This page has been robot translated, sorry for typos if any. Original content here.

Money and credit - Ivanov V.M.

7.4. Establishing the balance and consequences of changes in supply and demand

Equilibrium in the money market takes place at the intersection of supply and demand curves. Equilibrium in the money market means the equality of the amount of money that business agents want to keep in their asset portfolios, the amount of money offered by the NBU in the implementation of the current monetary policy.

Fig. 9 illustrates the interaction of supply and demand in the financial market and determines the position of their equilibrium in relation to the money supply in circulation and the nominal rate of interest. The vertical money supply curve indicates that the government (NBU) is taking all necessary measures to maintain a constant money supply at the level of 200 den. units regardless of changes in the nominal interest rate. The graph shows that people will have exactly 200 den on hand. units only at an interest rate of 10. With a lower rate of interest, people will try to increase the amount of money in their portfolios, thereby pushing the price of securities down, and the rate of interest up, thus achieving equilibrium. At a higher interest rate, people will seek to reduce the amount of money in their portfolios by buying securities, thereby pushing the price of securities up, and the interest rate down, again trying to achieve equilibrium. Thus, no other rate of interest in these conditions can create a balance in supply and demand in the money market.

In fig. 10 shows the effects of changes in the money supply. Initially, the money market is in equilibrium E1 at M = 250 den. units and a percentage rate of 8. When decreasing

The interaction of supply and demand

money in circulation, up to 160 den. units the supply curve will shift from MS1 to MS2. As a result of the depletion of reserves of the banking system, banks are not able to provide an offer of money in an initial amount equal to 250 den. units at a rate of interest equal to 8.

In order to avoid an impending reserve deficit, banks must align their balance sheets. Some of them will increase reserves by selling their securities, thereby lowering the market price. Other banks can increase their reserves by withdrawing demand loans. Such measures tighten the conditions for obtaining a loan in the loan market and contribute to the growth of interest rates. In addition, some banks may try to increase their reserves by taking loans from other banks. However, given the general lack of reserves for the entire banking system, this will push up the interest rate for such transactions. Therefore, the reaction of the banking system to a decrease in reserves will lead to an increase in interest rates in all, without exception, credit markets.

As interest rates increase, business agents in turn will adapt to new conditions.

Faced with an increase in the opportunity cost of storing money, they will begin exchanging money for other assets that bring ever higher returns. Such changes correspond to an upward left movement along the money demand curve. When the nominal interest rate reaches 12.5%, the amount of money that business agents will ultimately prefer to store will coincide with the amount of money offered by the banking system. Thus, the economic system will reach a new equilibrium at point E2. An increase in the money supply directs the considered processes in the opposite direction. A purchase by the National Bank of securities shifts the money supply curve. Trying

The effect of a change in the money supply

maximize the use of newly received reserves, banks begin to buy securities and ease the terms of loans. Interest rates are reduced, which increases the amount of money in the portfolios of assets of firms and households. Thus, the money market moves to the right and down the demand curve for money to a new equilibrium position.

Suppose (Fig. 11) that some circumstances (for example, an increase in nominal national income) increase the demand for money from MD1 to MD2. This will lead to the fact that with an initial interest rate of 10, people will want to keep more money in their asset portfolios (300 den. Units), despite the fact that the banking system is able to offer only 200 den. units Therefore, an attempt is made to acquire more money by selling securities and asking for loans. These actions lead to an increase in the nominal interest rate to 15, which ensures that the amount of money in circulation (200 den. Units) matches the amount of money stored in the portfolios of assets of economic agents, in full accordance with their desires. The money market reaches a new equilibrium position (point E2).

Reducing the demand for money launches the processes under review in the opposite direction. Suppose that the demand curve has moved left down from MD2 to MD1 from the initial equilibrium position E2. In this case, the share of money in the portfolio of assets of economic agents would be greater than this would coincide with their desires. Therefore, they will begin structural changes in their asset portfolios or use the money to repay previously taken loans. Such actions will inflate securities prices and lower the rate of loan interest, but will not be able to change the quantity

The consequences of a change in money dispute

circulating money, which the banking system offers to business agents. Equilibrium in the money market can only be achieved when interest rates fall to a level that ensures that the amount of money in circulation matches the amount of money placed in the asset portfolios of business agents.