Concise Notes on Money Demand, Supply, and Monetary Policy

Money Demand

• Desire to hold money for transactions, precautionary, and speculative purposes.

• Crucial determinant of interest rates, inflation levels, and overall economic stability.

• Factors Influencing Money Demand

  • Income: Higher incomes correlate with increased spending and thus, higher money demand.

  • Interest Rates: Money demand is inversely related to interest rates; higher interest rates mean people prefer to invest money.

  • Price Level: The nominal demand for money is directly proportional to the price level.

  • Risk: Increased uncertainty in the economy may cause investors to increase their demand for money

• Types:

  • Transaction Demand: Money held for daily transactions; depends on income levels.

  • Precautionary Demand: Money held for unexpected expenses or emergencies; varies with income and perceived risk.

  • Speculative Demand: Money held to exploit investment opportunities; depends on interest rates and economic outlook.

• Factors:

  • Interest Rates: Higher rates reduce demand as opportunity cost of holding cash increases.

  • Income Level: Higher income increases demand due to more transactions.

  • Inflation Expectations: High inflation lowers demand as purchasing power decreases.

  • Financial Innovation: Reduces cash holdings through easier access to funds.

Factors Shifting Money Demand

• Aggregate Price Level: Increase raises demand, decrease reduces it. Directly proportional.

• Real GDP: Higher GDP increases demand, decline reduces it because of more transactions.

• Financial Technology: Decreases demand, shifts curve leftward; examples include mobile banking and credit cards.

• Institutional Changes: Influence money demand through regulatory and structural effects.

Factors Shifting Money Supply

• Central Bank Policies:

  • Open Market Operations (OMOs): Buying securities increases supply, selling decreases it. Injection or withdrawal of liquidity.

  • Reserve Requirements: Lowering increases supply, raising decreases it. Changes the amount banks can lend.

  • Interest Rates: Lower rates expand supply, higher rates contract it. Affects borrowing costs.

• Commercial Bank Lending:

  • Credit Creation: More loans expand supply, restricting contracts it. Depends on bank’s risk appetite.

  • Public Confidence: Influences lending and borrowing. Impacts stability of banking system.

• Government Fiscal Policies:

  • Deficit Spending: May increase supply; depends on financing method.

  • Taxation: Indirectly affects supply by influencing disposable income.

• Foreign Exchange Operations:

  • Currency Interventions: Affect domestic money supply. Buying or selling domestic currency.

Bank Responses to Reserve Shortages

1. Call loans: Reduce lending to meet reserve requirements.

2. Sell assets: Liquidate investments to increase reserves.

3. Borrow from Central Bank (at discount rate): Often a last resort due to stigma.

4. Borrow from commercial banks (at policy rate): Short-term solution in interbank market.

Policy Rate

• Central banks adjust to stimulate or cool down economy. Impacting borrowing and investment.

• Lowering encourages borrowing, raising controls inflation. Tool for managing economic cycles.

• Türkiye example: CBRT uses one-week repo auction rate. Key determinant of short-term interest rates.

How Monetary Policy Works

• Expansionary Monetary Policy:

  • Increase money supply, lower interest rates to stimulate activity. Encourages borrowing and spending.

  • Tools:

    • Lowering Policy Rates: Reduces borrowing costs for banks and consumers.

    • Open Market Operations (OMOs): Purchases government securities to inject money into the economy.

    • Reducing Reserve Requirements: Banks can lend more, increasing money supply.

  • Türkiye example: CBRT reduced rate to 45% in January 2025 to combat economic slowdown.

• Contractionary Monetary Policy:

  • Decrease money supply, increase interest rates to curb growth and inflation. Discourages borrowing and spending.

  • Tools:

    • Raising Policy Rates: Increases borrowing costs.

    • Open Market Operations (OMOs): Sells government securities to reduce money supply.

    • Increasing Reserve Requirements: Limits bank lending.

Lags in Monetary Policy

• Recognition Lag: Delay in recognizing economic event (3-6 months). Due to data collection and analysis.

• Impact Lag: Delay between policy implementation and observable effects. Monetary policy affects the real economy over time.

Loanable Funds Market

• Real Interest Rate: Interest rate after allowing for inflation, representing the true cost of borrowing. $Real\ Interest\ Rate ≈ Nominal\ Interest\ Rate − Inflation\ Rate$

• Components:

  • Supply of Loanable Funds: Savings from households, businesses, governments (upward-sloping). Influenced by income, expectations, and fiscal policy.

  • Demand for Loanable Funds: Borrowers seeking capital (downward-sloping). Driven by investment opportunities and consumer needs.

• Equilibrium Interest Rate: Where supply equals demand. Determines market-clearing interest rate.

Disequilibrium

• Excess Supply (Surplus):

  • Interest rate above equilibrium. More funds available than demanded.

  • Downward pressure on interest rate to reach equilibrium.

• Excess Demand (Shortage):

  • Interest rate below equilibrium. More demand for funds than available supply.

  • Upward pressure on interest rate to reach equilibrium.

Shifts in Loanable Funds Market

• Supply Shifts: Changes in savings rates, government budget, foreign capital inflows. Affects availability of loanable funds.

• Demand Shifts: Changes in business investment, consumer confidence, government borrowing. Alters borrowing needs and investment opportunities.