Demand and Supply of Money | CFA Level I Economics

PREREQUISITE LESSON

This lesson is a prerequisite for the course. While you won’t be directly tested on its content in the exam, it’s assumed you’ve gained this knowledge or skill during your university studies. We strongly recommend reviewing this lesson, as its content may be essential for understanding subsequent parts of the curriculum.

In this lesson, we’ll explore the demand and supply of money, discussing sources of money demand, the relationship between money demand and supply with short-term interest rates, and the connection between money supply and the price level in an economy.

Sources of Demand for Money

The demand for money refers to the amount of wealth that households and firms in an economy choose to hold in the form of money, which includes notes and coins in circulation, as well as very liquid bank deposits. There are three main reasons for holding money:

1. Transaction demand: Money needed for undertaking transactions like paying employee salaries and purchasing goods and services. As real GDP increases, demand for money to carry out transactions also increases.
2. Precautionary demand: Money held for unforeseen future needs. The total amount of precautionary demand for money increases with the size of the economy.
3. Speculative demand: Money set aside to take advantage of future investment opportunities.

Factors Affecting Speculative Demand

There are several key factors that influence the level of speculative demand for money:

1. Expected returns: Speculative demand is inversely related to returns available in the market. Higher returns from bonds and other financial instruments reduce speculative money balances.
2. Perceived risk: Speculative demand is positively related to perceived risk in the market. When risk is perceived to be higher, people choose to reduce exposure to risky assets and hold money instead.
3. Short-term interest rates: Demand for money for speculative reasons is inversely related to short-term interest rates. Lower interest rates encourage higher money demand, while higher interest rates increase the opportunity cost of holding money and lower speculative demand.

Money Demand, Money Supply, and Short-Term Interest Rates

When plotted against nominal interest rates, the money demand curve is downward sloping. The money supply, determined by the central bank, is independent of the interest rate and has a perfectly inelastic supply curve. Short-term interest rates are determined by the equilibrium between money supply and money demand.

A central bank can affect short-term interest rates by increasing or decreasing the money supply. For example, increasing the money supply shifts the money supply curve to the right, causing the equilibrium rate to fall and pressuring market interest rates to follow. Conversely, decreasing the money supply results in higher interest rates.

Money Neutrality and the Quantity Theory of Money

Some economists believe that in the long run, an increase in the money supply results in an increase in the aggregate price level, while real output and money velocity remain unchanged. This belief is referred to as money neutrality.

The quantity theory of money states that the quantity of money is proportional to the total spending in an economy. The theory is explained with the quantity equation of exchange:

MV = PY

Where M is the money supply, V is the velocity of circulation of money, P is the average price level, and Y is real output.

Monetarists assume that velocity and real output change very slowly. Thus, any increase in the money supply will lead to a proportionate increase in the price level. For example, a 10% increase in the money supply will increase the price of goods and services by 10%. This supports the money neutrality belief that when the money supply is increased, real output and money velocity remain unchanged, resulting in an increase in the aggregate price level.

Monetary Policy and Inflation Control

Monetarists argue that monetary policy, which regulates the supply of money, can be used to control inflation in an economy. By managing the money supply, central banks can influence short-term interest rates and, consequently, the overall price level.

Conclusion

That wraps up our lesson on the demand and supply of money. We’ve explored the reasons behind money demand, the factors affecting speculative demand, the relationship between money demand and supply with short-term interest rates, and the concept of money neutrality.