What Determines Money Supply and Demand

The supply and demand for money, or more specifically “real money balances” (that is, money with its value adjusted for inflation) is what on a basic level defines the interest rate within an economy. As such it is worth studying what factors will affect the supply and demand for money, as this will affect the interest rate, as well as having an effect on inflation.

– Money Demand –

There are two main theories of money demand. The first is the portfolio theory, which stresses the importance of money as part of a portfolio of assets, which might also include shares, bonds, houses etc. This suggests that demand for money will change when the riskiness of one of those assets changes – so if the riskiness of holding bonds increases, it is likely that you will reduce the amount of bonds you are holding and transfer this into other assets, with the likely result that money demand will increase.

The other theory is the transaction theory. Although there are many types of transaction theory, they all emphasise the importance of money over other assets because it is the only one that is useful for purchasing things. The Baumol-Tobin model of money demand emphasises a balance between the costs and benefits of holding money. The main benefit is convenience, and the consequent ability to buy things when you feel like it if you have enough money on you. The main cost is the foregone interest if you hold your money in your wallet rather than in the bank, as well as any costs incurred withdrawing money from the bank, namely the opportunity cost, or the fact that you have to forgo other activities if you have to go to the bank. So changes in the ease of withdrawing money or the amount of foregone interest will change a person’s demand for money on the Baumol-Tobin model. More ATMs will mean more trips to the bank because each trip is less time consuming, and therefore lower average money holdings and lower demand for money.

– Money Supply –

Three factors affect the money supply – the monetary base (currency plus bank deposits), the reserve-deposit ratio (the fraction of total deposits that banks keep in order to pay people wanting to withdraw their money) and the currency-deposit ratio (the fraction of people’s income that they keep as cash rather than putting it in the bank). The money supply increases and decreases proportionately to the monetary base, the smaller the reserve-deposit ratio the greater the money supply, and the smaller the currency-deposit ratio the greater the money supply as well. This is governed by the equation:

M = (cr + 1) / (cr + rr) x B

Where cr is the currency-deposit ratio, rr is the reserve-deposit ratio, and B is the monetary base. (cr + 1) / (cr + rr) denotes the money multiplier. This multiplier effect is created by banks lending money – the money they lend is either deposited in another bank account, or spent and then deposited, which in turn allows it to be lent again and again, increasing the money supply. If people put all of their income in the bank and banks did not keep any reserves, the multiplier would be infinite. In reality, banks keep reserves to pay people wanting to withdraw their money, and people keep some of the money as currency. This means the multiplier is a finite number, which increases as people put a greater proportion of their money in the bank and banks lend a greater proportion of this money.

The monetary base is simply the amount of money before it is lent and multiplied. If there were no lending, then this would be equal to the money supply.

A country’s central bank can control the three factors in the above equation in order to control the money supply, and therefore theoretically inflation as well. To increase and decrease the monetary base they can buy and sell bonds – selling bonds takes money out of circulation and vice versa. They (or the government) can also print money, which will increase the monetary base, but at the cost of strong inflation. Furthermore they can set a base rate at which they will agree to lend money to banks, which in turn should feed through and cause the banks to raise and lower their interest rates, which in turn will increase or decrease the currency-deposit ratio, as explained by the Baumol-Tobin model. Finally, they may set reserve requirements to force banks to keep a certain proportion of their deposits in reserve, which will increase or decrease the reserve-deposit ratio.