Money and Banking – Demand for Money (Cambridge IGCSE/A‑Level Economics 9708)
1. What is Money?
- Definition: Money is any asset that is widely accepted as a medium of exchange for goods and services.
- Four functions of money (syllabus requirement):
- Medium of exchange – eliminates the need for a double‑coincidence of wants.
- Unit of account – provides a common measure for pricing and accounting.
- Store of value – preserves purchasing power over time (subject to inflation).
- Standard of deferred payment – used to settle debts and contracts that are payable in the future.
2. Quantity Theory of Money
The long‑run relationship between the money supply and the price level is expressed by the equation of exchange:
\[
MV = PT
\]
- M = nominal money supply (stock of money).
- V = velocity of circulation – the average number of times a unit of money is spent in a period.
- P = price level.
- T = real transactions (often approximated by real GDP, Y).
Key assumptions (syllabus):
- Velocity (V) is stable in the long run.
- Real output (T or Y) is at full‑employment and therefore constant.
Implication: With V and Y constant, a rise in M leads proportionally to a rise in P – i.e. inflation in the long run.
Short‑run limitation: In the short run V may change (e.g., during a recession) so the direct link between M and P can break down.
3. How Money Supply Is Created
3.1 Central‑Bank Operations (Regulatory & Market Tools)
- Open‑market operations (OMO): buying government securities injects reserves → expands the monetary base; selling securities does the opposite.
- Policy interest rate: Bank Rate, Repo Rate, or Discount Rate – influences the cost of borrowing for banks and, indirectly, the interest rates faced by households and firms.
- Reserve‑requirement ratio (RRR): the proportion of deposits banks must hold as reserves. Raising the RRR contracts credit creation; lowering it expands credit.
- Capital‑adequacy ratio (CAR): a regulatory safeguard that can affect banks’ willingness to lend.
- Quantitative easing (QE): large‑scale purchases of government or private securities when short‑term rates are already near zero; expands the monetary base directly.
3.2 Commercial‑Bank Credit Creation (Deposit‑creation Process)
Step‑by‑step chain (illustrative diagram suggested):
- A customer deposits £1,000 in Bank A.
- Bank A keeps the required reserve (e.g., 10 % = £100) and can lend out the remaining £900.
- The borrower spends the £900, and the recipient deposits it in Bank B.
- Bank B again retains 10 % (£90) and can lend out £810, and the process repeats.
The total increase in deposits (and thus the money supply) is the original deposit multiplied by the money multiplier:
\[
\text{Money multiplier} = \frac{1}{RR}
\qquad\text{so}\qquad
\frac{M}{M_0}= \frac{1}{RR}
\]
where \(M_0\) is the monetary base (cash + reserves) and \(RR\) the required reserve ratio.
4. Liquidity‑Preference Theory – Why Do People Hold Money?
Keynes (1936) identified three motives for holding cash or cash‑equivalents:
| Motivation | Explanation |
|---|
| Transactions motive | Money needed for day‑to‑day purchases of goods and services. |
| Precautionary motive | Money held to meet unexpected expenses or income shocks. |
| Speculative motive | Money kept as a hedge against future changes in interest rates and bond prices. |
5. The Money‑Demand Function
The aggregate demand for real money balances is expressed as:
\[
M^{d}=L(Y,i)
\]
- \(M^{d}\) – nominal money demand.
- \(L\) – liquidity‑preference (money‑demand) function.
- \(Y\) – real national income (or output).
- \(i\) – nominal interest rate – the opportunity cost of holding money.
Because the nominal demand also depends on the price level, the syllabus notes:
\[
M^{d}_{\text{nom}} = P \times L(Y,i)
\]
so a rise in \(P\) raises nominal demand even though real demand \((M/P)\) is unchanged.
6. Determinants of Money Demand
| Determinant | Effect on (real) Money Demand | Underlying Motive(s) |
|---|
| Real income (Y) | ↑ Y → ↑ L (right‑ward shift) | Transactions & precautionary |
| Price level (P) | ↑ P → ↑ nominal \(M^{d}\) (real demand unchanged) | Transactions |
| Nominal interest rate (i) | ↑ i → ↓ L (left‑ward shift) | Speculative |
| Financial innovation (ATMs, e‑payments) | ↓ need for cash → ↓ L | Transactions & precautionary |
| Uncertainty about future income or prices | ↑ uncertainty → ↑ L | Precautionary |
7. The Money‑Demand Curve
- Holding Y and P constant, the relationship between the interest rate (i) and the quantity of real money demanded \((M/P)\) is downward sloping.
- Higher i raises the opportunity cost of holding cash, so people shift to interest‑bearing assets – the curve shifts left.
Diagram suggestion (labelled): vertical axis = i, horizontal axis = real money balances \((M/P)\); show the original curve and a leftward shift when i rises (or a rightward shift when Y rises).
8. From Money Demand to the LM Curve
Money‑market equilibrium:
\[
\frac{M}{P}=L(Y,i)
\]
Solving for the interest rate gives the LM (Liquidity‑Money) curve in (Y, i) space:
\[
i = f\bigl(Y,\frac{M}{P}\bigr)
\]
- Shift factors
- Real money supply ↑ (M/P rises) → LM shifts right (lower i for any Y).
- Real money supply ↓ (M/P falls) → LM shifts left.
- Real income ↑ (Y rises) → Money demand rises, LM shifts left (higher i for any M/P).
- Price level ↑ (P rises) → Real money supply falls, LM shifts left (same effect as a fall in M).
Link to the IS‑LM model: The LM curve intersects the IS curve (goods‑market equilibrium) to determine the simultaneous equilibrium output (Y) and interest rate (i). A right‑ward shift of LM (expansionary monetary policy) lowers i, raises Y, and consequently shifts the AD curve rightward in the AD/AS framework.
Diagram suggestion: Plot IS (downward sloping) and LM (upward sloping) in Y‑i space; illustrate a rightward LM shift and the resulting new equilibrium.
9. Monetary‑Policy Tools – Impact on the Money Market
| Tool | Mechanism | Effect on LM | Pros | Cons / Limitations |
|---|
| Open‑market purchases |
Central bank buys government securities → reserves ↑ → banks can lend more → M ↑ |
LM shifts right (lower i) |
Fast, directly changes monetary base; well‑understood. |
May be ineffective if banks hoard reserves (liquidity trap). |
| Open‑market sales |
Central bank sells securities → reserves ↓ → M ↓ |
LM shifts left (higher i) |
Useful for tightening policy. |
Can raise market interest rates sharply, risking recession. |
| Policy‑rate change (Bank/Repo/Discount) |
Alters the cost of short‑term borrowing for banks → influences market rates. |
Lower rate → LM right; higher rate → LM left. |
Signals intent; affects expectations. |
Transmission may be weak if banks’ balance sheets are fragile. |
| Reserve‑requirement ratio (RRR) |
Changing the proportion of deposits banks must hold. |
Lower RRR → more lendable funds → LM right; higher RRR → LM left. |
Direct control over credit creation. |
Used infrequently; large changes can destabilise banking sector. |
| Quantitative easing (QE) |
Large‑scale purchase of longer‑term securities → expands base when short‑term rates are near zero. |
LM shifts right, but effect may be muted if expectations of low demand persist. |
Provides stimulus when conventional tools are exhausted. |
Risk of asset‑price bubbles; can be hard to unwind. |
Liquidity Trap
When the nominal interest rate is at or near zero, further increases in the money supply may not lower i or stimulate spending. In the (Y, i) diagram the LM curve becomes almost horizontal, limiting the effectiveness of monetary policy.
10. Links to Other Macro Topics
- AD/AS model: A right‑ward LM shift (expansionary monetary policy) raises aggregate demand, shifting the AD curve rightward and putting upward pressure on the price level.
- Phillips curve: Lower interest rates (right‑ward LM shift) can boost output and reduce unemployment in the short run, moving the economy down along the Phillips curve.
- Inflation: Persistent increases in M (with V stable) raise P in the long run; short‑run effects depend on the gap between actual and potential output.
- Unemployment: Expansionary monetary policy can lower unemployment by stimulating investment and consumption, but only while there is spare capacity.
- Exchange rates & balance of payments: An expansionary stance tends to lower domestic interest rates, leading to capital outflows, a depreciation of the domestic currency, and a potential improvement in the current‑account balance.
11. Key Points for Examination (AO1–AO3)
- Define money and list its four functions.
- State the equation of exchange (MV = PT) and explain the long‑run implication for inflation, including the key assumptions.
- Outline the three motives for holding money (transactions, precautionary, speculative).
- Write the money‑demand function \(M^{d}=L(Y,i)\) and explain the role of each variable; note the effect of the price level on nominal demand.
- Explain how changes in interest rate, income, price level, financial innovation and uncertainty shift the money‑demand curve.
- Derive the LM curve from \(\frac{M}{P}=L(Y,i)\) and discuss how changes in M, P and Y shift it.
- Analyse the impact of a specific monetary‑policy tool (e.g., open‑market purchase) on the LM curve and on equilibrium output and interest rates.
- Evaluate the effectiveness of monetary policy in a liquidity‑trap situation, using the pros/cons of the tools listed above.
- Link movements of the LM curve to shifts in the AD curve and to outcomes for inflation, unemployment and the exchange rate.
12. Sample Exam Question & Model Answer
Question: Using the liquidity‑preference framework, explain how an increase in the nominal interest rate affects (a) the demand for money and (b) the position of the LM curve. Include a brief discussion of the speculative motive.
Model answer (outline):
- Higher nominal interest rates raise the opportunity cost of holding cash.
- According to the speculative motive, when i rises people expect bond prices to fall, so they shift from cash to interest‑bearing assets (e.g., bonds). This reduces the quantity of real money demanded at every level of income – the money‑demand curve shifts left.
- With a given real money supply \((M/P)\), the new equilibrium in the money market occurs at a higher interest rate for the same level of income; graphically the LM curve moves up (or left) in the (Y, i) diagram.
- Consequently, if the IS curve is downward sloping, the higher i leads to lower equilibrium output, illustrating the contractionary effect of an interest‑rate rise.