Money and interest rates

Business and interest rates

Important determinant of business activity is the rate of
interest.
Interest rates are seen as barometer of the future course of
the economy.
Higher interest rates- increases cost of borrowing
Higher interest rates on personal loans, on credit cards or on
mortgage cuts down borrowing and spending by consumers.
Aggregate demand falls.
What determines interest rates?
In a free market, interest rates are determined by the
demand for and supply of money.
The process of altering interest rates by the countrys
central bank is known as Monetary Policy.

Meaning of Money
Money takes many forms
Money is any asset which performs the functions of money.
Functions of money:
1. Medium of Exchange
2.Unit of account
3. A standard of Defered Payments
4. A store of value
Demand for money Theories
The amount of wealth that households and business desire to hold in the form of

money balances is called the demand for money.

Classical Quantity Theory of Demand for Money:
The theory of demand for money has been derived from the equation of exchange

developed by Irving Fisher.

MV = PQ =Y
M = Stock of money. It is simply the money supply (i.e, total amount of money

available in the economy.

V = Velocity (Velocity is the rate at which money moves as it carries out its functions.

It is the number of times an average rupee changes hands during a period of time.

 P = price. Price level of output

Q = real output of goods and services
Y = pq = GNP at current prices
Thus P x Q is simply the money value of all goods and services

produced and sold. The right hand side is the real flow of goods and
services, measured in money terms. The left hand side is the money
flow.
Cambridge approach:
M = k PQ = KY
Where, M,P and Q are defined as in the above equ
K = the fraction of Y or PQ that the community holds in the form of
money balances.
K is the reciprocal of V ie k = 1/V or V = 1/k
Md = Kpq = KY = Ms - Equilibrium
That means amount demanded is a proportion of PQ or Y or GNP.
Amount demanded is directly related to the spending involved in GNP.

Example
Suppose if GNP = Rs.27,000 crs
Velocity = 3
Then desired cash holdings will be 1/3 of GNP
Thus the amount demanded will be Rs.9,000 crs
Keynesian Approach:
According to classical approach money is demanded only for

spending purposes. Transaction is the only motive for holding

money.
Keynes view- Money would be held as an asset, a non-interest
paying asset, whereby velocity is affected and tends to
change.
The three motives for holding money are transactions,
precaution and liquidity or speculation
Transactions demand for money: holding money to spend it.
Money provides us with instant purchasing power.

 Payments and receipts are not perfectly synchronised income is

not received at the time purchases are to be made.

Determinants of demand for transactions
1. Level of income
2. Frequency with which income is received
3. Frequency with which expenditures are made.
Precautionary Demand for Money:
Precaution against uncertain circumstances
Another determinant of precautionary demand for money is the

level of income.
Speculative Demand for Money:
Speculative demand for money changes with the change in the

prices of securities and earnings possible.

The size of the demand for money is also determined by the

share prices or the prices of other securities apart from

income as seen earlier.

 Demand for money rise if people anticipate a fall in prices of

securities.
For instance, some intelligent individuals anticipated the
2000-03 stock market decline, and sold shares and went
liquid.
Rate of interest is the most important determinant in
the operations of money market.
It is related to the opportunity cost of holding money
Which means the interest foregone by not holding higher
interest bearing assets, such as bonds or shares.
Generally if interest rates rise, they rise more on bonds and
other securities than on bank accounts.
The demand for money will thus fall as people switch to these
alternative securities.
Therefore, the demand for money is inversely related to the
rate of interest.

 Can this process go indefinitely? No.

Banks have to keep a certain proportion of their deposits

in the form of cash to meet the demands of their

customers for cash.
Bank or deposits multiplier
The number of times greater the expansion of
bank deposits is than the additional liquidity in
banks that caused it. 1/L (the inverse of the
liquidity ratio).
Cash ratio = L
Deposit multiplier = 1/L
Liquidity ratio: the ratio of liquid assets (cash and
assets that can be readily converted to cash) to
total deposits.

What causes money supply to rise

1. Increased demand for credit banks will be prepared to operate

with a lower liquidity ratio to meet this demand

2. Extra money from abroad- build up of foreign currency reserves
3. increased government borrowing- if the govt. spends more than
it receives in tax revenues, it will have to borrow to make up the
difference. This difference is known as the public sector net cash
requirement (PSNCR).
Govt. borrows by selling interest bearing securities. Short termtreasury bills and long term securities in the form of bonds, also
known as gilts.
Securities get sold to the bank- money paid to govt in turn finds
its way to banks, the banks can use it as the basis for credit
creation.
Bonds being longer term, are not regarded as liquid asset by
banks and cannot be used as the basis for credit creation. The
government could attempt to minimise the boost to money
supply, therefore, by financing the PSNCR through the sale of
bonds.

Equilibrium rate of interest

Equilibrium in the money market occurs when the

demand for money is equal to the supply of money.

Demand for and supply of money are plotted against
interest rates

Money supply
Money supply is not just cash, but deposits in banks and other

financial institutions.
People can access and use this money in their accounts through
cheques, debit cards, standing orders, direct debits etc. without the
need for cash.
Measures of Money: M1, M2, M3 & M4
Banks and the creation of credit:
Banks play an absolutely crucial role in the monetary system
Banks create additional money by increasing the amount of bank

deposits.
By lending to people-granting overdrafts or loans- these loans are
spent-shops deposit in their accounts, or have it directly transferred
when debit cards are swiped across their tills.
Thus the additional loans granted by banks become deposits in the
shops banks. These are further used as loans again . These in turn
create further deposits and so on. The process is known as the
creation of credit.