Demand for Money, Supply of Money and Monetary Policy

Dr. Shylajan, C.S

Topics of Discussion
     

Money Supply Money Stock Measures The Money Market: DD & SS The Demand for Money: Keynesian Theory Determination of Interest Rates: Classical vs Keynesian Theory Monitory Transmission Mechanism (Change in Monetary Policy and Impacts on Interest Rate, Consumption, Investment, AD and GDP) Nominal Vs Real Interest Rates

Money Supply-How is it Supplydefined

  

Money is a medium of exchange. It is what we use to make payments What is that we use to make payments? Currency and Chequeable deposits with banks

Components of Money Supply

  

Narrow Money (M1) Broad Money (M3) M1 = Currency with public + saving (demand) deposits with banks + other deposist with RBI M3 = M1 + time (fixed) deposits with banks

Why do we Demand Money



 

Role of Money in Classical Theory: Does not influence price, real interest rate and real income. Quantity theory of money: MV=PT Keynesian Theory: 3 motives Transaction demand for money Precautionary demand for money Speculative Demand for Money

Why do we Demand Money

Transaction demand for money
 

Positive function of income Negative function of interest rate

Precautionary demand for money

 

Positive function of income Negative function of interest rate

Why do we Demand Money



Speculative Demand for Money Expected change in interest rates In short, demand for money is a negative function of interest rate and positive function of income Stability of demand for money is the key to proper conduct of monetary policy Md=kY+f( Md=kY+f(i)

 

The Money Market and Determination of Equilibrium Rate of Interest



Interest rate: cost of borrowing money How does the interest rate determined? (both in classical and Keynesian theory) Supply of money and demand for money Interest rate is set by the intersection of DD for and SS of money Md=Ms Md=Ms

 

Determination of Interest RateRate- Graphically



Demand for money is inversely related to interest rate Supply of money is given (determined by Monetary authority, RBI for instance)

Interest Rates


Consumers and investors rely on money for purchase of goods and services. Monetary authority can augment AD or reduce AD by changing money supply and thereby interest rates.

Change in Monetary Policy



Monetary authority may follow a

Easy monetary policy or Tight monetary policy



What is easy and tight monetary policy? Easy Monetary Policy money supply growth increases ..interest rate decline

Change in Monetary Policy



Then what happens to demand for money? Demand for money will increase and Then spending on goods and services increases

Change in Monetary Policy



Tight Monetary Policy ..money supply growth falls ..interest rate increases Then demand for money will fall ..so spending on goods and services falls What kind of monetary policy RBI is following now?

Change in Monetary Policy and Impacts Graphically



ADAD-AS framework

Nominal Vs Real Interest Rates



Real interest rate = Nominal interest rate minus rate of inflation 12% nominal interest rate 3% inflation rate =9 % real interest rate

The Money Supply Process



 

What causes change in money supply? M=C+D Where M is money stock, C is currency with public and D is bank deposits Three groups influence money supply growth 1. Central bank 2.Commercial Bank 3. Public

Money Multiplier
  

Money multiplier (m) = M3/H M3 = Currency with Public + Deposits High powered money = Currency + Reserves Where m is money multiplier M3 is total money supply

Control of Money Supply by RBI

Instruments of Control Changing Reserve Requirements (CRR, for instance) Changing the Bank Rate Direct Credit Controls

Monetary Policy Transmission Mechanism

 Money

supply change  Effect on interest rate r  Impact on business spending  Impact on consumer spending  Impact on Output or GDP

Monetary Policy in the ADAD- AS Framework

Two Cases


The case of increase in AD where potential output is not achieved The case of increase in AD and its impact on output and price when potential output is reached Graphical approach

Monetary Policy in India



Changes in major Monetary Policy Measures: Bank Rate Cash Reserve Ratio (CRR) Statutory Liquidity Ratio (SLR)

  

Monetary Policy in India

        

Bank Rate in 1999: In 2003 : In 2007 : CRR in 1991 In 2004 In 2007 SLR in 1992 In 1997 In 2007 : : : : : :

12 % 6% 6% 15 % 5% 7.50% 38.5 % 25 % 25 %

Summary