Money supply and demand are crucial concepts in monetary policy. They determine how much money circulates in an economy and why people hold it. Understanding these factors helps explain how central banks influence interest rates and inflation.

The money market balances supply and demand, setting equilibrium interest rates. Changes in supply or demand shift this balance. Long-term, money supply growth can lead to inflation, affecting nominal and real interest rates through the Fisher effect.

Money supply and demand

Determinants of money supply

• Money supply: the total amount of money in circulation in an economy at a given time
  • Includes currency, coins, and various types of bank deposits (checking accounts, savings accounts)
• Key determinants of money supply:
  • Monetary base: currency in circulation and bank reserves held at the central bank
  • Reserve requirement ratio: the fraction of deposits that banks must hold as reserves
  • Money multiplier: the ratio of the money supply to the monetary base, determined by the reserve requirement ratio and the public's preference for holding currency versus bank deposits

Factors influencing money demand

• Money demand: the desire of individuals and businesses to hold money for various purposes
  • Transactions demand: holding money to facilitate regular purchases of goods and services
  • Precautionary demand: holding money as a safety net for unexpected expenses or emergencies
  • Speculative demand: holding money with the intention of investing in assets when favorable opportunities arise
• Key determinants of money demand:
  • Price level: higher prices require more money to conduct transactions
  • Real income: higher income leads to increased spending and demand for money
  • Interest rates: higher interest rates increase the opportunity cost of holding money, reducing money demand
  • Expectations about future economic conditions: optimism may increase spending and money demand, while pessimism may lead to increased saving and reduced money demand

Money market equilibrium

Equilibrium in the money market

• Money market equilibrium: occurs when the quantity of money supplied equals the quantity of money demanded at a given interest rate
  • Graphically represented by the intersection of the money supply and money demand curves
• Equilibrium interest rate: the interest rate at which the money market clears, balancing the supply and demand for money

Factors shifting the money market equilibrium

• Changes in money supply:
  • Open market operations: central bank purchases (expansionary) or sales (contractionary) of government securities, altering the monetary base and money supply
  • Changes in reserve requirement ratio: a lower ratio increases the money multiplier and money supply, while a higher ratio has the opposite effect
• Changes in money demand:
  • Shifts in real income: an increase in income shifts money demand to the right, putting upward pressure on interest rates
  • Changes in price level: higher prices shift money demand to the right, while lower prices shift it to the left
  • Expectations: optimistic expectations may increase money demand, while pessimistic expectations may decrease it

Money, inflation, and interest rates

Money supply and interest rates

• Short-run relationship: an increase in the money supply, all else being equal, tends to put downward pressure on interest rates
  • More money available for lending reduces the "price" of borrowing (interest rates)
• Long-run relationship: an increase in the money supply can lead to higher inflation
  • More money chasing the same amount of goods and services drives up prices
  • Sustained inflation erodes the purchasing power of money over time

Fisher effect and nominal interest rates

• Fisher effect: the relationship between nominal interest rates, real interest rates, and expected inflation
  • Nominal interest rate ≈ Real interest rate + Expected inflation
• Nominal interest rates: the stated interest rate not adjusted for inflation
  • As inflation expectations rise, nominal interest rates tend to increase to compensate lenders for the erosion of purchasing power
• Real interest rates: the nominal interest rate adjusted for inflation
  • Represents the true cost of borrowing and return on lending after accounting for changes in the price level

Measures of money supply

Narrow and broad money supply measures

• Narrow money supply (M1):
  • Includes currency in circulation, demand deposits, and other highly liquid assets
  • Closely related to the transaction demand for money
• Broad money supply (M2):
  • Includes M1 plus savings deposits, small-denomination time deposits, and money market mutual fund shares
  • Captures a wider range of assets that can be used for transactions or converted into cash relatively easily

Implications for monetary policy

• Choice of money supply measure can affect the central bank's assessment of monetary conditions and policy decisions
  • Monitoring different measures provides a more comprehensive view of the money supply
• Monetary aggregates with different liquidity characteristics may have different implications for economic activity and inflation
  • M1 is more closely tied to short-term spending and economic activity
  • M2 may better capture the potential for future spending and inflationary pressures
• Central bank may target a specific money supply measure or use a combination of measures to gauge the stance of monetary policy and its potential impact on the economy
  • Adjusting monetary policy tools (open market operations, discount rate) to influence money supply and achieve macroeconomic objectives (price stability, full employment)