Demand for Money and its relationship to Money Supply

There are two theories for demanding money: Classical and Keynesian. In accordance with classical theory, money is a medium of exchange in that it facilitates the exchange of goods and services. This theory suggests that the demand for money can be expressed in terms of the cyclical speed of the economy. In accordance with the classical economist Fisher, the relationship between the money supply (M), velocity (V), price level (P), and the total quantity of goods or services exchanged for money (T) is given by can do.: MV= PT, where PT represents the demand for money which depends on price level and total amount of commodities or services that can be exchanged for money in the economy (Welch, Ivo). MV on the other hand represents money supply. At equilibrium, the demand for money equals money supply and thus the above equation can be expressed as follows: Md = PT.

The above equation expresses transactions demand for money and it is known as Fisher’s equation of exchange. The main assumption under Classical theory is that individuals hold money for transaction purposes (Rahman). This means that demand for money is also determined by the full level of employment in the economy since when people are employed they earn incomes which increases their purchasing power for various goods or services.

However, the Classical theory has two major shortcomings. Firstly, individuals do not hold money for transactions purposes only, but also for investment purposes or for unforeseen circumstances (Rahman). Secondly, Classical theory assumes that money is only used as a medium of exchange and thus ignoring the asset function money (Friedman, David H). Thus, Keynes came up with Keynesian theory to address weaknesses of Classical theory.

Keynesian theory suggests that there are three motives that lead to demand for money in an economy: transactions motive, precautionary motive, and speculative motive. The transactions motive arises from the function of money as a medium of exchange whereby individuals or businesses demand for money to purchase various goods or services (Welch, Ivo). According to Keynes, transactions demand for money depends on the level of individuals’ income, the interest rates and the business turnover.

The transactions demand for money is directly proportional to the level of income. This means that as the level of income increases, the proportion of income set aside for transaction purposes also increases and vice versa. This relationship can be expressed in the equation L1=kY , where L1 is the transactions demand for money, Y is the level of income and k is the proportion of income set aside for transactions purposes (Welch, Ivo). However, the transactions demand for money is inversely related to interest rates. This implies that as interest rates rise, the transaction demand for money declines.

The precautionary motive relates to the idea that sometimes unforeseen events may occur and hence the need for individuals or businesses to have money for such purposes. This gives rise precautionary demand for money. According to Keynes, precautionary demand for money depends on the level of income, opportunities for unexpected profitable deals, or the additional expenses of holding liquid assets in bank reserves.

Lastly, the speculative motive is related to idea of predicting what money will bring forth in the future (Welch, Ivo). In this case, after setting aside enough money for transaction and precautionary purposes, individuals or businesses may invest their surplus money in bonds with the hope to gain in future. This gives rise to speculative demand for money. It is important to note that money held for speculative purposes is liquid and hence can be invested in interest bearing bonds or securities. Speculative demand for money is a decreasing function of interest rates. As interest rates rise, the speculative demand for money decreases and vice versa.

Keynesian theory gave rise to the concept of Liquidity Trap to explain speculative demand for money. According to Keynes, speculative demand for money can be so high or totally elastic such that changes in the quantity of money would have no effect on prices or income (Welch, Ivo). This is known as Liquidity Trap. However, it is imperative to note that Liquidity Trap only happens when market interest rates are very low such that yields on securities such as bonds and equities are very low (Welch, Ivo). In this case, when interest rates are very low it becomes riskier to hold bonds due to their perceived low returns and hence individuals prefer to hold money in cash rather than investing in bonds.

Interactions between Fiscal and Monetary Policy using the Keynesian IS and LM curves

Fiscal policy is a policy by the government that targets the total level of spending or the total composition of spending in an economy (Welch, Ivo). The two commonly used fiscal policy tools are changes in government spending and changes in tax policy. Monetary policy on the other hand is a policy by the government concerned with the management of interest rates and total money supply in the economy (Welch, Ivo). The Keynesian IS-LM curve plots the relationship between interest rates and national income. Changes in fiscal policies causes a shift in IS curve whereas changes in monetary policies causes a shift in LM curve. Fiscal and monetary policies can either expansionary or contractionary.

The government uses expansionary fiscal and monetary policies to influence overall GDP growth in the economy. Expansionary fiscal policies are either in form of an increase in government expenditure or reduction in taxes. In this case, an increase in government expenditure leads to an increase in the level of national income. This is in turn leads to an increase in aggregate demand for goods and services and hence casing the IS curve to shift rightwards (Welch, Ivo). However, it is worth to note that the rightward shift in IS curve as a result of increase in government expenditure also leads to a rise in interest rates which have a negative impact on private investment due to the crowding-out effect (Welch, Ivo).

When government reduces taxes, individuals’ disposable income increases leading to a rightward shift in IS curve. However, the rise in disposable income as a result of reduction in taxes also leads an increase in interest rates which have a crowding-effect on private investment.

An expansionary monetary policy involves expansion of money supply in the economy. In this case, when the economy is in a recession, the government through central bank is compelled to increase money supply in the economy (Welch, Ivo). The increase in money, holding other factors constant such as demand for money will lead to a fall in interest rates. A reduction in interest rates will act as an incentive to investors in that it will motivate them to engage in more investments. Increased investments leads to an increase in aggregate demand and income and this in turn causes the LM curve to shift rightwards.

It is imperative to note that increase in money supply leads to increased aggregate demand for goods and services in the economy. Furthermore, an increase in money supply leads to a reduction in interest rates and thus stimulating private investments. Thus, the rise in GDP associated with an expansionary monetary policy is higher compared to rise in GDP associated with an expansionary fiscal policy.

Major types of financial intermediaries in the U.S

A financial intermediary is a firm or an institution that facilitates indirect channeling of funds between different parties engaged in a financial transaction (Welch, Ivo). An example of a financial intermediary is a bank that lends depositors’ money to businesses and in turn pays interest to depositors. In the U.S, financial intermediaries are placed in two major categories: monetary (bank) and non-monetary (non-bank) intermediaries. Monetary intermediaries include the central bank and commercial banks. An important characteristic of monetary intermediaries is that they issue indirect debt of their own when soliciting funds (Welch, Ivo). When monetary intermediaries issue indirect debt in exchange of funds, their balance sheets show a high proportion of financial to tangible assets as well as high proportion of indirect liabilities to equity. It is also worth noting that for monetary intermediaries, their assets include loans while their liabilities include deposits and payment obligations.

Non-monetary intermediaries on the other hand include depositary intermediaries (credit banks and mutual savings banks), insurance and pension intermediaries, finance companies, investment companies, agricultural credit organizations and government lending institutions (Welch, Ivo). Non-monetary intermediaries can be further grouped as governmental and private. They may also be primary such that they only deal with general public, or secondary whereby they deal with financial institutions. Moreover, non-monetary institutions may be grouped according to assets whereby they only lend to borrowers, or grouped as liabilities whereby they borrow at short-term or long-term with or without any payment obligations (Welch, Ivo).

It is imperative to note that non-monetary intermediaries participate in four markets: markets for primary securities; markets for money balances; markets for productive factors; and markets of their own issue of indirect debt (Welch, Ivo). Also, the assets recorded in the balance sheets of non-monetary intermediaries include stocks and bonds, whereas liabilities include payment obligations.

Financial intermediaries can be further grouped as either depositary or non-depositary intermediaries. Depositary intermediaries are those institutions that are legally allowed to accept monetary deposits from customers (Welch, Ivo). Examples include commercial banks, credit unions and savings banks. Non-depositary intermediaries on the other hand do not accept monetary deposits, however, they pool payments of several individuals in form of premiums and either provide credit to others or invest it (Welch, Ivo). Examples include pension funds, securities firms, finance companies and insurance companies. It is worth noting that recently banks have handled majority of financial transactions in the US. This is due to the fact that banks offer depositors safety of their funds and hence reducing financial risks. Banks also provide payment services and hence reducing difficulties in paying bills.

Role of the FOMC and the three major policies it implements to help regulate banks

The Federal Open Market Committee (FOMC) is tasked with formulating the US’s monetary policy. Basically, the organization structure of FOMC comprises board of governors with seven members and five Reserve Bank presidents. The FOMC implements three major policies to help regulate banks. Firstly, they control open market operations which includes buying and selling of government securities in the open market so as to expand or contract the amount of money in the banking system. Secondly, they set the discount rate or the interest rate that banks pay on short-term loans from a Federal Reserve Bank. Lastly, they set reserve requirements which include the amount of tangible funds that depositary intermediaries are required to hold in reserve against deposits in banks.

Bank reserves include the amount of cash physically available that a bank has not yet invested or advance as loans (Friedman, David H). The Federal Reserve in the US requires banks to maintain a certain proportion of their total deposits as required reserves. The bank reserves which exceed required reserves are known as excess reserves. Hence the equation for measuring bank reserves is expressed as follows:

Bank Reserves = Required Reserves + Excess Reserves

As discussed earlier, the FOMC is charged with controlling open-market operations which involves trading the securities. The overarching goal of buying and selling securities is to affect the federal funds rate. In this case, the federal funds rate is the rate at which banks borrow reserves from each other (Friedman, David H). The FOMC sets a target for federal funds rate. Usually, the interest rate that banks pay on short-term loans from a Federal Reserve Bank is lower than the federal funds rate.

References

Friedman, David H. Money & Banking. 1st ed., Washington, D.C, American Bankers

Association, 2003.

Rahman, Nahid. Corporate Finance. 1st ed. North Ryde: McGraw-Hill Australia, 2015.

Welch, Ivo. Corporate Finance. 1st ed., Los Angeles, Ivo Welch, 2014.