Money Supply and Demand Overview

Money Supply Definitions

  • Monetary Base (High Powered Money)
    • Narrow (M0): Cash outside Central Bank ~ £94bn (4% GDP)
    • Wide (M1-3): Cash + banks’ operational deposits with Central Bank
  • Broad Money (M4): M0 + deposits in retail and wholesale banks, sterling certificates, sight and time deposits ~ £3tn (132% GDP)

Complications in Money Supply

  • Variability in bank liquidity needs due to seasons/economic climate.
  • Inclusion of various bank liabilities complicates liquidity assessment.

Determinants of Money Supply

  • Central Bank Behavior: Creates new money when low levels of money supply are observed.
  • Household Behavior: Allocation of wealth affects bank multiplier and money supply.
  • Bank Behavior: Liquidity ratios impact money supply.
  • International Finance: Inflows/outflows of funds affect money supply size.
  • Government Budget Deficits: Central Bank financing through securities can increase money supply.

Money Supply and Interest Rate

  • Conventional theory: Money supply is exogenous and independent of interest rates.
  • Alternative models (Keynesian/Post-Keynesian): Money supply may increase with rising interest due to demand for credit.
  • Higher interest rates can lead to an increase in deposits from abroad.

Determinants of Money Demand

  • Transactions Motive: More transactions increase money demand.
  • Precautionary Motive: Hold cash for unexpected needs.
  • Speculative Motive: Hold cash while waiting for lower asset prices.

Liquidity Preference**

  • Cash: Liquid but low return.
  • Bonds/Shares: Illiquid but higher potential returns.
  • Trade-off between liquidity and returns.

Money Demand (L)

  • Total Money Demand: L = L1 + L2
    • L1: Transaction and precautionary demand, affected by income and interest rates.
    • L2: Speculative demand, influenced by expectations and interest rates.

Money Market Equilibrium

  • Equilibrium occurs when total money demand equals total money supply.
  • Average interest rates reflect various asset demands.

Quantity Theory of Money

  • Formula: MV = PY
    • M: Money supply
    • V: Velocity of circulation
    • P: Price level
    • Y: Real GDP
  • Changes in money supply can impact price levels when GDP and velocity are constant.