85. MONEY SUPPLY AND INFLATION IN 1995 As in January 1994, a year later a part of the cash issued in December for servicing the seasonally increased incomes of the population was again withdrawn from circulation. True, in 1995, not only the cash supply decreased, but also

Topic 23. Money market

The market economy is a money economy, all market transactions are mediated by the movement of money. Moreover, money is not just a technical medium of exchange; the state of the entire economy of the country depends on the streamlining of monetary circulation, the amount of money in circulation. In the previous chapter, the conditions for achieving equilibrium in commodity markets were considered, but the general economic equilibrium is an equilibrium in all markets, including the money one. This chapter will examine the conditions for achieving equilibrium in the money market.
The main questions of the topic:

Question 1. Lots of money in circulation.
Question 2. Demand for money.
Question 3. Money supply.
Question 4. Money market.

In the first section of the course, you got acquainted with the essence, functions, types of money. Let us recall that modern money is non-exchangeable credit money. Cash (banknotes) are debt obligations of the central state bank, non-cash - debt obligations of commercial banks.
The aggregate of all monetary funds in the economy in cash and non-cash forms and performing the functions of a means of circulation and accumulation, forms the money supply.
Certain types of funds circulating in the country, in accordance with their inherent level of liquidity, are combined into monetary aggregates (M). An aggregate with a higher level of liquidity is an integral part of an aggregate with a lower level of liquidity. As a result, a system of aggregates is formed, each of which characterizes a certain composition and structure of the money supply.
The most commonly used units are:
М0 - paper (banknotes) and cash metal (small change) money in circulation (without bank cash);
M1 - includes M0 and money in non-interest-bearing bank accounts on demand (current, settlement accounts of enterprises);
M2 - consists of M1, savings accounts (interest-bearing accounts on demand) and small time deposits;
M3 - is formed from M2 and large time deposits.
In some countries, another aggregate is used - L, which includes M3 and some types of highly liquid securities (certificates of deposit, treasury bills).
Another important indicator of the amount of money in circulation is the monetary base ("strong money") - this is money under the direct control of the central state bank (cash in circulation and money in the accounts of commercial banks, in the central state bank).
An idea of \u200b\u200bthe amount of money in the Russian economy is given by the data in Table 23.1.
Table 23.1
Dynamics of monetary aggregates in Russia 1995-2002
(1995-1997 in trillion rubles, since 1998 - in billion rubles)

neg in the total mass of money - about 30%. Note that the ratio of non-cash to cash in developed market countries is 9 to 1.
Monetary aggregates determine the amount of money in circulation. But what does it depend on? How much money should there be in the economy?
The answer to this question is given by the equation of exchange of I. Fischer, according to which the amount of money in circulation should be such that a balance is maintained between it and the value of goods and services produced in the country, taking into account their prices:
M x V \u003d P x Q,
where M is the amount of money (or money supply) in circulation;
V is the velocity of money circulation (the average annual number of times that the monetary unit is spent on the purchase of goods and services);
P - price level (index of weighted average prices of goods and services);
Q is the real volume of national production.
Simple transformations make it possible to obtain a formula for the amount of money required for circulation:
M \u003d (P x Q): V.
It is clear from this formula that the larger the national product created in the country, the more money must be in circulation. With an increase in the physical quantity of goods, it is necessary to increase the money supply.
Since the velocity of money circulation is determined by non-monetary factors, it can be considered as a constant value. Dividing both sides of the equation by V and expressing the value (1 / V) in terms of k, we get a formula called the Cambridge equation:
M \u003d k x P x V,
where k is the proportionality coefficient between nominal income (P x V) and the desired cash supply, i.e. part of the income that business entities want to keep in cash.
The coefficient k is called the coefficient of monetization, since it characterizes the saturation of the economy with money. In practice, the monetization coefficient (k) is calculated as the ratio of M2 to GDP multiplied by 100%.
For example, in 2002 the monetization coefficient in Russia was 19%, while in countries with developed market economies this figure reaches 50-80%.
From the formula under consideration, it can be seen that the price level and the amount of money in circulation are in direct relationship: an increase in prices necessitates an increase in the money supply, and, conversely, an increase in the money supply leads to an increase in prices. However, there will be no rise in prices if, simultaneously with the growth of the money supply, the volume of output of goods and services expands to the same or greater extent.
The amount of money in circulation directly affects its value. Modern money, unlike commodity money, has no value of its own. Cash paper money is just a piece of paper, bank deposits are entries in the books of banks. As for metallic money, their face value must always be greater than the actual (metal value). So what is the value of modern money? Why are they worth?
The value of money is its real purchasing power, i.e. the amount of goods and services that can be bought for a monetary unit. This indicator expresses the actual value (real value) as opposed to the face value (nominal) value of money. The value of money is inversely related to the amount of money in circulation. The more money is in circulation, the lower its value, and vice versa.
Self-test questions

1. What is money supply? By what principle are different monetary aggregates formed?
2. What types of monetary aggregates do you know?
3. Analyze the dynamics of the money supply in Russia in 1995-2000.
4. What dependence does the equation of exchange of I. Fischer establish? What are the left and right sides of the equation?
5. What determines the amount of money in circulation?
6. What is the relationship between the amount of money in circulation, its value and the level of commodity prices?

Demand for money

The demand for money is predetermined by such functions as a medium of exchange and a means of accumulation. Business agents need money to spend, using it as a medium of circulation in the present and accumulating it for future payments.
J.M. Keynes, analyzing the motives for which economic actors prefer to keep part of their wealth in the form of liquid monetary assets, identifies the following motives for keeping money:
- a transactional motive arising from the convenience of using money as a means of payment. People keep money for the purpose of making transactions. At the same time, transactional demand depends on the level of income (with an increase in income, transactional demand grows) and the time interval between receiving income;

1. a precautionary motive (a safety motive) that allows unplanned costs to be incurred. In an environment of uncertainty, there may be a need for unexpected payments. If they are not done, then this will lead to losses, therefore, individuals prefer to have a certain money supply;
2. a speculative motive due to market fluctuations and a desire to avoid capital losses caused by holding assets in the form of securities during periods of expected increases in interest rates.

Aggregate (total) demand for money (Dm) includes:

1. business demand, or demand for transactions;
2. demand for money as a reserve value (store of value).

Business demand - Dm (Q) is the demand for money to make purchases and payments. Each economic entity at any given moment must have a certain amount of money (cash balances) in order to be able to freely make transactions. Households need money to buy goods, pay utility bills, etc. Businesses need money to pay for raw materials, materials, pay wages, etc.
The amount of demand for "cash balances" depends on the nominal GNP. Business demand for money is directly proportional to the real volume of GNP and the level of prices. Obviously, an increase in real GNP leads (all other things being equal) to an increase in income, which stimulates higher spending and greater demand for money for transactions. The same direct relationship exists between business demand and prices. It is known that the purchasing power of money is measured by the amount of goods and services that can be bought with it. If prices rise, the purchasing power of money falls, and more money will be needed to keep real incomes at the same level.
In this way:
Dm (Q) \u003d f (Q P),
where Q is the real volume of the gross national product;
p is the absolute price level.
People save part of their income, and these savings can be carried out either in cash (accumulation of cash or funds in deposit accounts), or in the form of various financial assets (government securities, stocks, bonds, etc.). Each of these forms of savings has its own benefits. Money is absolutely liquid, but does not generate income. Securities are less liquid, but generate income. The demand for money as a reserve value (as a store of value) - Dm (i) - depends on the preference for liquidity.
If economic entities prefer to have highly liquid assets, the demand for money grows, if less liquid, but profitable, it falls. In turn, the question of how savings are allocated between money and non-monetary assets is decided depending on the interest rate (i). If the interest rate rises, then the rate (market price) of securities falls, their profitability rises, and economic agents prefer savings in the form of non-monetary assets - the demand for money as a store of value falls. And vice versa.
Hence:
Dm (i) \u003d f (i).
Thus, the aggregate demand for money depends on the real volume of production, the price level and the rate of interest on loans. This dependence is described by the following formula:
Dm \u003d Dm (Q) + Dm (i).
Graphically, the demand for money can be represented as follows (Fig. 23.1).

In fig. 23.1, a business demand for money is presented. The money demand curve for transactions is vertical, since demand does not depend on the level of the interest rate, but is determined by the nominal GNP.
In fig. 23.1, b presents the demand for money (reserve value), which is inversely related to the level of the interest rate.
In fig. 23.1, in the aggregate demand for money is presented - the sum of business demand and demand for money as a store of value. The curve of the total demand for money is determined by displacing the direct demand for money as a reserve value along the horizontal axis by an amount equal to the demand for money for transactions.
Self-test questions

1. What functions of money determine the demand for them?
2. What are the main reasons for keeping money according to Keynes?
3. What are the types of demand for money?
4. What determines business demand for money?
5. What does liquidity preference mean? What is the relationship between the level of interest and the demand for money as a reserve value?
6. What is the aggregate demand for money and what does it depend on?

Money supply

Money supply refers to the formation of the money supply in the country. The market does not create money. Providing money to the economy is a function of the state. The central state bank exercises direct control over the money supply and its regulation.
One of the features of the modern monetary system is the separation of the functions of creating cash and non-cash money. The creation of cash is the function of the central bank, while non-cash money is created by the system of commercial banks in the process of lending to the economy.
A commercial bank is a financial intermediary that accumulates temporarily free funds (buying money) and lending them on credit (selling money). For more information on banks, see chap. 8.
However, banks are not allowed to issue a loan for the entire amount of their deposits (deposits). The bank is obliged to keep part of its deposits in the form of cash or deposits in interest-free accounts of the central bank. The minimum deposit that a bank must keep with the central bank or have in cash is called the required reserves.
The amount of required reserves is determined on the basis of the ratio (rate) of required reserves (rr) set by the central bank as a share (percentage) of the bank's deposits. For example, if the bank's deposits amount to 100 million rubles, and the required reserve ratio is set at 20%, then the bank is obliged to keep 20 million rubles in the accounts of the central bank.
At first glance, it may seem that the amount of required reserves is a kind of insurance fund from which commercial banks can draw the funds they need in case of large and unexpected withdrawals of money by their depositors. However, it is not. The fact is that deposits in commercial banks are several times larger than the amount of reserves, i.e. reserves are partial, therefore, in case of sudden and large withdrawals of invested funds, the availability of required reserves will not save commercial banks from bankruptcy.
The requirement to keep part of the liabilities in the form of reserves is due to the need for control by the central bank over the ability of commercial banks to lend to their clients. The Central Bank, as a coordinating body, seeks to prevent an excess or shortage of credit resources and thereby exert the necessary influence on the amount of money in circulation and on the macroeconomic situation in general. The actual reserves of the bank, as a rule, are more than the required ones. This excess is called excess reserves. They are the source of loans.
Let's continue with the example. If the bank has 100 million rubles. actual reserves, then he can issue new loans in the amount of 80 million rubles. (100 million rubles of actual reserves minus 20 million rubles of mandatory reserves).
The role and importance of banks in a market economy are related to their ability to create new money in the process of lending (to carry out non-cash emission of money) and thereby influence the amount of money in circulation.
By issuing a loan and crediting it to the borrower's bank account, banks create new (non-cash) money.
To understand how banks make money, consider the following example. It should be remembered that bank deposits are non-cash money, and it is they that make up the bulk of the mass of money in circulation (M).
Let us assume that the reserve requirement ratio is set by the central bank at 0.2. Then bank A, which received a deposit equal to 1000 den. units, can issue a loan of 800 den. units ... The received loan is spent on paying bills (for the supply of materials, equipment, etc.) and goes to the account of Bank B. Bank B, having received a deposit of 800 den. units, can issue a loan equal to 640 den. units ... This loan, similarly to the first one, is spent and comes in the form of a deposit to the account of bank B, which from the received deposit of 640 den. units can provide a loan of 512 den. units etc.
The overall result of the chain of creation of deposits can be presented in the table.

Initial deposit of 1000 den. units caused a chain of secondary depots
2 3
zits, increasing the total amount of deposits in times. This expression is the sum of the members of an infinite geometric progression, which equals
, or - (1: 0.2), i.e. 5.
Initial deposit equal to 1000 den. units, the entire banking system increased 5 times, turning it into 5000 den. units, i.e. there is a multiplicative expansion of deposits.
Out of the total mass of money, 4000 den. units is new money created by the banking system. The total amount of newly created money is equal to the original excess reserve multiplied by the money multiplier (800 x 5).
A significant change in the volume of credit and the money supply due to a small change in the bank deposit is due to the ability of the banking system to use the same money to issue loans.
The coefficient characterizing the degree of increase in the money supply as a result of the increase in excess reserves is called the money multiplier (MRm). The monetary multiplier is equal to one divided by the required reserve requirement ratio (yr):
MRm \u003d (1: rr) x 100%.
A change in the standard of mandatory reserve requirements is reflected in the amount of money in circulation: its increase reduces the amount of money created by banks, while a decrease increases it.
In addition to the value of the required reserves ratio, the degree of change in the total money supply depends on the propensity of economic entities to keep cash outside the banking system. The full money multiplier, taking into account the population's propensity to have money in cash, looks like:
MRm \u003d (сс + 1): (сс + rr), where rr is the required reserves ratio;
сс - the share of cash in the total mass of money (in%).
The more money is outside the banking system, the lower the value of the multiplier. Thus, the degree of the final change in the money supply depends on the ratio of reserve requirements and the proportion in which money is divided into cash and bank deposits.
Self-test questions

1. What is a money offer and who implements it?
2. What is the purpose of the required reserves? Who determines the amount of required reserves and how?
3. What are excess reserves? What is their purpose?
4. What happens to the money supply when a bank issues a loan?
5. How much can the money supply increase the loans of an individual bank and the banking system as a whole?
6. Explain how the banking system creates new money.
7. What is the money multiplier and what is it equal to?
8. What determines the degree of change in the money supply?

Money market

Combining the money supply (Sm) with the total demand for money (Dm) gives a picture of the money market. The money market is a market in which the demand for money and their supply determine the level of the interest rate, the price of money.
The main participants in the money market are firms, government, central and commercial banks, etc. The object of sale and purchase is money provided for temporary use. The price of money is the amount of money that is paid for the use of money, i.e. loan interest.
The peculiarity of the money market is that, unlike commodity markets, where the process of buying and selling is an exchange of goods and services at prices measured in monetary units, in the money market money is actually exchanged for other liquid assets at an opportunity cost measured in units of the nominal interest rate.
As in any market, equilibrium occurs at the intersection of the supply and demand curves (Figure 23.2).

Since the supply of money is not determined by its price, but is regulated by the state, proceeding from the general goals of macroeconomic development (for more details, see topic 29), the supply of money is completely inelastic, i.e. does not depend on the value of the interest rate (their price). At the same time, the demand for money is a function of interest and is inversely related to the level of the interest rate.
Equilibrium in the money market means that the amount of assets that economic agents want to have in the form of money corresponds to the amount of money offered by the banking system. This equilibrium is achieved at a certain rate of interest (ie).
If the rate of interest (i \\) exceeds the equilibrium level, then business agents will not want to have the amount of money offered by the banking system, and a surplus of money will arise. This is explained by the fact that as a result of an increase in the interest rate, the value of securities will fall, they will become more profitable, and business agents will prefer non-monetary assets (securities) to monetary ones. However, a drop in demand for money will lead to a decrease in the lending rate to an equilibrium level. Equilibrium will be restored in the market.
If, on the contrary, the interest rate turns out to be less than the equilibrium rate (i2), the number of those wishing to keep their assets in securities will decrease. Those with savings will increasingly prefer liquidity, realizing that low interest rates are synonymous with high security prices. The demand for them will fall, which will cause an increase in their rate. This will lead to increased demand for money and higher interest rates, which will go up. Equilibrium will be restored in the market.
As in any market, the equilibrium achieved in the money market can be upset by various non-price factors:

1. a change in GNP affects the value of real income, and therefore is reflected in business demand and the demand for money as a store of value. Changes in demand under the influence of changes in income will lead to shifts in the demand curve for money and (other things being equal) to a change in equilibrium;
2. when presenting a demand for money, business agents take into account their purchasing power, which is measured by the amount of goods that can be bought with it. When the prices of commodities rise, the demand for money rises. An increase in the demand for money can serve as a signal for the state to increase the money supply, which can trigger further price increases.

Changes in the value of GNP, prices of goods lead to shifts in the demand curve for money (Fig. 23.3).

Figure: 23.3. Change in demand for money

An increase in the demand for money with a constant supply leads to a change in the equilibrium in the money market and an increase in the interest rate from i \\ to i2. A fall in the demand for money under the same conditions leads to a decrease in the interest rate from i \\ to i3.
A change in the supply of money, a shift in the supply curve, also leads to a change in the interest rate, which is reflected in investment demand and, indirectly, in the volume of production and the level of employment. More details in topic 29.
Thus, an important conclusion can be drawn: the money and commodity markets are closely related. Events occurring in the money market are reflected in the commodity market. In turn, changes in the production of goods and services are reflected in the demand for money. The relationship between the money market and commodity markets can be schematically represented as follows.

An increase in GNP, an increase in incomes, increases the demand for money, which, in turn, leads to an increase in the interest rate. An increase in interest rates affects investment and aggregate demand. Changes in aggregate demand are reflected in output and income.
Self-test questions

1. What is the money market? How does it differ from product markets?
2. What is the shape of the money supply curve? Does the supply of money depend on the demand for it?
3. What is the mechanism for restoring equilibrium in the money market if the actual interest rate is higher (lower) than the equilibrium one?
4. What will happen to the demand curve for money when the prices of goods increase (fall), and real incomes rise (fall)?
5. Describe the relationship between the commodity and money markets.

Basic concepts and terms

Money supply,
monetary aggregates,
monetary base,
I. Fischer's exchange equation,
a lot of money in circulation,
monetization coefficient,
value for money;
aggregate money demand,
preference for liquidity,
transactional motive,
precautionary motive,
speculative motive,
business demand,
the demand for money as a reserve value;
money offer,
mandatory reservation,
excess reserves,
money multiplier;

Equilibrium of the money market.

conclusions

1. Modern cash represents debt obligations of central banks, non-cash - debt obligations of commercial banks. All money circulating in the country (cash and non-cash) are combined into monetary aggregates that differ in their level of liquidity. The amount of money required for circulation is directly proportional to the volume of real national production, the level of prices, and inversely proportional to the velocity of circulation of money. The monetization coefficient characterizes the saturation of the economy with money. The value of money (their purchasing power) is determined by the amount of goods and services that can be purchased for a monetary unit.
2. The demand for money is determined by the functions of money as a medium of circulation and a means of accumulation. The main motives for keeping money, according to Keynesian views, are the transactional motive, the precautionary motive, and the speculative motive. The aggregate demand for money includes: business demand, the value of which depends on the real volume of production and the level of prices in the country, and the demand for money as a spare value, which is inversely related to the level of the interest rate.
3. In a market economy, money is created by banks. Whenever banks issue loans, new money appears. An individual bank can issue a loan within its excess reserves equal to the difference between the amount of deposits and required reserves, the amount of which is determined by the central state bank of the country. The entire banking system can create much more money than the initial surplus reserve, due to the ability of the banking system to use the same money to make loans. The coefficient characterizing the degree of increase in the money supply as a result of the increase in excess reserves is called the money multiplier and is equal to one divided by the ratio of the required reserve requirements.
4. Equilibrium in the money market is achieved when money demand matches money supply. Moreover, if the demand for money is formed by all subjects of economic relations, then the supply of money is regulated by the state and is absolutely inelastic, i.e. does not depend on the price of money (percentage). If the equilibrium is disturbed, it is restored automatically through interest rate fluctuations. Changes in the money market affect commodity markets. A change in GNP entails changes in income and demand for money, which is reflected in the level of the interest rate. Changes in interest rates affect investment, aggregate demand, and ultimately output and income.