SUPPLY AND DEMAND

FOR MONEY
PMCF7
3.8.23
KEY MEASURES FOR THE MONEY SUPPLY
 • M1. The narrowest measure of the money supply. It includes currency in
circulation held by nonbank public, demand deposits, other checkable
deposits, and traveler’s checks. M1 refers primarily to money used as
medium of exchange.
 • M2. In addition to M1, this measure includes money held in savings
deposits, money market deposit accounts, noninstitutional money market
mutual funds and short-term money market assets (e.g. “overnight”
Eurodollars). M2 refers primarily to money used as a store of value.
 • M3. In addition to M2, this measure includes the financial institutions,
(large-denominations time deposits and term Eurodollars). M3 refers
primarily to money used as a unit of account.
 • L. In addition to M3, this measure includes liquid and near-liquid assets
(e.g., short-term Treasury notes, high-grade commercial paper and bank
acceptance notes).
THE DEMAND FOR MONEY
 • Transaction demand
 Money demanded for day-to-day payment through balances held by
households and firms (instead of stocks, bonds or other assets). This kind of
demand varied with GDP; it does not depend on the rate of interest.
 • Precautionary demand
 Money demanded as a result of unanticipated payments. This kind of
demand varies with GDP.
 • Speculative demand
 Money demanded because of expectations about interest rates in the
future. This means that people will decide to expand their money balances
and hold off on bond purchases if they expect interest rates to rise. This kind
of demand has a negative relationship with the interest rate.
THE IMPACT OF MONEY

 higher interest rates will decrease the investment because it becomes more
expensive to borrow money, tend to decrease consumption
 higher Philippine interest rates increase the demand for pesos on the
foreign exchange markets (because of the higher returns on Philippines
deposits)
 the higher pesos will decrease exports by making them increasingly
expensive
 real GDP growth and the inflation rate slow when the BSP raises the interest
rate
THE QUANTITY THEORY OF MONEY
 The quantity theory of money holds the changes in the money supply MS directly
influences the economy’s price level, but nothing else. This theory follows from the
equation of exchange:

 Where M = quantity of money

 V = velocity of money (i.e. the average number of times a unit of
money is used during a year to purchased GDP’s goods and
services)
 P = price level
 Y = real GDP


 MxV=PxY
 The quantity theory of money states that in an economy, the money supply and price
levels are in direct proportion to one another. When the money supply changes, there
is a proportional change in price levels, and when price levels change, the money
supply changes by the same proportion
INTEREST RATES
 From the viewpoint of potential borrower, the interest rate is the premium that must
paid in order to acquire goods sooner and pay for them later

 From the lender’s viewpoint, it is a reward for waiting – a payment for supplying
others with current purchasing power. The interest rates allow the lender to
calculate the future benefit (future payments earned) of extending a loan or saving
funds today.
 It is the earlier availability of goods and services purchased, not the money itself
that is desired by the borrower.
THEORIES FOR DETERMINING THE INTEREST
RATE
 Marginal Productivity Theory:
This theory simply states that the marginal productivity of capital determines the rate of interest. Interest
is paid because capital is productive and is equal to the marginal product of capital
 Demand and Supply Theory:
According to this theory, the demand for and the supply of capital jointly determine the rate of interest.
The demand for capital is governed by its marginal product and the supply of capital by waiting or
saving.
 Abstinence or Waiting Theory:
This theory holds the view that interest is the reward for the abstinence from the present consumption.
People save to create capital- goods, but saving implies the abstinence from, or the sacrifice of,
present consumption. The abstinence is, however, unpleasant. Most people do not like it. So, interest
must be paid to induce the people for making the sacrifice of the present consumption.
CON’T.
 ‘Agio’ or the ‘Time Preference’ Theory:
According to the Austrian economist Bohm- Bawerk, interest is the agio or premium which
the present consumption has over the future consumption of the same amount. Later on,
Fisher developed the time-preference theory on the basis of the agio theory. According to
him, interest functions as a price in exchange between present and future goods.
As he put it, “The theory of interest is one of investment opportunity and human impatience
as well as exchange.”
 Loanable Funds Theory:
The neoclassical writers hold the view that the rate of interest is the price for the use of
loan-capital and is determined by the demand for, and the supply of, loanable funds.
 Liquidity-Preference Theory:
According to Lord Keynes, the rate of interest is determined by the demand for and the
supply of money. Interest is the reward for parting with liquidity for a specified period of
time
The Loanable Funds Theory:
 The rate of interest is price paid for using someone else’s money for a specified
time period. According to Dennis Roberston and neo-classical economists this
price or the rate of interest is determined by the demand for and supply of loanable
funds. The market for loanable funds consists of arrangements and procedures to
carry out transactions between people who want to borrow money and people who
want to lend money.
 Demand:
 The demand for loanable funds originates from two basic units of the economy—
consumers and business firms.
 Supply:
 Even though higher interest rates lead to a fall in the amount of borrowing by
consumers and investors, they encourages lenders to make a larger volume of
funds available to the market. Even individuals with a positive rate of time
preference will curtail current consumption to supply more loanable funds in the
market if the rate of interest is reasonably high or sufficiently attractive.
CRITICISMS:
 Major criticisms of the loanable funds are:
 1. The classical writers noted the effect of money on the rate of interest through the
saving- investment process.
 2. Secondly, the loanable funds theory ignores certain real forces exerting influence on
the rate of interest such as the marginal productivity of capital, the abstinence, and time
preference.
 3. In most modern economics, the rate of interest is not determined by the market
forces, i.e., by the forces of demand and supply. Instead, it is determined by institutional
forces, i.e., by the policies and actions of the central bank and the government. Their
policies exert the most important influence on the rate of interest by determining both
the demand for and supply of loanable funds-in the country.
 4. Indeterminate rate of interest: The rate of interest, as pointed out by Keynes, remains
indeterminate in the theory as the supply of loanable funds cannot be ascertained
without knowing the level of income.
 5. Interest is not the reward of saving: Interest cannot be regarded as the reward for
savings as savings in the form of idle cash balances do not bring any interest.
 The points to be said in favor of loanable funds
theory are:
 1. Firstly, it appeals to common sense.
 2. Secondly, it is related to money.
 3. Thirdly, it gives due recognition to the role played by the banking system in the
determination of interest.
 4. Fourthly, due importance is assigned in this theory to demand and for cash balance for
precautionary and speculative purposes.
 5. Finally, it admits the fact that the volume of saving is positively related to the level of income
INTEREST RATES AND RISKS

 Risk Premium + Inflationary Premium + Pure interest

IMPACT OF CHANGING INTERESTS
RATES
Activity:

 1. How low interest rates can impact your personal finances?

 2. How does rising interest rates affect inflation?
 3. How to benefit from low interest rates? From high interest rates?
 4. What would be the effect of low interest rates in financial institution? Or
higher interest rates?
 5. Can financial institution like banks increase money in circulation in
general?
Thank you.