Money market. The demand for money and supply, factors that determine them. Equilibrium in the money market.

Money are financial assets that can be used for performing transactions. Money includes currency and checkable deposits. Money pay no interest, for this reason some of people’s wealth can be held in bonds, which pay positive interest rate, i.

Demand for money (Md) – the amount of money people want to hold. The demand for money for the economy as a whole is a sum of all the individual demands for money. Thus, money demand for the economy depends on the overall level of transactions in the economy and on the interest rate. The overall level of transactions is roughly proportional to nominal income: if nominal income increases by 10%, it is reasonable to think that the amount of transactions in the economy also increases by roughly 10%. The relation between the demand for money, nominal income, and the interest rate is as follows:

 

Md = $Y*L(i)

(-)

 

The demand for money Md is equal to nominal income, $Y, times a function of the interest rate, i, denoted by L(i). The minus sign under L(i) shows that the interest rate has a negative effect on money demand, i.e. increase in the interest rate decreases the demand for money. Thus, the demand of money depends positively on the level of income and negatively on the interest rate.

Money supply (Ms)

There are two suppliers of money:

1) Central bank, which supplies currency. The CB changes the supply of money through open-market operations, i.e. by buying or selling bonds in the “open-market” for bonds. If it wants to increase the amount of money in the economy, it buys bonds and pays for them by creating money. If it wants to decrease the amount of money in the economy, it sells bonds, and removes from circulation the money it receives in exchange for the bonds.

2) Commercial banks, which supplies checkable deposits. Banks act as financial intermediaries, institutions that receive funds from depositors, and use these funds to buy bonds or stocks, or make loans to other people and firms.

Equilibrium in the money market

Equilibrium in the money market requires that money supply be equal to money demand, that Ms=Md. Then, using Ms=M, and equation for money demand (Md = $Y*L(i)), the equilibrium condition is

Money supply = Money demand

M=$Y*L(i)

This equation tells us that the interest i must be such that, given their income $Y, people are willing to hold an amount of money equal to the existing money supply M.

Characteristics:

-A growth in nominal income increases the level of transactions in the economy, which leads to an increase in demand for money, as a result the interest rate grow. (Money demand curve shifts to the right)

-An increase in the supply of money leads to a decrease in the interest rate. (Money supply curve shifts to the right)