The State of Monetarism - The Importance of the Demand for Money

Monetarism might be associated with a focus on the supply of money, but we cannot ignore the demand for money. The demand for money is the demand by individuals and businesses for money held as cash as opposed to any other form of money.

I have a bank account. In that account I have £1,000. My potential spending, therefore, could be represented by that £1000. However, I only ever hold £50 as cash at any one time. My demand for money is therefore different to the amount of money I have at my disposal to spend.

The demand for money is dependent on the price of money - in other words, the interest rate. Holding money as cash implies that there is a price to pay for doing so. The price is the opportunity cost of holding money as cash - the interest sacrificed. Money as cash does not attract interest in the same way that holding money in some interest-bearing accounts does.

Holding cash involves an opportunity cost. The sacrifice is the interest foregone - what the cash could have earned in interest if it was put into some form of interest bearing account. Copyright: Andy Culpin, from stock.xchng.

The demand for money along with the supply of money is, in theory, a determinant of the price of money, the interest rate. Changes in both the demand and supply of money have an impact on the interest rate. If the demand for money rises and the supply of money stays constant, we might expect the interest rate to rise and vice versa.

Monetarists will also place some importance on the interest elasticity of demand for money. This is the relationship between the demand for money and changes in interest rates. We might be able to tell from simple theory that the demand for money would rise if interest rates fell - but by how much? Conversely, if interest rates increase by 0.5%, what will happen to the demand for money? Would it decrease by less than 0.5%, more than 0.5% or exactly 0.5%? If interest rates fall by a quarter point, what effect does this have on the demand for money?

Task 5

Assume that the supply of money increases as a result of a major discovery of gold. Using demand and supply analysis, explain what you would expect to happen to the interest rate and the demand for money.
The Bank of England raises the interest rate from 5.0% to 5.25%. Explain what you would expect to happen to both the demand and supply of money as a result.
How different would your answer be if the increase in interest rates had changed from 5.0% to 6.0%? (Hint - think about the interest elasticity of demand). Can the Bank of England control both the interest rate and the money supply at the same time?

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