Money and Interest rates

• Narrow money M0 is the most liquid form of money and it comprises of notes and coins in circulation in the hands of the public, tills, banks and building societies
• Broad money M4 includes narrow money and wholesale and retail deposits held in monetary financial institutions such as banks
• The functions of the money are:

  1. Medium of exchange
  2. Store of wealth
  3. Unit of account
  4. Standard of deferred payment
• Medium of exchange means money can be used to purchase goods and services, eradicating the need for a barter system
• Characteristics of money:

  1. Acceptable to all
  2. Fairly durable
  3. Limited in supply
  4. Divisible
  5. Portable
• Money supply is interest inelastic because it is set by policymakers and not influenced by changes in the rate of interest
• Money supply curve is a straight line because we assume that the central bank has control over the money supply, making it independent of the price money
• Demand for money can increase with a rise in incomes
• The money demand is the amount of money that people are willing to hold
• Fisher was an American economist who believed that there was a direct relationship between the money supply and the price level
• PT = MV where P is price level, T is output, M is the money supply and V is the velocity of circulation
• Liquidity refers to how easily something can be spent
• The rate of return on illiquid assets (like corporate bonds) is generally higher than that on more liquid assets, so the bank wants less liquid assets
• Loanable funds are the total amount of money available for the borrowing.
• Loanable fund theory says the interest rate is determined by the supply and demand of loanable funds.
• At higher interest rates, the supply of loanable funds will be higher as people save more, and demand will lower since people borrow less
• When interest rates are high, bonds are more attractive, the reward of the interest outweighs the risk of a price fall. If interest rates are low, bonds are less attractive, the risk of a price fall outweighs the reward of the interest
• Demand for liquid money also depends on people's expectations of future interest rates (speculation)
• Money as a store of value is the function that allows it to be used for future transactions
• Money as a unit of account is the function of money that allows the value of goods, services and other assets to be compared
• Money as a standard of deferred payment is the function of money that allows contracts for payment at a future date to be agreed
• Liquidity is the extent to which an asset can be converted in the short term and without the holder incurring a cost
• A liquidity trap is when a change in the supply of money does not change the interest rate. This means monetary policy cannot be user to influence consumption and investment
• The quantity theory of money states that there is inflation if the money supply increases at a faster rate than national income