Chapter Notes: Money Demand, Money Supply & Interest Rate Determination
Hey everyone! Welcome to a super important topic in macroeconomics. Ever wondered why the interest rate on your savings account changes, or why it costs more to borrow money sometimes? This chapter holds the answers! We're going to break down how the 'price' of money – the interest rate – is decided in the economy. It might sound complex, but we'll take it step-by-step. Understanding this helps you understand big news stories about the economy and even your own personal finance decisions. Let's get started!
1. The Demand for Money (Md)
First things first, when economists talk about the 'demand for money', they don't mean 'the desire to be rich'. We all want that! Instead, it means: how much of your wealth you want to hold as actual money (like cash or in your bank account) instead of other assets (like stocks or property).
Think of it this way: You have $50,000 in savings. Do you keep it all as cash under your bed? Or put it in a savings account? Or use it to buy stocks? The amount you decide to keep as cash or in a simple bank account is your demand for money.
There are two main reasons why we hold money:
Transactions Demand for Money
This is the most obvious reason. We need money for our day-to-day buying and selling.
- What it is: Money held for the purpose of making everyday purchases. It's the money you use for lunch, MTR rides, shopping, and paying bills.
- Main Factor Affecting It: Income (Y). The more income you have, the more you tend to spend. To spend more, you need to hold more money. Therefore, there is a positive relationship between income and transactions demand.
Example: A university student might only need $200 in their wallet for a few days, but a high-earning professional might need $2,000 for their daily expenses, business lunches, and transport. Higher income leads to a higher transactions demand for money.
Quick Review Box
Transactions Demand: Money for daily spending.
When Income (Y) goes UP ↑, Transactions Demand goes UP ↑.
Asset Demand for Money
This is about holding money as a safe place to store your wealth. Money is very liquid (meaning it's easy to spend), and it's very safe (its value doesn't crash overnight like a stock might). However, it comes with a cost!
- What it is: Money held as a store of value, chosen over other assets like bonds or stocks.
- Main Factor Affecting It: Nominal Interest Rate (i). The interest rate is the opportunity cost of holding money.
Don't worry, 'opportunity cost' is simple here!
Imagine you have $10,000. You have two choices:
- Hold it as cash: You earn 0% interest.
- Buy a bond: The bond pays 5% interest per year. You would earn $500.
By choosing to hold the $10,000 as cash, you are giving up the $500 you could have earned. That forgone interest is the opportunity cost. So, the nominal interest rate is the opportunity cost of holding money.
- The Relationship: It's a negative relationship.
- When the interest rate is high (e.g., 10%), the opportunity cost of holding money is very high. You'd rather put your money in assets that earn that high interest. So, your asset demand for money is low.
- When the interest rate is low (e.g., 0.5%), you don't lose much by holding cash. The opportunity cost is low. So, your asset demand for money is high.
Quick Review Box
Asset Demand: Holding money as a safe store of wealth.
When the Nominal Interest Rate (i) goes UP ↑, the opportunity cost of holding money goes UP ↑, so Asset Demand goes DOWN ↓.
The Overall Money Demand (Md) Curve
If we put this all on a graph with the nominal interest rate on the y-axis and the quantity of money on the x-axis, the Money Demand (Md) curve slopes downwards. This shows the negative relationship between the interest rate and the quantity of money demanded.
- A change in the interest rate causes a movement along the Md curve.
- A change in income causes a shift of the entire Md curve. (Higher income shifts Md to the right).
Key Takeaway for Money Demand
People demand money for two reasons: transactions (related to income) and as a safe asset (related to the interest rate). The overall demand for money increases when income rises and decreases when the nominal interest rate rises.
2. The Supply of Money (Ms)
This part is much more straightforward! The money supply is the total amount of money circulating in an economy.
Who Controls the Money Supply?
In our simple model, we assume the money supply is controlled by the central bank. In Hong Kong, this role is largely performed by the Hong Kong Monetary Authority (HKMA).
The central bank determines the amount of money in the economy through its policies. This means the quantity of money supplied does NOT depend on the interest rate.
The Money Supply (Ms) Curve
Because the money supply is fixed by the central bank at any given time, regardless of the interest rate, the Money Supply (Ms) curve is a vertical line.
- If the central bank decides to increase the money supply, the vertical Ms curve shifts to the right.
- If the central bank decides to decrease the money supply, the vertical Ms curve shifts to the left.
Did you know?
Unlike in most countries where only the central bank issues currency, Hong Kong's banknotes are issued by three commercial banks: HSBC, Standard Chartered Bank, and Bank of China. The HKMA authorises and oversees this process, effectively controlling the money supply.
Key Takeaway for Money Supply
The money supply is determined by the central bank and is independent of the interest rate. Its curve is a vertical line.
3. Interest Rate Determination: The Money Market
Now, let's put demand and supply together to find the price! The "market" for money is called the money market. The "price" of money is the equilibrium interest rate.
The equilibrium interest rate is found where the quantity of money demanded equals the quantity of money supplied. On a graph, this is where the downward-sloping Md curve intersects the vertical Ms curve.
Reaching Equilibrium
What if the interest rate isn't at the equilibrium level? The market will naturally adjust.
Case 1: Interest Rate is too High
If the current interest rate is above equilibrium, the quantity of money supplied is greater than the quantity demanded (Ms > Md). This is a surplus of money.
- People are holding more money than they want to at that high interest rate.
- They will try to get rid of this excess money by buying interest-earning assets, like bonds.
- This increased demand for bonds pushes their price up.
- Important: When bond prices go up, their effective interest rate goes down.
- The interest rate will continue to fall until it reaches the equilibrium level where Md = Ms.
Case 2: Interest Rate is too Low
If the current interest rate is below equilibrium, the quantity of money demanded is greater than the quantity supplied (Md > Ms). This is a shortage of money.
- People want to hold more money than is available in the economy.
- To get more money, they will sell their assets, like bonds.
- This increased supply of bonds for sale pushes their price down.
- When bond prices go down, their effective interest rate goes up.
- The interest rate will continue to rise until it reaches the equilibrium level where Md = Ms.
Shifting the Equilibrium: What Changes the Interest Rate?
This is the crucial part for exams! The interest rate changes when either the Ms or Md curve shifts.
Scenario A: Change in Money Supply
Let's say the HKMA increases the money supply.
- The vertical Ms curve shifts to the right.
- At the old interest rate, there is now a surplus of money (the new Ms is greater than Md).
- People have excess money, so they buy bonds.
- Bond prices rise, and the interest rate falls.
- This continues until a new, lower equilibrium interest rate is reached.
Conclusion: An increase in money supply leads to a decrease in the equilibrium interest rate. (And vice-versa!)
Scenario B: Change in Money Demand
Let's say there is strong economic growth and everyone's income increases.
- The transactions demand for money rises.
- The entire Md curve shifts to the right.
- At the old interest rate, there is now a shortage of money (the new Md is greater than Ms).
- People need more money for transactions, so they sell bonds to get cash.
- Bond prices fall, and the interest rate rises.
- This continues until a new, higher equilibrium interest rate is reached.
Conclusion: An increase in money demand (due to higher income) leads to an increase in the equilibrium interest rate. (And vice-versa!)
Key Takeaway for Interest Rate Determination
The nominal interest rate is determined by the interaction of money demand and money supply. It is the rate that balances the market. Any policy that changes the money supply (Ms) or any economic event that changes money demand (Md) will lead to a new equilibrium interest rate.