What Causes An Increase In Demand For Money
Macro Notes 3: Coin Demand
3.1 Demand for CoinThe notion of a demand for coin may strike you at commencement glance every bit bizarre. Don't you but want as much as you tin get? Or isn't coin what you use when you demand other appurtenances? Here is where we have to remember that money is a stock not a flow, and that income and wealth are not money. Demand for money is a question of how much of your wealth you wish to agree in the class of money at any betoken in time. (Supply of money is also a stock concept.)
Your demand for money is how much of your wealth y'all wish to hold as money at any moment in time. It is thus a stock demand. Your wealth is a stock, and you must decide how to allocate that stock of wealth between different kinds of assets -- for case a business firm, income-earning securities, a checking account, and cash.
Why would you concord any of your wealth as coin -- as cash or checking deposits? Those assets earn picayune or no involvement. Wouldn't it be more sensible to hold all your wealth in the course of assets that yield income? Note that:
- 1. There is a cost associated with holding money balances (you give up interest payments),
2. There is no intrinsic value in the coin balances yous concord except in their utilize as a medium of substitution. By and large, you acquire coin in order to get rid of it -- to purchase things. While you hold it, money does not continue yous warm, entertain you, or provide whatsoever other benefit.
three.ii Transactions Motive for Belongings Money
The most obvious answer is that we concur some money considering it's convenient to buy stuff with. We'll call this first reason the transactions motive. Essentially, information technology's convenient to hold a certain average amount of money at any given fourth dimension, depending on the kind of purchases you lot brand and the size of your income.
One of the near important functions of money is that information technology is the universally accepted medium of substitution -- this is the principal reason yous hold money. Thus, one reason to concord money is to use it equally a means of payment in transactions in the futurity. At present, if there was a perfect lucifer between the moments yous receive money in transactions and the moments you use money, you lot would non need to hold any coin at all. If I were paid every Fri, and I could pay all my bills on the same day, so I would need to concord very little money.
Unfortunately, in the real world, there is not going to be an exact match betwixt when I receive money and when I demand to make payments. Let united states of america say that every bit a work study pupil, you receive $500 every month as payment for your work. This payment comes once a month. But y'all demand to pay for hire, food, movies, books, copying, pens etc. This is spread out over the month. So, on the outset of the calendar month, you eolith $500 in you bank account at Fulton bank, so you withdraw this coin and run your account down to zero over the form of the month. In the class of the month, you hove an boilerplate money holding of $250. Same thing happens the adjacent month, and the next, over the year.
Your average holding of money then, is $250: this is how much you lot take on average in your bank business relationship over the grade of a twelvemonth.
If instead, you were paid $250 every 2 weeks, then y'all would concord $250 at the start of the two weeks, and run it down to goose egg over the form of two weeks, repeat this the next two weeks, then on.
Can y'all see that on boilerplate, you would be holding $125 in your account?
In other words, the demand you accept for property coin balances will depend on the smoothness with which the time you lot go paid and the time you utilise the money to make payments mesh. Thus, the demand to hold money balances is in part a result of the institutional payments mechanisms in the economy. An agrarian twenty-four hours laborer in India does non hold very much cash balances because she will get paid on a daily basis in small amounts and then use up the money she receives to pay for her transactions of purchasing food almost immediately. She will accept a virtually zip holding of money balances. But in a system where people are paid with longer term contracts, regularized wages and salaries, and where they get paid in intervals of a week, a fortnight or a month, and where incomes are relatively stable, the need to hold money balances volition be higher.
Even if at that place was not a perfect match between my receipts of cash and the moments in which I utilise it as a means of payments for transactions, if I could costlessly and immediately catechumen any bonds I hold into money, then there is no reason to concur money. I would hold all wealth as bonds, and sell a bond for money the moment I need to brand a purchase, holding money for only an instant.
So for instance, you are paid $500 per calendar month. Yous hold an average residuum of $250 as you outset out the month with a $500 banking concern balance, and then run to downwards over the calendar month. Simply what if you detect that you lot can buy a $250 bail at the get-go of the calendar month, and sell information technology in the middle of the calendar month, earning an interest for one-half the month? When you get paid, you lot could put $250 in your checking account as a coin holding, and buy a bond for $250. At the end of two weeks, when your $250 has been used upwardly, you lot tin can sell the bond and deposit another $250 in your account. Your average coin holdings take just dropped to $125, and you earn interest on $250 bonds every fortnight.
You can take this farther an further. Why not deposit only $125, and buy $375 worth of bonds? Sell $125 of bonds every week, and earn interest for three weeks. In upshot, the question is:
Why hold any money balances at all? Why not always hold bonds and only become concur of money the moment you need information technology to pay for transactions?
It is plush, in terms of time and resources, to keep moving in and out of bonds or other assets and coin. Since this is the case, I will desire to hold a certain level of money balances on boilerplate, to meet my needs to pay for transactions. This is called the transactions demand for money.
If the involvement payments I receive on bonds and other assets is high, then information technology is worth my while to move in and out of stocks and bonds and coin, so that I can earn this interest payment instead of holding money balances. If the interest charge per unit is not that loftier, then information technology is not worth it to move in and out of money and bonds in order to receive this interest payment.
Another style to look at it is that the involvement charge per unit describes the cost of belongings money balances. This is because the interest rate tells yous the amount of interest income you lot have to forego by holding money balances instead of lending out that money and holding an asset like a bail.
This is plenty to generate a curve which plots the demand for money -- the amount yous wish to concur every bit opposed to property wealth as bonds -- equally a office of r. This bend will slope downward.
Caution: This looks like the kind of need curve you're used to in micro. It isn't. Those stand for need for a catamenia of a good. This shows what stock of coin people wish to concord equally part of their nugget portfolios.
We emphasize the mode that r affects transactions need considering it's of import to our money market story. But 2 other things volition too bear upon transactions demand. If income changes, transactions need should change with it. As your income rises then do your expenditures, and hence the corporeality of wealth you might want to hold as money at any instant in time. Similarly it's reasonable to presume that at a national level, need for money will grow as national income grows, and decline if national income declines. Additionally, as the overall toll level of goods and services changes, transactions demand will change with it: if you hold money to buy stuff, and it becomes less expensive to purchase stuff, you'll hold less money.
And so the transactions need for coin depends on 3 things:
a) interest rate: equally we have noted above, the interest charge per unit is in effect the cost of belongings money balances. It is the income I forego when I hold money balances. If the involvement rate goes up, then the returns on moving in and out of money into other avails and back will increase, and then people will hold a lower level of coin balances. If the involvement charge per unit falls, and then the returns on moving out of money balances and into assets are non so slap-up. In this case, it is not worth it to movement out of money into other assets and so back when you demand to make payments on transactions, then you will hold a college level of money balances.
b) amass income: if the volume of income and output produced in the goods markets increases, then clearly in that location will be a larger volume of transactions and exchanges taking identify. People will demand to agree a larger volume of money to see all these transactions and make payments.
c) price level: if prices rise, and then people will need to concord a college level of money balances to run into their payments transactions. If prices fall, people will need a lower volume of coin balances to back up a given level of transactions.
3.3 Speculative Motive for Holding Money
At present, in addition to the transactions motive, at that place is 1 other reason why people take a demand for holding money balances. This is called the speculative motive. Suppose that involvement rates fluctuate. At a two percent rate of interest, y'all would get $1,020 in a twelvemonth's time in commutation for $one,000 in cash now (i.e. by buying at present for $ane,000 a bond that pays $1,020 in a year, which is the same thing as lending $i,000 at two percent involvement). Suppose that the rate of interest is now two percent, just you expect it to rise to ten percent before long. At 10 percent, $1,000 in greenbacks now will get y'all $1,100 in a year's fourth dimension. So if you recollect interest rates re unusually low and likely to rise, you might keep your wealth as money rather then buying bonds at the low electric current involvement rate.
Another mode to remember near this, which will become clearer after you terminate the next department, is that if you think that interest rates will rising, then any bonds you lot buy now at two per centum interest will fall in value after the interest rate rises. "Speculative" simply means speculating -- gambling, if you similar -- that the value of an asset volition change and you tin profit past it. Unremarkably we think of speculating in terms of buying an asset: if I await that real manor in Carlisle is nigh to rise in value, I might buy some in hope of selling afterward the price rises. But if I think that an asset's cost is about to fall, I can also speculate past property cash, so that I tin can buy it after the price drops.
Of course if I remember that involvement rates are unusually high, then I volition buy as many bonds equally possible to lock in the higher involvement charge per unit. Another way to put it is that later the interest rate falls, these bonds will exist worth more.
To recapitulate: in general, when interest rates are loftier, people speculate that they will not stay high, but will fall. If this is the case, then people will demand less money holdings and move into bonds. When (or if) interest rates practice fall, their bonds volition rise in value.
But, if interest rates are depression, people wait that they will go up. So they adopt to hold on to coin balances, and will motility out of bonds, for fear that the value of those bonds volition fall when (or if) interest rates rise in the future.
iii.4 Coin Demand as a Function of the Interest Rate
And so far, nosotros take two reasons why the corporeality of money that people wish to hold might vary with the interest rate. Information technology happens that they both hold about the nature of the change: at low interest rates money demand will be loftier, at loftier interest rates the corporeality ot their portfolios that people wish to hold equally money volition be depression.
Before we put this together with the supply of money, we demand to become over the relation between the interest rate and the price of bonds.
3.5 Bond Prices and the Interest Charge per unit
The terminal link in this story is that the fluctuations in assets prices are intimately linked to the interest rate. This is considering the reason to buy an asset like a bond and to agree to loan out your money is that your plan to earn an interest on the loan. Thus, the price of a bail is linked to the interest that it promises to requite the lender.
There are several ways to think about this. One is to call back that a bail is nothing merely a hope to make future payments -- a piece of paper that gives you the right to get sure payments of coin at certain hereafter times.
The price of a bond is simply the amount of money one tin sell it for right at present. This volition touch both the "primary" marketplace in bonds -- firms selling bonds to raise money to buy capital letter appurtenances, or government selling bonds to finance a fiscal arrears -- as well as the "secondary" market -- people ownership and selling previously-issued bonds. If I desire to purchase a i-year bond, and so a new one-year bond issued by the U.South. regime, and a 2-twelvemonth bond issued a twelvemonth agone whose holder wishes to sell it, are the same thing as fas as I'grand concerned -- both are promises to pay coin in a year's time.Here is the same idea in more full general mathematical language.An "interest rate" is just a dissimilar way of discussing the price. To get an interest rate, nosotros decrease the money paid now for the bail from the money the bond promises to pay after, and phone call that difference "interest." If we limited that "interest" every bit a percentage of the money paid at present for the bail, we have an involvement rate. So if the money that the bail pays in the future is given, and then the higher the toll (in coin at present) of the bond, the lower the difference between that price and what the bond pays later, so the less the interest and hence interest charge per unit.
Let usa say that the interest rate is r%. If you lot lend $B today, and then you volition become:
A = B (ane + r)Thoutwhere A is the amount you become dorsum at the cease of t years, B is the amount you lot loaned today, and r is the interest charge per unit you receive.
At present, a bail is basically a promise to pay an amount A at the end of t years.
Permit u.s. say yous bought a bond that promised to pay you $110 at the end of 1 year. If you lot bought that bond for $100, then in result, y'all loaned out $100 and got dorsum $110 at the end of 1 year. You got $10 in "interest," so you lot are receiving an effective return of 10%.
And so, the toll yous are ready to pay for a bail is really equivalent to the principal y'all are lending out today to receive repayment in the future. Once more, the difference between the price you pay today (B) and the amount the bond promises to pay you lot in the hereafter (A) is equivalent to the interest rate that the bond is finer going to give you. Or
A B = ------------ (1 + r)twhere P is the price you lot will pay for this bail today, in order to receive an amount of a in t years time, based on an interest rate of r. You can now come across algebraically what we demonstrated in words -- the inverse human relationship betwixt the bail price and the interest rate.
Let us say you bought a bail which promised to pay $275 in a years time. Yous bought this bond for $250, which means that implicitly, you would take earned a 10% interest.
Now, let us say that by the time you go to sell this bond, interest rates rose to 20%. This ways that no one volition want to buy your bond for $250, since this bond simply promises to give them $275 or a ten% render at the end of a year. Why volition they pay $250 to become $275 at the end of a year, when they tin lend out their $250 to someone else and get $300, or a 20% return, at the end of a yr?
Then, y'all will non find anyone who is ready to buy your bail for $250. If notwithstanding, y'all sell your bond for around $229, and so people will exist set up to purchase it from y'all. This is because at $229, if they get back $275 at the stop of a year, this is virtually equivalent to a 20% return.
Thus, if the interest rates become up, the value of your bond volition autumn from $250 to $229, and you have simply fabricated a loss of $21.
Tin you see that if the interest rates went downwardly the value of your bail would go up, and you could sell it for more than the $250 you purchased it for? What is the amount you could sell this bond (which promises to pay $275 at the end of the twelvemonth) for, if interest rates dropped to five%?
You tin can try this with a spreadsheet. For example yous volition find that a bond which pays $1,000 in one year's time would be worth:
$990.x at an involvement rate of 1% $980.39 at an interest rate of 2% $970.87 at an interest rate of 3% $961.54 at an interest charge per unit of 4% $952.38 at an interest charge per unit of five% $943.40 at an interest rate of 6% $934.58 at an interest rate of seven% $925.93 at an involvement charge per unit of 8% $917.43 at an interest rate of nine% $909.09 at an involvement charge per unit of 10% $900.90 at an interest charge per unit of xi% $892.86 at an interest rate of 12% $884.96 at an interest rate of 13% $877.19 at an involvement charge per unit of 14% $869.57 at an interest rate of 15% $862.07 at an interest charge per unit of xvi% $854.lxx at an interest rate of 17% $847.46 at an interest rate of 18% $840.34 at an interest rate of 19% $833.33 at an interest charge per unit of xx% . . . $666.67 at an involvement rate of 50% . . . $500.00 at an interest charge per unit of 100%3.six Money Market Equilibrium
What'south equilibrium? A situation in which in that location is no further force per unit area for change.
Describing equilibrium in the money market place volition exist a affair of describing what the pressures are that will push button the involvement rate to change. Equilibrium will occur whenever the involvement rate stops irresolute. That will exist whenever money supply equals coin need.
Caution: Do non confuse this with a typical micro market equilibrium story of how the cost of craven reaches equilibrium. That's a flow equilibrium : a catamenia of craven produced and a flow consumed. This is a stock equilibrium: in that location is a certain amount of money circulating in the economy, and a certain amount that people wish to hold.
Remember how we discussed equilibrium before (in section ane.3). Equilibrium will be a situation in which all the behavioral conditions are satisfied -- when everyone'southward desired holdings of coin equal all the money actually held. An equilibration process will tell united states of america how the money market really moves to a situation where everybody manages to meet their desired behavior (given from the behavioral functions). The supply of money is the total stock of coin bachelor for use in transactions, and held by the private sector. The need for money balances is the total stock of money that the individual sector wishes to hold. Annotation that when we modify the supply of money, as we did in the terminal chapter, nosotros are irresolute the amount in deposit accounts. At whatever instant in time, all the coin has to be somewhere: every dollar of the money supply must exist held by someone.
Equilibration Stories:
i. Allow us suppose that nosotros starting time with a supply of money that does equal the demand for money, at an involvement rate of five percent.
Now we increase the supply of money. That means people now agree more than money, relative to bonds, than they used to and want to.
In an effort to readjust their portfolios, they will seek to plough some of this coin into bonds -- they'll buy bonds.
This additional demand for bonds volition drive up the toll of bonds. Equally you know from the previous department, a higher price of bonds is the same affair as a lower interest rate.
As the interest rate falls, money demand volition ascent. One time it rises to equal the new money supply, in that location will be no farther difference between the amount of money people concord and the amount they wish to hold, and the story will end.
This is why (and how) an increase in the money supply lowers the involvement rate.
two. Let us suppose that nosotros start with a supply of money that does equal the demand for money, at an involvement rate of five percent.
At present nosotros decrease the supply of coin. That ways people now hold less coin, relative to bonds, than they used to and desire to.
In an endeavor to readjust their portfolios, they volition seek to turn some of their bonds into money -- they'll sell bonds.
These additional sales of bonds will drive down the cost of bonds. Equally you know from the previous section, a lower price of bonds is the same thing as a higher interest rate.
Equally the interest rate rises, money demand volition fall. Once it falls to equal the new money supply, there volition be no further difference betwixt the amount of coin people concur and the amount they wish to concord, and the story will end.
This is why (and how) a decrease in the money supply raises the interest rate.
We have a notion of how the interest rate affects demand to hold coin which is shown in the downwards-sloping coin demand curve.
To this, nosotros can add the supply of money. Since it's not afflicted by the interest charge per unit, it'south a vertical line. The Fed fixes the supply of coin, equally described in the previous chapter. This is the total stock of money in apportionment -- the money supply at any given fourth dimension.
Ane More Caution: An excess supply of money balances, every bit occurred when we initially increased the money supply, ways that there are more coin balances in the economy than individuals desire to concur with them. What are coin balances? Money balances are the amount of cash and checking account deposits with the private sector available for use in substitution. In effect, an excess supply of money balances implies that at the going interest rate, there is more than greenbacks and a higher level of checking business relationship deposits than individuals desire to hold. This is non the same thing as an "backlog supply of apples," since an excess supply of apples ways that in that location is a grouping of people trying to sell apples just unable to do so. An excess supply of money literally means that folks have more than greenbacks in their pockets and a larger level of checking accounts than the want to concur with them.
3.7 Federal Reserve Policy and the Interest Rate
In effect, the Fed can set the interest charge per unit by irresolute the supply of money. It changes the supply of money past using any of its three instruments -- open market operations, disbelieve rate changes, or required reserve ration changes -- which work on the banking organization to increment or decrease the stock of money that is circulating through the economy. The changing supply of money, in turn, changes the interest rate through the procedure described above.
Caution: The Fed can not "set" the marketplace interest rate by decree. It can not just tell the money market what the interest charge per unit should be. Exercise not confuse the discount rate, which the Fed can gear up, with the interest charge per unit in general. The disbelieve rate is a special rate that banks need to pay if they borrow reserves. It is entirely possible that the discount rate volition be substantially higher than the market place interest rate. Information technology can also be lower, though in that case the Fed would probably heighten it and so that banks would not be tempted to use Fed borrowing as a inexpensive source of funds.
iii.viii Other Changes that May Affect the Interest Rate
When we introduced coin need, and in particular transactions need, the most important part of money demand, nosotros noted that the corporeality of money that people wished to hold for transactions purposes would be affected past 3 things:
- a. the interest rate, which represented the opportunity cost of property money
b. the cost level, which would affect how much coin was needed for transactions
c. income, considering as income rises yous buy more, and equally it falls you purchase less
So if either Y or P (the price level) ascent, coin demand will increase. Graphically, we represent this as a rightward shift of the money demand bend.
If either Y or P (the price level) fall, money demand volition fall. Graphically, we represent this every bit a leftward shift of the money demand bend.
©1998 S. Charusheela and Colin Danby.
What Causes An Increase In Demand For Money,
Source: https://faculty.washington.edu/danby/notes/notes12.html
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