The Demand for Money. Спрос на деньги

The demand for money is the quantity of liquid assets people are willing to have in hand at any given moment. It depends on the income they gain and the opportunity costs connected with the interest rate. But why do people hold money at all?

Money is a stock. It is the quantity of circulating currency and bank deposits held at any given time. Holding money is not the same as spending money when we buy a meal or go to the cinema. We hold money in order to spend it later.

The distinguishing feature of money is its use as a medium of exchange, for which it must also serve as a store of value. It is in these two functions of money that we must seek the reasons why people wish to hold it.

The Transactions Motive for holding money. In a monetary economy we use money to purchase goods and services and receive money in exchange for the goods and services we sell. Without money, making transactions by direct barter would be costly in time and effort. Holding money economizes on the time and effort involved in undertaking transactions.We need to hold money between receiving payments and making subsequent purchases.

How much money we need to hold depends on two things, the value of the transactions we wish to make and the degree of synchronization of our payments and receipts. We do not know how much $100 will buy until we know the price of goods. If all prices double, we will need to hold twice as much money to make the same transactions as before.

The demand for money is a demand for real money.We need a given amount of real money to undertake a given quantity of total transactions.

The Precautionary Motive for holding money. Thus far we have assumed that people know exactly when they will obtain receipts and make payments. But of course we live in an uncertain world. Tills uncertainty about the precise timing of receipts and payments gives rise to a precautionary motive for holding money. Suppose you decide to buy a lot of interest-earning bonds and try to get by with only a small amount of money holdings. You are walking down the street and spot a great bargain in a shop window. But you do not have enough money to take advantage immediately of this opportunity. By the time you have arranged for some of your interest-earning bonds to be sold off in exchange for money, the sale may be over. Someone else may have snapped up the video recorder on sale at half-price. This is the precautionary motive for holding money. In advance, we decide to hold money to meet contingencies the exact nature of which we cannot foresee.

Together, the transactions and the precautionary motives provide the main reasons for holding the medium of exchange. They are the motives most relevant to the benefits from holding money.

The Asset Motive for holding money. Suppose we forget all about the need to transact. We think of a wealthy individual or a firm deciding in which assets to hold wealth. At some distant date there may be a prospect of finally spending some of that wealth, but in the short run the objective is to earn a good rate of return.

Some assets, such as industrial shares, on average pay a high rate of return but are also quite risky. Some years their return is very high, but in other years it is negative. When share prices fall, shareholders can make a capital loss, which swamps any dividend payment to which they are entitled. Other assets are much less risky, but their rate of return tends to be much lower than the average return on risky assets. Since people dislike risk, they will not put all their eggs in one basket. As well as holding some risky assets, they will keep some of their wealth in safe assets. Although on average this portfolio will earn a lower rate of return, it will help avoid absolute disaster at hard times.

The asset motive for holding money arises because people dislike risk. People are prepared to sacrifice a high average rate of return to obtain a portfolio with a lower but more predictable rate of return.

THE MONEY MARKET

The money market comprises the demand for money and the money supply. The equilibrium in the money market is such a state of balance when the demand for money from households and businesses is satisfied by the quantity of the money supplied. The equilibrium in the money market is reached by changing bond prices.

People can hold their wealth in various forms — money, bonds, equities, and property. For simplicity we assume that there are only two assets:money, the medium of exchange that pays no interest, andbonds, which we use to stand for all other interest-bearing assets that are not directly a means of payment. As people earn income, they ad to their wealth. As they spend, they deplete their wealth. How should people divide their wealth at any instant between money and bonds to gain the best profits possible and not to incur losses?

There is an obvious cost of holding money.The opportunity cost of holding money is the interest one would have gained if he (she) had held bonds. It naturally follows that people will hold money rather than bonds only if there is a benefit to offset this cost, only if holding money is more profitable than holding bonds. It may happen only when interest rates on bonds are too low to make it profitable to hold bonds.

Suppose the money market is in equilibrium when the interest rate on interest-bearing assets (e.g. Treasury bills and other securities) is 6% and the amount of money demanded is $200 mm. Now suppose the interest rate goes down, say, to 4%. In this case interest-bearing assets are no longer profitable as they can't earn a sufficient return. Hence the demand for money will rise and will lead to a temporary lack of money in the money market. If they lack money, households and businesses are likely to sell bonds they possess for cash. That will cause an increase in the bond supply, which lowers bond prices and rises interest rates on interest-bearing assets. With a higher interest rate the amount of money people are willing to have in hand will decrease again. Consequently, the money supply will adjust to a current demand to reflect a new higher interest rate.

Conversely, the increase in the money supply creates its temporary surplus, which results in the demand for bonds and bond prices going up. The interest rate falls thus restoring balance in the money market, but at a new lower interest rate.

MARKETS AND INTEREST RATES

For each type of investment and for many of their derivatives there is a market. There is a market in money in London. It is not a physical marketplace: dealings take place over the telephone, and the price a borrower pays for the use of money is the interest rate. There are markets in commodities. And there is a market in government bonds and company shares:

the stockmarket. The important thing is that no market is entirely independent of the others. The linking factor is the cost of money (or the return an investor can get on money). If interest rates rise or fall there is likely to be a ripple of movement through all the financial markets. Money will gravitate to where it earns the best return, commensurate with the risk the investor is prepared to take and the length of time for which he can tie up his money. This is the most important mechanism in the financial sphere. As ageneral rule:

A primary market is one in which the government, companies or other bodies can sell new securities to investors to raise cash.

A secondary market is a market in which the investors can buy and sell these securities among each other. The buying and the selling in the secondary market does not directly affect the finances of government and companies. But if investors did not know they could buy and sell securities in the secondary market they might well be reluctant to put up cash for the government or companies by buying securities in the primary market when they were first issued. And the prices established by the buying and selling by investors in the secondary market help to determine the price that government and companies will have to pay next time they need to issue further securities for cash in the primary market. A reasonably liquid secondary market is normally considered vital for a healthy primary market.

MONETARY POLICY

Monetary policy is one of the main instruments of macroeconomics. It is based on the ability of the Central bank to control the money supply, which leads to changes in interest rates and the exchange rate, and therefore in the amount of investment, which influences directly the national output. This method of controlling the economy centres on adjusting the amount of money in circulation in the economy and so the level of spending and economic activity. Monetary policy was first employed as a means of control in the 1950s, but has been more widely used since the 1970s. The Central Bank plays a major role in the implementation of a nation's monetary policy. In some countries (for example, Germany) the Central Bank operates monetary policy independent of government policy. However, the UK's Central Bank, the Bank of England, implements monetary policy on behalf of the government. Monetary policy has three main aspects:

· Controlling the money supply

· Controlling interest rates

· Managing the exchange rate

In this section we study the ways in which a central bank cancontrol the supply of money in the economy. The aim of the authorities when controlling the money supply is to limit the amount borrowed, and hence spent, by businesses and individuals during a inflationary period. It is hoped in this way to limit the level of overall demand in the economy and thus to remove or reduce inflationary pressure. During a recession monetary policy is aimed at increasing the money supply to encourage spendings. We now describe the three most important instruments available to affect the money supply: open market operations, reserve requirements and the discount rate.