Professor Jim Davis
Econ 1 C1
June 20, 2013
The Control of Money Supply & Demand of Money
Today, we live in a world of scarcity where resources are limited and the choices one make has become so vital the economy. In the US, the government, the Federal Reserve, have control on the effect of supply and demand and money growth. As both supply and demand for money each depend on the interest rate, we specifically look at how inflation effects supply and demand on money. There are differences of money supply and demand for money; where it comes from and how it’s demanded. Given there are many variables that can effect money supply and the demand for money, we will ...view middle of the document...
The real rate of interest is then, nominal interest less the inflationary premium. Hence, as the purchasing power of money decreases, nominal interest rates decrease. While, increasing or high rates of inflation lead to increasing rates of nominal interest rates (Gwartney).
The money supply in the U.S. economy is controlled by the government, it has assigned the Federal Reserve to oversee the banking system and control it. Money supply is the quantity of money available or supplied in the economy. It can change the amounts of money supply in the Federal banking system through the purchases and sales of government bonds. In open-market, the Federal Reserve buys and sells government bonds, by adding money and taking money from central banks. When it buys bonds, it adds money back into the bank. When it sells its bonds, the dollars it receives are withdrawn from the bank. Changes in bank reserves (deposits and withdraws), can alter the banks’ ability to make loans and create money. This type of monetary control is important because it explains how changes in the money supply affect the demand for goods and services.
Money demand is different because it comes from people wanting more of it and wanting to hold it rather than holding other types of assets. With money, people can purchase goods and services and also earn interest if held. The concept behind liquidity is that one may convert assets into cash. Cash is capital that allows for resources to be purchased. Today, money is of utmost importance than it was hundreds of years ago and is the most liquid asset available. The liquidity of money explains the demand for it. People choose to hold money instead of other assets because it offers higher rates of return. The quantity of money demand is explained through interest rate. It is also the opportunity cost of holding money (Keynes). Gwartney states, “Because resources are scarce, the use of resources to produce one good diverts those resources from production of others…The highest valued alternative that is sacrifice is the opportunity cost of the chosen option” (page 7). In essence, there is greater value placed on interest rates because people expect to earn income on the dollar. However, an increase in the interest rate raises the cost of holding money and reduces the quantity of money demanded. A decrease in interest rate, reduces the cost of holding money and raises the quantity demanded.
There are some advantages investors and lenders have from availability of early loanable funds. For investors, loans allow them to finance their capital assets because they expect to be able to increase output and have a greater return in profits. Gwartney states, “Investors can gain from borrowing funds…only when the capital assets they purchase permit them to expand out (or reduce costs) by enough to make interest payments and still have more output than they would have without the investment” (page 267). For consumers, having...