CONT’DCBPDC CONT’D
• When the banking system receives an additionalWhen the banking system receives an additional
primary deposit, there will be multiple expansionprimary deposit, there will be multiple expansion
of credit.of credit.
• When the banking system loses cash, there willWhen the banking system loses cash, there will
be multiple contraction of credit.be multiple contraction of credit.
• The extent to which the banks can create creditThe extent to which the banks can create credit
together could be found out with the help of thetogether could be found out with the help of the
credit multiplier formula given as: K=1/rcredit multiplier formula given as: K=1/r

19. CBPDC CONT’DCBPDC CONT’D
• Where K is the credit multiplier, and r, theWhere K is the credit multiplier, and r, the
required reserves.required reserves.
• If the reserve ratio is 20% the size ofIf the reserve ratio is 20% the size of
credit multiplier will be: K=1/r =1/0.2 = 5credit multiplier will be: K=1/r =1/0.2 = 5
• It means that the banking system canIt means that the banking system can
create credit together to the amount whichcreate credit together to the amount which
is five times more than the originalis five times more than the original
increase in the deposits.increase in the deposits.

20. CBPDC CONT’DCBPDC CONT’D
• Note that the size of credit multiplier isNote that the size of credit multiplier is
inversely related to the percentage of cashinversely related to the percentage of cash
reserves the banks have to maintain.reserves the banks have to maintain.
• Thus, If the reserve ratio increases, theThus, If the reserve ratio increases, the
size of credit multiplier is reduced and if thesize of credit multiplier is reduced and if the
reserve ratio is reduced, the size of creditreserve ratio is reduced, the size of credit
multiplier will increasemultiplier will increase

21. CBPDC CONT’DCBPDC CONT’D
• In general, increase in reserve, ∆R causesIn general, increase in reserve, ∆R causes
deposits increase, ∆D until requireddeposits increase, ∆D until required
reserves increase, r∆D equalizes it (∆R).reserves increase, r∆D equalizes it (∆R).
• Thus, ∆R = r∆D)Thus, ∆R = r∆D)
• ∆∆D = 1/r ∆RD = 1/r ∆R
• We can define deposit multiplier (K) asWe can define deposit multiplier (K) as
increase in deposits per unit increase inincrease in deposits per unit increase in
bank reserves as: ∆D/ ∆R = 1/r = Kbank reserves as: ∆D/ ∆R = 1/r = K

22. LIMITATION TO COMM.BANKLIMITATION TO COMM.BANK
DEPOSIT CREATIONDEPOSIT CREATION
• The commercial banks do not have unlimited power ofThe commercial banks do not have unlimited power of
credit creation. The following factors limit their power tocredit creation. The following factors limit their power to
create credit:create credit:
• I) Amount of Cash: If banks receive more cash, they canI) Amount of Cash: If banks receive more cash, they can
create more credit and vice versa. Cash supply iscreate more credit and vice versa. Cash supply is
controlled by the central bank of the countrycontrolled by the central bank of the country
• II) Cash Reserve Ratio: Banks must keep certainII) Cash Reserve Ratio: Banks must keep certain
percentage of deposits in cash as reserve as directed bypercentage of deposits in cash as reserve as directed by
Central Bank. If the cash reserve ratio is increased, theCentral Bank. If the cash reserve ratio is increased, the
volume of credit that the banks can create will fall andvolume of credit that the banks can create will fall and
vice versa.vice versa.

23. LIMITATION CONT’DLIMITATION CONT’D
• III) Banking Habits of the People: There can beIII) Banking Habits of the People: There can be
multiple expansion only when people form the bankingmultiple expansion only when people form the banking
habit & keep their money in the banks as deposits andhabit & keep their money in the banks as deposits and
use cheques for the settlement of transactions.use cheques for the settlement of transactions.
• Iv) Nature of Business Conditions in the Economy:Iv) Nature of Business Conditions in the Economy:
Credit creation will be large during a period ofCredit creation will be large during a period of
prosperity bcos more demand for loans and advancesprosperity bcos more demand for loans and advances
for investment purposes, thus, the volume of bankfor investment purposes, thus, the volume of bank
credit will be high. Opposite is the case during acredit will be high. Opposite is the case during a
depression period.depression period.

24. LIMITATION CONT’DLIMITATION CONT’D
• V) Leakages in Credit-Creation: Leakages in theV) Leakages in Credit-Creation: Leakages in the
process of credit creation where people keep aprocess of credit creation where people keep a
portion of their amount as idle cash instead ofportion of their amount as idle cash instead of
keeping it in Banks limits credit creation.keeping it in Banks limits credit creation.
• Vi) Liquidity Preference: If people desire to holdVi) Liquidity Preference: If people desire to hold
more cash, the power of banks to create credit ismore cash, the power of banks to create credit is
reduced.reduced.
• Vii) Monetary Policy of the Central Bank: TheVii) Monetary Policy of the Central Bank: The
Central Bank has powerful tools such as bank rate,Central Bank has powerful tools such as bank rate,
open market operations to control the expansionopen market operations to control the expansion
and contraction of credit by the commercial bank.and contraction of credit by the commercial bank.

25. CENTRAL BANK & THE SUPPLY OFCENTRAL BANK & THE SUPPLY OF
MONEYMONEY
• Central bank (CB) Controls the Money Supply (MS)Central bank (CB) Controls the Money Supply (MS)
In many ways:In many ways:
• The required reserve ratio: If the CB wants toThe required reserve ratio: If the CB wants to
increase the MS, it creates more reserves, therebyincrease the MS, it creates more reserves, thereby
freeing banks to create additional deposits byfreeing banks to create additional deposits by
making more loans. If it wants to decrease the MS,making more loans. If it wants to decrease the MS,
it reduces reserves.it reduces reserves.
• The Discount Rate: Banks may borrow from the CBThe Discount Rate: Banks may borrow from the CB
& charged interest rate known as discount rate.& charged interest rate known as discount rate.
The higher the discount rate, the higher the cost ofThe higher the discount rate, the higher the cost of
borrowing, and the lower the MS and vice versa.borrowing, and the lower the MS and vice versa.

26. CB & MSCB & MS
• In practice, discount rate are not often used byIn practice, discount rate are not often used by
CB to control the MS with great precision, bcosCB to control the MS with great precision, bcos
its effects on banks’ demand for reserves areits effects on banks’ demand for reserves are
uncertain.uncertain.
• Moral suasion: This is the pressure exerted byMoral suasion: This is the pressure exerted by
the CB on member banks to discourage themthe CB on member banks to discourage them
from borrowing heavily from the CB.from borrowing heavily from the CB.
• Open Market Operations: OMO is the (purchase)Open Market Operations: OMO is the (purchase)
or sale of govt. securities by the CB in the openor sale of govt. securities by the CB in the open
market in order to (expand) or contract themarket in order to (expand) or contract the
amount of reserves in the system and thus, theamount of reserves in the system and thus, the
MS.MS.

27. CB & MSCB & MS
• An open market purchase of securities by the CBAn open market purchase of securities by the CB
results in an increase in reserves and an increaseresults in an increase in reserves and an increase
in the supply of money by an amount equal to thein the supply of money by an amount equal to the
money multiplier times the change in reserves.money multiplier times the change in reserves.
• An open market sale of securities by the FedAn open market sale of securities by the Fed
results in a decrease in reserves and a decreaseresults in a decrease in reserves and a decrease
in the supply of money by an amount equal to thein the supply of money by an amount equal to the
money multiplier times the change in reserves.money multiplier times the change in reserves.
• OMOs are the CB’s preferred means of controllingOMOs are the CB’s preferred means of controlling
MS bcos they can be used with some precision,MS bcos they can be used with some precision,
are extremely flexible, and are fairly predictable.are extremely flexible, and are fairly predictable.

28. MONEY DEMANDMONEY DEMAND
• Keynesian Theory: According to Keynes, thereKeynesian Theory: According to Keynes, there
three motives for holding money. These arethree motives for holding money. These are
• Transaction MotivesTransaction Motives
• Precautionary MotivesPrecautionary Motives
• Speculative Motive:Speculative Motive:
- Uncertainty about future interest rates & rxp btw- Uncertainty about future interest rates & rxp btw
changes in the interest rate and the price of bonds.changes in the interest rate and the price of bonds.
––The illustrations are provided belows:The illustrations are provided belows:

29. MONEY DEMANDMONEY DEMAND
-Suppose in the past an investor bought govt.-Suppose in the past an investor bought govt.
bond at mkt price (PB) of RM1,000, at interestbond at mkt price (PB) of RM1,000, at interest
rate (r) of 5% and entitlement or coupon paymentrate (r) of 5% and entitlement or coupon payment
(CP) of RM50 per yr. Thus, [ PB= {CP x 100}/r ](CP) of RM50 per yr. Thus, [ PB= {CP x 100}/r ]
gives RM1,000.gives RM1,000.
-Suppose today, mkt int. rate, r = 5% (same as-Suppose today, mkt int. rate, r = 5% (same as
past). The price of bond is still RM1,000 and nopast). The price of bond is still RM1,000 and no
capital gain or loss.capital gain or loss.
-If the mkt. int. rate, r has risen to 10%, then the-If the mkt. int. rate, r has risen to 10%, then the
PB now at CP of RM50 gives RM500 [ i.ePB now at CP of RM50 gives RM500 [ i.e
(50x100)/10]. Thus, capital loss of RM500.(50x100)/10]. Thus, capital loss of RM500.

30. MONEY DEMANDMONEY DEMAND
-If the mkt. int. rate, r has declined to 2%, then the-If the mkt. int. rate, r has declined to 2%, then the
PB now at CP of RM50 gives RM2500 [ i.ePB now at CP of RM50 gives RM2500 [ i.e
(50x100)/2]. Thus, capital gain of RM1500.(50x100)/2]. Thus, capital gain of RM1500.
- Given the assmptn, the return on money is zero- Given the assmptn, the return on money is zero
bcos it earns no interest & its value is not subjectbcos it earns no interest & its value is not subject
to capital loss or gain as the int. rate changes.to capital loss or gain as the int. rate changes.
-Bond will pay an int. rate of r. the expected return-Bond will pay an int. rate of r. the expected return
on bond equals int. return plus or minus anyon bond equals int. return plus or minus any
expected gain or loss.expected gain or loss.

31. MONEY DEMANDMONEY DEMAND
-Therefore, If investor expects int. rate to fall,-Therefore, If investor expects int. rate to fall,
bonds have higher expected return and yield abonds have higher expected return and yield a
capital gain.capital gain.
-Conversely, If investor expects int. rate to rise, it is-Conversely, If investor expects int. rate to rise, it is
possible that the expected capital loss on bondspossible that the expected capital loss on bonds
will outweigh the interest earnings. The expectedwill outweigh the interest earnings. The expected
return on bonds would be negative and thereturn on bonds would be negative and the
preferred asset would be money.preferred asset would be money.
-Thus, if r is expected to rise, the price of bonds is-Thus, if r is expected to rise, the price of bonds is
expected to fall & capital loss expected, thenexpected to fall & capital loss expected, then
money is demand for as an asset now.money is demand for as an asset now.

32. MONEY DEMANDMONEY DEMAND
-Keynes assumes that investors have a-Keynes assumes that investors have a
relatively fixed conception of the normal int.relatively fixed conception of the normal int.
rate.rate.
-Thus, when the actual int. rate is above the-Thus, when the actual int. rate is above the
normal rate, investors expect the int. rate tonormal rate, investors expect the int. rate to
fall. Conversely, when the int. rate is below thefall. Conversely, when the int. rate is below the
normal rate, they expect it to rise.normal rate, they expect it to rise.
-Based on this assmptn, a rxp btw the level of-Based on this assmptn, a rxp btw the level of
the speculative demand for money and int.the speculative demand for money and int.
rate can be developed.rate can be developed.

33. MONEY DEMANDMONEY DEMAND
Fig.1: Individual speculative demand for moneyFig.1: Individual speculative demand for money
Int. rate. rInt. rate. r
nrnr
crcr
MM2i2i
(Whi-M(Whi-M1i1i))
Speculative demand for moneySpeculative demand for money

34. MONEY DEMANDMONEY DEMAND
Fig 2: Agg. speculative demand for MoneyFig 2: Agg. speculative demand for Money
Int. rate. rInt. rate. r
MM22
Speculative demand for moneySpeculative demand for money

35. MONEY DEMANDMONEY DEMAND
• MM1i1i + M+ M2i2i ≡ M≡ Mii
wherewhere MM2i2i is the speculative dd for money, andis the speculative dd for money, and
MM1i1i is the transactions dd for money by individual.is the transactions dd for money by individual.
• MMii + B+ Bii ≡ Wh≡ Whii
where Mwhere Mi ,i , BBii ,Wh,Whii are individual’s total moneyare individual’s total money
holdings, bond holdings and wealth, respectivelyholdings, bond holdings and wealth, respectively
• r, nr, cr, and (Whi-Mr, nr, cr, and (Whi-M1i1i))
are interest rate, normal interest rate, criticalare interest rate, normal interest rate, critical
interest rate, and bond holding respectively.interest rate, and bond holding respectively.

36. MONEY DEMANDMONEY DEMAND
• Fig 1 shows the individual’s speculative dd forFig 1 shows the individual’s speculative dd for
money. At any int. rate above the critical rate,money. At any int. rate above the critical rate,
the speculative dd for money is zero. Below thethe speculative dd for money is zero. Below the
critical interest rate, individual shifts to money.critical interest rate, individual shifts to money.
• Fig 2 shows the agg. speculative dd for moneyFig 2 shows the agg. speculative dd for money
schedule. As the interest rate becomes lower, itschedule. As the interest rate becomes lower, it
fall below the critical rate for more individualsfall below the critical rate for more individuals
and the speculative demand for money rises.and the speculative demand for money rises.
• This situation at a very low r where speculativeThis situation at a very low r where speculative
dd for money schedule becomes nearlydd for money schedule becomes nearly
horizontal is known as the liquidity Trap.horizontal is known as the liquidity Trap.

37. EQUILIBRIUM INTEREST RATESEQUILIBRIUM INTEREST RATES
int. rate r Equilibrium in the moneyint. rate r Equilibrium in the money
MsMs00
marketmarket
r*r*
MdMd00
M* MM* M
FIG. 1 Quantity of moneyFIG. 1 Quantity of money

38. EQUILIBRIUM INTEREST RATESEQUILIBRIUM INTEREST RATES
Int. rate r Effects of a shift in MoneyInt. rate r Effects of a shift in Money
MsMs00 MsMs11 DemandDemand
r1r1
r*r*
r2 Mdr2 Md22 Md* MdMd* Md11
FIG.2 Qty of money M* MFIG.2 Qty of money M* M11 MM

39. EQUILIBRIUM INTEREST RATESEQUILIBRIUM INTEREST RATES
• Fig.1 shows the intersection of money demandFig.1 shows the intersection of money demand
and supply schedules (Md & Ms) to determine theand supply schedules (Md & Ms) to determine the
equilibrium interest rate r*.equilibrium interest rate r*.
• Ms is assumed to be exogenous and the MsMs is assumed to be exogenous and the Ms
target M* is achieved by Central Bank usingtarget M* is achieved by Central Bank using
monetary base to control it.monetary base to control it.
• Also, equilibrium interest rate r* is considered theAlso, equilibrium interest rate r* is considered the
desired level by the Central Bank.desired level by the Central Bank.

40. EQUILIBRIUM INTEREST RATESEQUILIBRIUM INTEREST RATES
• Consider the effects of shifts in Money demandConsider the effects of shifts in Money demand
schedule in Fig 2schedule in Fig 2
• The shifts could be due to changes in income (∆ Y)The shifts could be due to changes in income (∆ Y)
which change money demand for a given int. rate.which change money demand for a given int. rate.
• Or due to the effects of actual shifts in Md functionOr due to the effects of actual shifts in Md function
i.e changes in the amount of money demandedi.e changes in the amount of money demanded
(∆Md) at a given levels of both Y and the int. rate.(∆Md) at a given levels of both Y and the int. rate.
• ∆∆Md could shift the Md schedule to say MdMd could shift the Md schedule to say Md11 (an(an
increase in money demand) or Mdincrease in money demand) or Md22 (a decline in(a decline in
money demand).money demand).

41. EQUILIBRIUM INTEREST RATESEQUILIBRIUM INTEREST RATES
• What will the Central Bank (CB) do in response toWhat will the Central Bank (CB) do in response to
the shifts?the shifts?
• If CB maintains the Ms at M* which is CB MsIf CB maintains the Ms at M* which is CB Ms
target, the desired level of CB’s int. rate, r* will nottarget, the desired level of CB’s int. rate, r* will not
be achieved as it will move away from the positionbe achieved as it will move away from the position
r*.r*.
• A decline in Md from Md* to MdA decline in Md from Md* to Md22 leads r to declineleads r to decline
from r* to rfrom r* to r2.2.
• An increase in Md from Md* to MdAn increase in Md from Md* to Md11 leads to anleads to an
undesirable rise in the r from r* to rundesirable rise in the r from r* to r1.1.

42. EQUILIBRIUM INTEREST RATESEQUILIBRIUM INTEREST RATES
• The CB can prevent or mitigate theseThe CB can prevent or mitigate these
movements in the r only by changing themovements in the r only by changing the
monetary base & hence the money supply.monetary base & hence the money supply.
• In the case of an increase in Md, CB could moveIn the case of an increase in Md, CB could move
the money supply to the level Msthe money supply to the level Ms11 schedule soschedule so
as to have equilb. in money market at the desiredas to have equilb. in money market at the desired
int. rate, r* by increasing the monetary base.int. rate, r* by increasing the monetary base.
• By so doing, CB would not achieve the Ms targetBy so doing, CB would not achieve the Ms target
as the money supply would be Mas the money supply would be M11 above M*. Inabove M*. In
this case, the increase in demand for money bythis case, the increase in demand for money by
public is accommodated by the CB.public is accommodated by the CB.

43. EQUILIBRIUM INTEREST RATESEQUILIBRIUM INTEREST RATES
• In this scenario, the monetary base and moneyIn this scenario, the monetary base and money
supply are not determined exogenously butsupply are not determined exogenously but
rather respond to the behaviour of the public.rather respond to the behaviour of the public.
• In an extreme case where int. rate is pegged atIn an extreme case where int. rate is pegged at
a fixed level for a long time by the CB, thea fixed level for a long time by the CB, the
monetary authority have no choice in the moneymonetary authority have no choice in the money
supply process than to supply the requiredsupply process than to supply the required
amount of money to maintain the desiredamount of money to maintain the desired
interest rate.interest rate.