Definition of Money
Money is anything that is generally accepted as a means of payment for goods and services and for settling debts.
Examples include notes and coins, and bank deposits that can be used to make payments.
Functions of Money
1. Medium of exchange
Money is used to buy and sell goods and services.
→ Buyers pay money to sellers instead of exchanging goods directly.
→ This removes the need for a double coincidence of wants, which is required in a barter system.
Example: A customer pays ₹500 for a pair of shoes instead of exchanging another product for them.
2. Measure of value (unit of account)
Money provides a common unit for expressing and comparing the values of goods and services.
→ Prices can be stated in the same unit.
→ Consumers can compare prices, and firms can calculate revenue, costs and profit.
Example: A book costing ₹400 can be compared with a bag costing ₹800.
3. Store of value
Money allows people to transfer purchasing power from the present to the future.
→ People can save money and use it later.
→ However, inflation reduces the purchasing power of money because the same amount buys fewer goods and services.
Example: A person saves ₹10,000 to purchase a laptop later. If prices rise significantly, the savings may buy less than before.
4. Standard of deferred payment
Money allows payments to be made in the future.
→ Loans, mortgages and credit purchases can be expressed in monetary terms.
→ Borrowers can repay debts using money at an agreed future date.
Example: A person borrows ₹50,000 and agrees to repay it in monthly instalments.
Characteristics of Good Money
Acceptability
→ People must be willing to accept money as payment.
→ If sellers do not trust or accept it, it cannot function effectively as a medium of exchange.
Durability
→ Money should last for a reasonable period without being damaged or destroyed easily.
Portability
→ Money should be easy to carry and transfer.
Divisibility
→ Money should be available in smaller units so that goods of different values can be purchased.
Recognisability
→ People should be able to identify genuine money and distinguish it from counterfeit money.
Scarcity or limited supply
→ Money should not be available in unlimited quantities.
→ If the money supply increases excessively relative to the economy’s output, inflationary pressure may develop.
Stability of value
→ Money should retain its purchasing power reasonably well over time.
→ High inflation reduces its usefulness as a store of value and makes future prices more difficult to predict.
Money Supply
Definition of Money Supply
The money supply is the total amount of money available in an economy at a particular point in time, measured using a defined monetary aggregate.
It generally includes notes and coins held by the public and certain bank deposits, depending on how the monetary aggregate is defined.
→ A narrow measure includes the most liquid forms of money, such as currency and demand deposits.
→ Broader measures may include savings deposits and other deposits that can be converted into money relatively easily.
→ Money held in bank accounts can be used for payments even though it is not physically held as cash.
Important distinction:
- Money supply refers to the stock of money available at a particular time.
- Income refers to the flow of earnings received over a period.
- Wealth refers to the value of assets owned, minus liabilities.
For example, ₹20,000 in a bank account is part of a person’s monetary assets, while their monthly salary is income.
Quantity Theory of Money
Definition
The quantity theory of money explains the relationship between the money supply, the velocity of circulation, the price level and real transactions in an economy.
The equation is:
MV=PT
Where:
- M = money supply
- V = velocity of circulation of money
- P = average price level
- T = volume of transactions
Meaning of the Equation
Money supply (M)
→ The amount of money available in the economy.
Velocity of circulation (V)
→ The average number of times each unit of money is used for transactions during a given period.
Price level (P)
→ The average price of the goods and services represented in the transactions measure.
Volume of transactions (T)
→ The number or volume of transactions taking place during the period.
Therefore:
→ MV represents the total monetary value of spending.
→ PT represents the total monetary value of transactions.
The two sides must be equal by the definition of the equation.
How the Quantity Theory Explains Inflation
The quantity theory suggests that an increase in the money supply can cause the price level to rise, particularly if the velocity of circulation and the volume of transactions remain unchanged.
Example:
Assume:
- Money supply M=₹1,000 million
- Velocity V=4
- Transactions T=2,000 million units
Using MV=PT:
P=TMV
P=2,0001,000×4=2
The average price per transaction unit is ₹2.
If the money supply doubles to ₹2,000 million while velocity and transactions remain unchanged:
P=2,0002,000×4=4
The average price doubles from ₹2 to ₹4.
Causal chain:
→ Money supply increases → total spending increases, assuming velocity is unchanged → if the volume of transactions does not increase → prices rise.
Assumptions and Limitations
The simplest prediction that a percentage increase in the money supply causes an equal percentage increase in the price level depends on restrictive assumptions.
→ Velocity remains constant: In reality, people may change how frequently they spend or hold money.
→ Transactions or real output remain constant: If firms can increase production, extra spending may increase output rather than prices alone.
→ The increase in money translates into spending: People and firms may hold additional money rather than spend it.
→ The economy’s productive capacity matters: When spare capacity exists, higher demand may increase output and employment. Near full capacity, additional demand is more likely to create inflationary pressure.
The quantity theory is therefore useful for understanding the possible link between money growth and inflation, but it does not mean that every increase in money supply immediately causes an equal increase in prices.
Functions of Commercial Banks
What Are Commercial Banks?
Commercial banks are financial institutions that accept deposits from customers and provide loans and other banking services.
They connect people and businesses that save money with those that need to borrow money.
Providing Deposit Accounts
1. Demand deposit accounts
Demand deposits are bank deposits that customers can withdraw or transfer on demand, subject to the account’s terms.
→ They are highly liquid because they can be used for payments without a lengthy notice period.
→ They commonly include current accounts used by businesses and some other transaction accounts.
→ Customers can make payments through cards, transfers, cheques or other banking facilities.
Example: A business keeps its daily sales receipts in a current account and uses the account to pay suppliers.
2. Savings accounts
Savings accounts allow customers to deposit money, earn interest where offered and withdraw funds according to the account’s terms.
→ They provide a relatively safe and convenient way to hold savings.
→ They help banks attract deposits that can support their lending activities.
→ Some savings accounts may have transaction limits, minimum-balance requirements or other conditions.
Example: A household saves part of its monthly income in a bank account for emergencies.
Lending Money
Commercial banks provide credit to households and businesses. Lending can support consumption, investment and economic activity.
1. Loans
A loan is an agreed amount of money provided by a bank that the borrower must repay, usually with interest, according to specified terms.
→ Loans may be used to buy houses, purchase machinery, finance stock or expand a business.
→ Interest provides income to the bank.
→ If borrowers fail to repay, the bank may suffer losses.
Example: A manufacturer borrows ₹20 lakh to purchase machinery that increases production capacity.
2. Overdrafts
An overdraft allows an account holder to withdraw more money than is available in their account, up to an agreed limit.
→ It provides short-term access to funds.
→ It can help businesses pay wages or suppliers when cash receipts are delayed.
→ Interest and fees may be charged on the amount used.
→ The bank may reduce or withdraw the facility according to the agreement.
Example: A retailer uses an overdraft to pay a supplier before receiving payment from customers.
Holding and Managing Financial Assets and Liabilities
Commercial banks have assets, liabilities and equity.
| Item | Meaning | Example |
|---|---|---|
| Cash and reserves | Funds held to meet withdrawals and payment obligations | Cash in branches and balances held at the central bank |
| Securities | Financial instruments held by the bank | Government bonds |
| Loans | Money lent to customers and other borrowers | Business loans |
| Deposits | Money owed by the bank to its customers | Savings and current account balances |
| Equity | Owners’ funds invested in the bank, including retained earnings | Share capital and accumulated profits |
Understanding the balance sheet:
→ Deposits are liabilities because the bank owes the money to depositors.
→ Loans and securities are assets because they provide future payments or financial value to the bank.
→ Equity provides a financial cushion against losses.
→ Banks must manage their assets and liabilities carefully to remain liquid, solvent and profitable.
Reserve Ratio
The reserve ratio is the proportion of a bank’s relevant deposits or other specified liabilities that it holds as reserves, according to the definition being used.
Reserve ratio=Relevant depositsReserves×100
Example:
A bank holds reserves of ₹20 million against relevant deposits of ₹200 million.
Reserve ratio=20020×100=10%
→ A higher reserve ratio generally means that a larger proportion of deposits is held as reserves.
→ This can strengthen the bank’s ability to meet withdrawals and payment obligations.
→ However, holding more reserves may reduce the funds available for lending, depending on other funding and regulatory constraints.
Important: Actual banking systems do not always operate through a simple fixed-reserve formula. Capital rules, liquidity requirements, demand for credit, risk and central-bank policy also affect lending.
Capital Ratio
A bank’s capital ratio measures its capital relative to a defined measure of its assets or risk-weighted assets.
A common regulatory measure is:
Capital adequacy ratio=Risk-weighted assetsRegulatory capital×100
Example:
A bank has regulatory capital of ₹12 million and risk-weighted assets of ₹100 million.
Capital adequacy ratio=10012×100=12%
→ Capital provides a buffer against unexpected losses.
→ A stronger capital position can improve confidence in the bank.
→ Higher capital requirements may limit how much additional risk a bank can take with a given amount of capital.
Reserve ratio vs capital ratio:
- The reserve ratio concerns reserves held against relevant deposits or liabilities.
- The capital ratio concerns the bank’s own loss-absorbing capital relative to a defined asset measure.
They are not the same thing.
Objectives of Commercial Banks
Commercial banks generally balance three important objectives: liquidity, security and profitability.
1. Liquidity
Liquidity is the ability of a bank to meet withdrawals and payments when they fall due.
→ Banks need cash and readily available funds to meet customer withdrawals.
→ Highly liquid assets usually provide lower returns than some longer-term loans.
→ Holding too few liquid assets may make it difficult to meet withdrawals.
2. Security
Security means protecting the bank’s funds and maintaining its ability to meet its obligations.
→ Banks assess borrowers’ creditworthiness before lending.
→ They may require collateral, credit checks or guarantees.
→ They diversify lending and monitor borrowers to reduce the risk of losses.
→ Excessive lending to risky borrowers can lead to bad debts and threaten the bank’s stability.
3. Profitability
Profitability is the ability of a bank to earn income greater than its costs over time.
→ Banks earn interest on loans and securities, and may receive fees for services.
→ They pay interest on some deposits and incur staff, technology and other operating costs.
→ Lending to riskier borrowers may offer higher interest income but can also lead to greater losses.
The trade-off:
→ Holding more cash can improve liquidity but reduce potential interest income.
→ Lending more money can increase profitability but also raises credit and liquidity risks.
→ Banks must balance earning returns with maintaining sufficient liquidity and financial security.
Causes of Changes in the Money Supply in an Open Economy
An open economy trades goods, services and financial assets with other countries. Its money supply can be affected by commercial bank lending, central-bank actions, government financing and international transactions.
Commercial Banks and Credit Creation
Commercial banks can create deposit money when they make loans.
How credit creation works:
→ A bank grants a loan to a customer.
→ The loan is credited to the customer’s bank account.
→ The customer now has a deposit that can be used for spending.
→ When the customer makes a payment, the recipient may deposit the money into another bank.
→ The receiving bank may use part of its available funds to support further lending, subject to regulation, risk and demand for credit.
→ Further lending can create additional deposits in the banking system.
This process is known as credit creation.
Important: Banks do not simply lend out every rupee deposited with them. Lending depends on capital, liquidity, regulation, creditworthy borrowers, profitability and the availability of settlement funds.
The Bank Credit Multiplier
In a simplified textbook model, the deposit or credit multiplier estimates the maximum potential expansion of deposits from an initial increase in bank reserves.
Credit multiplier=Reserve ratio1
The reserve ratio must be expressed as a decimal.
Example:
If the reserve ratio is 10%:
Credit multiplier=0.101=10
If the banking system receives an additional ₹10 million in reserves, the simplified model gives:
Potential total deposits=₹10 million×10
=₹100 million
This is the potential total deposit expansion in the model, not an automatic or guaranteed outcome.
Assumptions of the simplified multiplier:
→ Banks lend all funds beyond required reserves.
→ Recipients redeposit all loan proceeds in the banking system.
→ Banks maintain a constant reserve ratio.
→ There is sufficient demand for loans from creditworthy borrowers.
→ Capital and other regulatory constraints do not prevent further lending.
Limitations:
→ Customers may hold some money as cash rather than redeposit it.
→ Banks may hold excess reserves.
→ Banks may lack sufficient capital or may be unwilling to lend because of credit risk.
→ Businesses and households may not want to borrow.
→ Central-bank policy and wider economic conditions affect lending.
Therefore, the actual increase in money supply may be smaller or differ substantially from the theoretical multiplier.
Role of the Central Bank
A central bank is the institution responsible for monetary policy and important functions within the banking and financial system.
Its functions commonly include:
→ Issuing banknotes and managing currency.
→ Acting as banker to the government.
→ Holding reserve accounts for commercial banks.
→ Influencing interest rates and monetary conditions.
→ Providing liquidity to the banking system when appropriate.
→ Supervising or supporting the regulation of banks, depending on the country’s institutional arrangements.
How central-bank actions affect money supply:
1. Changing policy interest rates
→ A lower policy rate can reduce borrowing costs.
→ Households and firms may borrow and spend more.
→ Commercial banks may create more deposits through lending.
→ The money supply may increase.
Conversely:
→ Higher interest rates raise borrowing costs.
→ Loan demand may fall.
→ Credit creation and spending may slow.
→ Money supply growth may weaken.
The outcome depends on the response of banks and borrowers.
2. Open market operations
Open market operations involve the central bank buying or selling financial assets, often government securities, to influence banking-system liquidity and short-term interest rates.
→ When the central bank buys securities, it generally adds reserves to the banking system.
→ Greater reserves may make it easier for banks to settle payments and support lending, depending on demand and other constraints.
→ When the central bank sells securities, reserves may be withdrawn from the banking system.
→ This can tighten liquidity and influence interest rates.
3. Reserve requirements
→ A higher required reserve ratio can reduce the proportion of deposits available to support lending in a simplified model.
→ A lower ratio can increase potential lending capacity.
→ The actual impact depends on bank capital, liquidity management, credit demand and the central bank’s operating framework.
Government Deficit Financing
A government budget deficit occurs when government expenditure exceeds government revenue over a period.
The effect on the money supply depends on how the deficit is financed.
1. Borrowing from commercial banks
→ The government borrows from banks.
→ Banks acquire government debt and the government receives funds to spend.
→ Government spending increases deposits received by households and businesses.
→ The money supply may increase, particularly if bank lending expands and the funds remain within the banking system.
2. Borrowing from the non-bank public
→ Households and firms buy government bonds using existing savings.
→ The government spends the borrowed funds.
→ Deposits move between different holders, but the overall effect on the money supply depends on the financial transactions and subsequent banking activity.
→ It does not necessarily create the same increase in money supply as direct central-bank financing.
3. Central-bank financing
→ If the central bank directly finances government spending or purchases government securities in a way that creates additional central-bank money, the monetary base may increase.
→ Government spending places funds into the economy.
→ This can increase broader money supply and aggregate demand.
→ If the economy is near full productive capacity, inflationary pressure may rise.
Important: A budget deficit does not automatically increase the money supply. Its effect depends on the method of financing and the response of banks, borrowers and the central bank.
Quantitative Easing
Quantitative easing (QE) is a monetary policy in which a central bank purchases large quantities of financial assets, usually to lower longer-term interest rates and ease financial conditions when conventional interest-rate policy is insufficient.
How QE works:
→ The central bank purchases assets, often government bonds, from banks or other financial institutions.
→ Payment for these assets generally increases the reserve balances of banks.
→ The additional reserves increase the monetary base.
→ Asset purchases may raise bond prices and lower bond yields.
→ Lower yields and easier financial conditions may encourage borrowing, investment and spending.
→ Commercial banks may create additional deposits if lending expands.
Possible effects:
→ The money supply may increase.
→ Interest rates on longer-term borrowing may fall.
→ Investment and consumption may rise.
→ Aggregate demand may increase, reducing cyclical unemployment.
→ Inflation may rise if spending increases faster than the economy’s ability to produce goods and services.
Limitations:
→ Banks may not increase lending if they lack suitable borrowers or wish to reduce risk.
→ Firms may not invest if confidence is weak.
→ QE may raise asset prices, benefiting existing asset owners more than people who own few assets.
→ Its effects on spending and inflation are uncertain and may take time.
Key distinction: An increase in bank reserves does not guarantee an equal increase in bank lending or the broader money supply.
Changes in the Balance of Payments
The balance of payments records transactions between residents of a country and the rest of the world.
International transactions can affect the domestic money supply, especially when they involve foreign currency being converted into domestic currency through the banking system or central bank.
1. Current-account surplus
A current-account surplus occurs when receipts from trade in goods and services, primary income and secondary income exceed payments abroad.
→ Exporters and other recipients receive foreign currency.
→ If they convert it into domestic currency through the banking system, domestic deposits may rise.
→ If the central bank buys the foreign currency and pays in domestic currency, domestic central-bank money may increase unless the effect is offset.
→ The money supply may rise, depending on the exchange-rate system and how the transactions are handled.
2. Current-account deficit
A current-account deficit occurs when current payments to the rest of the world exceed current receipts.
→ Domestic buyers make payments abroad for imports and other current transactions.
→ Domestic funds may flow out of the banking system.
→ This can reduce domestic liquidity or deposits in some circumstances.
→ However, the overall money-supply effect depends on how the deficit is financed, capital flows and central-bank intervention.
3. Capital and financial flows
→ Foreign investment entering the country can increase demand for domestic currency and bring funds into the domestic financial system.
→ Domestic investment abroad can result in funds moving overseas.
→ The money-supply effect depends on the exchange-rate regime, banking transactions and central-bank actions.
Important: A balance-of-payments surplus or deficit does not mechanically determine the money supply. The effect depends on the composition of transactions, the exchange-rate system, capital flows and whether the central bank intervenes.
Policies to Reduce Inflation and Their Effectiveness
Inflation is a sustained increase in the general price level. A fall in the inflation rate means prices are rising more slowly; it does not necessarily mean that prices are falling.
Policies to reduce inflation depend on whether it is caused mainly by excessive aggregate demand, rising production costs or other factors.
Contractionary Monetary Policy
Contractionary monetary policy involves raising interest rates or using other measures to tighten monetary conditions.
How it reduces demand-pull inflation:
→ The central bank raises policy interest rates.
→ Borrowing becomes more expensive.
→ Households may reduce credit-financed consumption.
→ Firms may reduce investment because borrowing costs rise.
→ Aggregate demand grows more slowly or falls.
→ Pressure on prices decreases.
Advantages:
→ Can reduce excessive consumption and investment.
→ May help control inflation expectations and support confidence in the currency.
→ Can be adjusted as economic conditions change.
Limitations:
→ Higher interest rates can reduce investment and economic growth.
→ Unemployment may rise if firms reduce production and recruitment.
→ Households with variable-rate debt may face higher repayments.
→ Monetary policy may be less effective against inflation caused by supply shortages or imported cost increases.
Effectiveness: Most effective when inflation is driven by excessive aggregate demand. It can be costly if the economy is already weak.
Contractionary Fiscal Policy
Contractionary fiscal policy involves reducing government expenditure, increasing taxes or combining both.
How it reduces inflation:
→ Higher taxes may reduce households’ disposable income.
→ Lower disposable income can reduce consumption.
→ Lower government spending directly reduces one component of aggregate demand.
→ Aggregate demand grows more slowly.
→ Demand-pull inflationary pressure falls.
Advantages:
→ Can directly reduce government-related demand.
→ May also reduce the budget deficit.
Limitations:
→ Lower consumption and government spending may reduce output and employment.
→ Cuts to essential public services can have adverse social effects.
→ Tax increases may reduce incentives to work, save or invest, depending on their design.
→ Fiscal policy may take time to implement.
Effectiveness: More useful when excessive aggregate demand is a major source of inflation. It may be less suitable if inflation mainly results from rising production costs.
Supply-Side Policies
Supply-side policies aim to increase the economy’s productive capacity or reduce production costs.
Examples include:
→ Improving education and worker training.
→ Investing in transport, electricity and other infrastructure.
→ Encouraging research, innovation and productivity improvements.
→ Reducing unnecessary barriers to competition.
→ Improving access to essential inputs and supply chains.
→ Supporting energy efficiency and reliable energy supply.
How they reduce inflationary pressure:
→ Productivity rises or production costs fall.
→ Firms can produce more goods and services at a given cost.
→ Aggregate supply increases.
→ The economy can meet higher demand with less upward pressure on prices.
Advantages:
→ Can improve productivity and long-term economic growth.
→ May reduce cost-push inflation without relying solely on lower demand.
→ Can improve international competitiveness.
Limitations:
→ Results often take time.
→ Infrastructure and training programmes can be expensive.
→ Poorly designed reforms may fail to increase productive capacity.
→ Some reforms may create short-term disruption for workers or businesses.
Effectiveness: Particularly useful for persistent supply-side problems, but generally not a quick solution to immediate inflation.
Policies to Address Cost-Push Inflation
Cost-push inflation occurs when rising production costs reduce firms’ willingness or ability to supply goods and services at existing prices.
Possible responses include:
→ Improving energy supply and transport infrastructure to reduce bottlenecks.
→ Encouraging competition in markets where limited competition contributes to high prices.
→ Supporting productivity improvements that reduce unit costs.
→ Using temporary, targeted assistance for vulnerable households rather than broad measures that unnecessarily stimulate demand.
→ Reducing avoidable supply disruptions.
Limitations:
→ Supply-side solutions may take time.
→ Broad subsidies can be expensive and may increase demand without resolving the underlying shortage.
→ Monetary tightening can reduce inflationary pressure but may also weaken output and employment.
Comparison of Anti-Inflation Policies
| Policy | Main mechanism | Main limitation |
|---|---|---|
| Higher interest rates | Reduces borrowing, consumption and investment | May reduce growth and employment |
| Higher taxes | Reduces disposable income and consumption | May weaken incentives and output |
| Lower government spending | Reduces aggregate demand | May affect public services and employment |
| Supply-side improvements | Raises productive capacity or reduces costs | Takes time and may be expensive |
| Competition reforms | May reduce market power and improve efficiency | Results depend on market conditions and implementation |
Overall Evaluation
→ If inflation is mainly caused by excessive aggregate demand, contractionary monetary and fiscal policies can reduce spending pressure.
→ If inflation is mainly caused by rising energy, food or other input costs, supply-side policies may address the underlying causes more directly.
→ If inflation expectations have become persistent, credible monetary policy may be needed to prevent continuing wage and price increases.
→ A combination of policies may be appropriate, but policymakers must consider the trade-off between lower inflation and weaker output or higher unemployment.
Demand for Money: Liquidity Preference Theory
Definition of Liquidity Preference
Liquidity preference theory explains the demand for money as the preference people have for holding wealth in liquid form rather than in less liquid assets such as bonds.
The theory is associated with economist John Maynard Keynes.
People demand money for three main motives.
The Three Motives for Holding Money
1. Transactions motive
People hold money to make everyday payments.
→ Households need money for food, transport, rent and other expenses.
→ Businesses need money to pay wages and suppliers.
→ The transactions demand for money generally increases as income and economic activity rise.
Example: A household keeps enough money in its bank account to cover regular bills and shopping.
2. Precautionary motive
People hold money to meet unexpected expenses or emergencies.
→ Households may need money for medical bills or urgent repairs.
→ Businesses may hold funds to manage unexpected costs or delayed customer payments.
→ Higher uncertainty may increase the desire to hold liquid funds.
Example: A family maintains emergency savings in case a household appliance breaks down.
3. Speculative motive
People hold money because they expect changes in interest rates and bond prices.
→ Bonds generally have an inverse relationship between their market price and their yield.
→ If people expect interest rates to rise, existing bond prices may fall.
→ They may prefer to hold money rather than buy bonds that could lose value.
→ If people expect interest rates to fall, bond prices may rise, making bonds more attractive.
Example: An investor holds money temporarily because they expect bond prices to fall when interest rates rise.
Factors Affecting Demand for Money
Income
→ Higher income generally increases transactions and precautionary needs.
→ Demand for money therefore tends to rise as income increases.
Interest rates
→ Holding money may involve an opportunity cost because it earns little or no interest compared with some financial assets.
→ Higher interest rates increase the return that could be earned on interest-bearing assets.
→ This may reduce the amount of money people wish to hold, particularly for speculative purposes.
Uncertainty
→ Greater uncertainty about future income, expenses or financial markets may increase precautionary demand for money.
Prices
→ If the general price level rises, people need more money to purchase the same quantity of goods and services.
→ Nominal demand for money may therefore increase, even if real purchasing power has not increased.
Liquidity Preference and the Interest Rate
In Keynesian theory, the interest rate helps bring the demand for money into line with the available money supply.
→ When people want to hold more money than is available, they may sell bonds or other assets to obtain money.
→ Bond prices fall.
→ Bond yields and interest rates rise.
→ Higher interest rates can reduce the quantity of money demanded.
Conversely:
→ When the money supply increases relative to money demand, people may hold more money than they wish.
→ They may buy bonds and other interest-bearing assets.
→ Bond prices rise.
→ Interest rates fall.
→ Lower interest rates can increase the demand for money.
This explanation depends on the monetary framework and the way the central bank supplies reserves and sets policy rates.
Interest Rate Determination
Two important explanations are the loanable funds theory and the Keynesian liquidity preference theory.
Loanable Funds Theory
Loanable funds theory explains the interest rate through the demand for funds to borrow and the supply of funds available for lending.
In the simplified model, the real interest rate adjusts to equate the supply of loanable funds with the demand for loanable funds.
Supply of loanable funds
The supply mainly comes from saving and other funds made available for lending.
Factors that may increase the supply include:
→ Higher household saving.
→ Higher business saving.
→ Greater willingness to lend.
→ Inflows of foreign funds available for domestic borrowing.
Effect of an increase in supply:
→ More funds become available for borrowing.
→ The supply of loanable funds increases.
→ The equilibrium real interest rate tends to fall.
→ Lower borrowing costs may encourage investment.
Demand for loanable funds
Demand comes from households, firms and governments wishing to borrow.
Factors that may increase demand include:
→ Higher expected returns on investment.
→ Greater business confidence.
→ More profitable investment opportunities.
→ Higher government borrowing requirements.
Effect of an increase in demand:
→ More borrowers compete for available funds.
→ The demand for loanable funds increases.
→ The equilibrium real interest rate tends to rise.
→ Higher borrowing costs may reduce some private investment.
The Effect of Government Borrowing
→ A government budget deficit may increase government demand for loanable funds.
→ If the supply of funds does not increase correspondingly, the real interest rate may rise.
→ Higher interest rates can discourage private-sector borrowing and investment.
→ This is known as crowding out.
However:
→ Crowding out may be limited when the economy has substantial spare capacity or monetary policy accommodates the borrowing.
→ Government investment may also increase productive capacity and encourage private investment if it improves infrastructure or business conditions.
Keynesian Theory of Interest Rate Determination
Keynesian liquidity preference theory explains the interest rate through the interaction between the demand for money and the supply of money.
Demand for money
→ Transactions and precautionary demand tend to rise with income.
→ Speculative demand is influenced by interest rates and expectations about future bond prices.
Supply of money
→ In the simplified Keynesian model, the money supply is set by the monetary authority and is shown as fixed for a given period.
→ The interest rate adjusts to equate money demand and money supply.
When money supply increases:
→ The supply of money rises relative to demand.
→ People may use excess money to buy bonds.
→ Bond prices rise.
→ Interest rates fall.
→ Lower interest rates may encourage investment and consumption.
When money demand increases:
→ People want to hold more money at the existing interest rate.
→ They may sell bonds to obtain money.
→ Bond prices fall.
→ Interest rates rise.
Liquidity Trap
A liquidity trap is a situation in which interest rates are very low and people expect them to rise in the future, so they are willing to hold additional money rather than buy bonds.
→ An increase in the money supply may be held as money instead of being used to purchase bonds or finance additional spending.
→ Interest rates may fall very little further.
→ Conventional monetary policy may have limited effectiveness in stimulating demand.
→ Fiscal policy or other monetary measures may be considered, depending on the economic situation.
Comparing the Two Theories
| Loanable funds theory | Keynesian liquidity preference theory |
|---|---|
| Interest rate is determined by the supply and demand for funds available for lending. | Interest rate is determined by the supply of money and demand for liquidity. |
| Supply is strongly linked to saving and other available lending funds. | Money supply is treated as set by the monetary authority in the simplified model. |
| Demand is linked to borrowing for consumption, investment and government spending. | Demand reflects transactions, precautionary and speculative motives. |
| Focuses on the market for borrowing and lending funds. | Focuses on the choice between holding money and holding interest-bearing assets. |
| Higher saving tends to lower the equilibrium real interest rate, other things equal. | Higher money supply tends to lower the interest rate, other things equal. |
| Higher borrowing demand tends to raise the equilibrium real interest rate, other things equal. | Higher money demand tends to raise the interest rate, other things equal. |
Overall understanding: Loanable funds theory focuses on the availability of funds for borrowing, while Keynesian theory focuses on the demand for liquidity relative to the money supply. Both explain interest rates through market interactions, but they emphasise different markets and mechanisms.