### It is common to present 3 approaches that explain how the public decides on the amount of money they wish to hold. As empirical studies show, a small portion of the public decides according to Approach I, another small portion decides according to Approach II, while the majority of the public decides according to Approach III, which is some combination of the first 2 approaches. #### Approach I – Holding a certain percentage of income (Y) According to this approach, at any time, the consumer holds an amount of money that constitutes a certain percentage of his income. The percentage varies according to the market interest rate. The percentage increases as the interest rate decreases. For example:
– When the interest rate is 2%, he keeps 30% of his income.
– When the interest rate is 8%, he keeps 20% of his income.
– When the interest rate is 12%, he holds 5% of his income. According to this approach, the demand for money (D_m) is a function of 2 variables: income (Y) and interest rate (i). In this approach:
1. A change in (Y) causes a shift in the demand curve:
– An increase in (Y) causes a shift to the right and a decrease in (Y) causes a shift to the left.
2. A change in (I) causes a shift on the curve.
– In any demand curve relating to any given date, (Y) is a constant. #### Approach II – Holding an amount of money sufficient for a certain basket of products For the sake of simplicity, let’s assume that the products are only bread. According to this approach, the consumer holds at all times an amount of money sufficient for him to purchase any quantity of products. The quantity of products varies according to the interest rate in the market. The quantity increases as the interest rate decreases. For example:
– When the interest rate is 2%, he holds enough money for 100 loaves of bread.
– When the interest rate is 8%, he holds enough money for 70 loaves of bread.
– When the interest rate is 12%, he holds enough money for 20 loaves of bread. According to this approach, the demand for money (D_m) is a function of two variables: the interest rate (i) and the prices of products (P). In this approach:
1. A change in (P) causes a shift in the demand curve:
– An increase in (P) causes a shift to the right and a decrease in (P) causes a shift to the left.
2. A change in (I) causes a shift on the curve.
– In any demand curve relating to any date, (P) is a constant. ### Banks’ demand for money For the sake of simplicity, we assume that the internal composition between cash and current deposits in the means of payment remains constant at any interest rate level. For example: 0.5 current deposits, 0.5 cash. In light of this, if the reserve ratio is, for example, 0.2, then the demand for money from banks is 0.1 (10%) of the public’s total demand for money (= 0.2 of the deposit component). #### Definitions – **Reserve** – cash that the bank holds + its deposits at the central bank.
#### Example: – Total public demand for money: $3000 million.
– Of which 1500 is cash, 1500 is current account deposits.
– Total bank demand: 300 (=0.2 * 1500$). ### Money supply curve The supply curve refers to the supply of money at any point in time. – **Curve symbol** (S_m). – **Curve path** It is customary to draw it as a vertical line that rises. From the (x) axis at a point that represents the quantity of (M_1) in the country at that time. And the explanation, we assume that the internal composition between cash and current deposits remains constant at any interest rate level and as a result, there is no change in the total means of payment along the curve. #### Factors that affect the shift of the supply curve 1. Increase in the quantity of cash in the economy.
2. Changes in the internal composition between cash held by the public and current deposits (a shift from cash to current deposits will cause the supply curve to shift to the right, and a shift from current deposits to cash will cause it to shift to the left).
3. Changes in the reserve ratio (an increase in the reserve ratio will decrease supply and the supply curve will shift to the left, and vice versa when the reserve ratio decreases). ### Money market equilibrium The interest rate in the economy will be determined at the intersection of the demand and supply curves. Point **e** in Figure 2. 1. **When interest rates are above the intersection**
– At any interest rate above the convergence point (e.g. 12%), the public will purchase bonds at the monetary gap between demand and supply ((cd)).
– Directing money to purchase bonds will increase demand for bonds and increase their price. Which means: a decrease in yield, up to point **e** (8%). 2. **When interest rates are below the convergence point**
– At any interest rate below the meeting point (e.g. 5%), the public will sell bonds in its possession for the entire monetary gap between: demand and supply ((ab)).
– The supply of bonds will cause its price to fall, which means: an increase in yield, up to point **e** (8%). ### The central bank controls the money supply It is important to emphasize that the money supply is controlled by the central bank and therefore has the ability to determine the interest rate in the economy.
