The money market
As with the analysis of any other kind of market, that of the money market focuses on theories of the main factors affecting (money) demand and (money) supply, and on the self-correcting chain of economic adjustments that could be set off when these are out of balance. As the supply of money is often taken to be more of a practical, institutional policy question of monetary control, bound up with the money-creating function of modern banking systems, the theory of money markets tends to focus more on the issue of money demand.
Why have money? To buy things or "just in case"
The theory of money demand comes down to this: since one of the main reasons for having money is to carry out transactions (ie to pay for things), when the volume of activity in the economy rises, and/or the prices of goods and services rise, a larger sum of money will be needed to accommodate this. That is, the transactions demand for money is a positive function of changes in economic income (like consumption in the goods market) and of the price level. This is only one source of monetary demand, however—money conceived as the oil that keeps running smoothly the process of purchasing production so that production itself can continue.
Why have money? For safety
A second source, which is a bit more complex to grasp, sees money as the asset that wealth-holders will favour to avoid capital losses when they anticipate changes in interest rates. Bonds—which promise to pay a specified sum of money at regular intervals—stand in for "all other kinds of assets except money", such as the ownership of property, or of shares in firms. Thus, money is conceived one of the two possible assets in which wealth can be held. This ingenious step greatly simplifies the analysis of the financial sector for the purposes of assessing the likely outcomes of real-world economic policies.
Bonds are sold by companies and governments to raise finance for investment projects. They come with a "face value" (the capital value) and a coupon (the interest rate, or return on the capital value), and can be sold on by the original purchaser to raise cash. For example, a bond with a face value of $100 and an annual coupon of 10% would bring to its owner an income of $10 per year. But if the market interest rises above 10%, a bond with a coupon of 10% will be worth less than its face value of $100. On the other hand, if the market interest rate falls below 10%, a bond with a coupon of 10% will be worth more than its face value of $100. Thus, bond prices move in the opposite direction to interest rates. From this point of view, the advantage of keeping your wealth in money is that its value is certain, uninfluenced by changes in interest rates, even if it is not earning its holder any additional income. In contrast, bonds come with a definite income stream attached—as indicated by the face value and coupon—but are more risky, since the market interest rate could change unfavourably, inflicting a capital loss.
To understand what's supposed to be going on, a very important distinction must be made between what happens on average in the money market when interest rates are expected to change and when they actually change. As more wealth-holders expect interest rates to rise (perhaps because inflation is starting to rise too rapidly and the government is signaling its intention to take remedial measures), more of them will begin to sell their bonds, forgoing the return in order to avoid a capital loss implied by a fall in bond prices. The selling of bonds implies an increasing the demand for money. However, as the market interest rate actually rises, creeping further above the norm for more people, larger numbers of wealth-holders will be tempted to switch back to bonds by the prospect of holding an interest-bearing asset and of making a capital gain. The movement back into bonds implies a corresponding reduction in the demand for money. This is the same as saying that speculative demand for money is a negative function of interest rate changes (like investment in the goods market).
Because people are thought to be concerned about the quantity of goods and services they can obtain for their money, rather than merely the volume of cash they hold, money demand is always conceived of as a wish for real money balances. In contrast, money supply is assumed initially to be a nominal variable, and hence is affected by changes in the prices level: if average prices rise and the nominal money supply stays fixed, its real value—the quantity of goods and services that it can command—falls. Additionally, the money supply is one of the policy variables that governments and central banks use to influence interest rates, and hence other key macroeconomic indicators, such as output, employment and inflation.
Balance and imbalance
In a money market in which the price level and income are fixed—two assumptions that can hold only for a short time—any adjustment because of a mismatch in money supply and money demand takes place by means of changes in the composition of speculative money holdings in response to changes in interest rates. If the interest rate is too low to equate the two, there is an excess demand for money and an excess supply of bonds, meaning that some wealth-holders want to convert bonds into money and some hold back from buying bonds. The glut of bonds pushes their price down and interest rates go up.
Loosening the two assumptions on prices and income—as we move the frame of reference to a slightly longer time period—a rise in prices, taken on its own, will reduce the real money supply, pushing up the interest rate, whereas a fall in prices will increases the real money supply, bringing interest rates down.
A factor that could shift the demand for money is a change in economic income, implying that there are different possible combinations of national income and interest rates in which the money market is in equilibrium. And in fact, this how, on the basis of this outline of the workings of the money market, we construct of the LM curve.
As with the analysis of any other kind of market, that of the money market focuses on theories of the main factors affecting (money) demand and (money) supply, and on the self-correcting chain of economic adjustments that could be set off when these are out of balance. As the supply of money is often taken to be more of a practical, institutional policy question of monetary control, bound up with the money-creating function of modern banking systems, the theory of money markets tends to focus more on the issue of money demand.
Why have money? To buy things or "just in case"
The theory of money demand comes down to this: since one of the main reasons for having money is to carry out transactions (ie to pay for things), when the volume of activity in the economy rises, and/or the prices of goods and services rise, a larger sum of money will be needed to accommodate this. That is, the transactions demand for money is a positive function of changes in economic income (like consumption in the goods market) and of the price level. This is only one source of monetary demand, however—money conceived as the oil that keeps running smoothly the process of purchasing production so that production itself can continue.
Why have money? For safety
A second source, which is a bit more complex to grasp, sees money as the asset that wealth-holders will favour to avoid capital losses when they anticipate changes in interest rates. Bonds—which promise to pay a specified sum of money at regular intervals—stand in for "all other kinds of assets except money", such as the ownership of property, or of shares in firms. Thus, money is conceived one of the two possible assets in which wealth can be held. This ingenious step greatly simplifies the analysis of the financial sector for the purposes of assessing the likely outcomes of real-world economic policies.
Bonds are sold by companies and governments to raise finance for investment projects. They come with a "face value" (the capital value) and a coupon (the interest rate, or return on the capital value), and can be sold on by the original purchaser to raise cash. For example, a bond with a face value of $100 and an annual coupon of 10% would bring to its owner an income of $10 per year. But if the market interest rises above 10%, a bond with a coupon of 10% will be worth less than its face value of $100. On the other hand, if the market interest rate falls below 10%, a bond with a coupon of 10% will be worth more than its face value of $100. Thus, bond prices move in the opposite direction to interest rates. From this point of view, the advantage of keeping your wealth in money is that its value is certain, uninfluenced by changes in interest rates, even if it is not earning its holder any additional income. In contrast, bonds come with a definite income stream attached—as indicated by the face value and coupon—but are more risky, since the market interest rate could change unfavourably, inflicting a capital loss.
To understand what's supposed to be going on, a very important distinction must be made between what happens on average in the money market when interest rates are expected to change and when they actually change. As more wealth-holders expect interest rates to rise (perhaps because inflation is starting to rise too rapidly and the government is signaling its intention to take remedial measures), more of them will begin to sell their bonds, forgoing the return in order to avoid a capital loss implied by a fall in bond prices. The selling of bonds implies an increasing the demand for money. However, as the market interest rate actually rises, creeping further above the norm for more people, larger numbers of wealth-holders will be tempted to switch back to bonds by the prospect of holding an interest-bearing asset and of making a capital gain. The movement back into bonds implies a corresponding reduction in the demand for money. This is the same as saying that speculative demand for money is a negative function of interest rate changes (like investment in the goods market).
Because people are thought to be concerned about the quantity of goods and services they can obtain for their money, rather than merely the volume of cash they hold, money demand is always conceived of as a wish for real money balances. In contrast, money supply is assumed initially to be a nominal variable, and hence is affected by changes in the prices level: if average prices rise and the nominal money supply stays fixed, its real value—the quantity of goods and services that it can command—falls. Additionally, the money supply is one of the policy variables that governments and central banks use to influence interest rates, and hence other key macroeconomic indicators, such as output, employment and inflation.
Balance and imbalance
In a money market in which the price level and income are fixed—two assumptions that can hold only for a short time—any adjustment because of a mismatch in money supply and money demand takes place by means of changes in the composition of speculative money holdings in response to changes in interest rates. If the interest rate is too low to equate the two, there is an excess demand for money and an excess supply of bonds, meaning that some wealth-holders want to convert bonds into money and some hold back from buying bonds. The glut of bonds pushes their price down and interest rates go up.
Loosening the two assumptions on prices and income—as we move the frame of reference to a slightly longer time period—a rise in prices, taken on its own, will reduce the real money supply, pushing up the interest rate, whereas a fall in prices will increases the real money supply, bringing interest rates down.
A factor that could shift the demand for money is a change in economic income, implying that there are different possible combinations of national income and interest rates in which the money market is in equilibrium. And in fact, this how, on the basis of this outline of the workings of the money market, we construct of the LM curve.
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