RATE OF INTEREST AND SUPPLY AND DEMAND OF CENTRAL BANK

FACTORS AFFECTING RATE OF INTEREST (i)

  1. PRICE LEVEL

As price level increases there will be an increase in the demand for money because at higher price, we need more money to buy goods and services . Therefore , with given money supply, it will result into excess demand for money at initial interest rate as a result rate of interest (i) will increase.

  1. LEVEL OF TRANSACTION

When level of transaction increase , there will be increase in demand for money. As, money is needed for transaction purpose, but with given money supply, it will result into increase in interest rate.

  1. MONETARY POLICY AND OPEN MARKET OPERATION

Monetary policy relates to change in money supply, open market operations is an instrument of monetary policy and it relates to sale and purchase of government bonds. If central bank purchases bonds, then money supply in economy increases. As a result, rate of interest decreases (expansionary policy).

source- google images

 

DEMAND AND SUPPLY OF CENTRAL BANK MONEY

When people can hold both currency and checkable deposit, then demand for money involves two decisions-

  1. People must decide how much money to hold
  2. They must decide how much of this money to hold in currency and how much to hold in checkable deposit.

The overall money demand function is expressed as-

m^d= P Y L(i)

Assume that people hold a fixed proportion of their money in currency and hold the remaining fraction in checkable deposits. Suppose, that people hold a proportion ‘c’ in currency and ‘1-c’ in checkable deposit. Therefore , demand of currency and deposit can be expressed as

Cu^d= Cm^d

D^d= (1-c) m^d

Larger will be the amount of checkable deposits , larger will be the amount of reserve, that banks must hold, for precautionary reason and legal reason. Let Q be reserve ratio, so we get

Q=R/D

Therefore, R= QD

R^d= Q (1-c) m^d

If people want to hold D^d in deposits, then bank must hold reserve R^d . Therefore,  demand for reserve , will be

R^d= QD^d

R^d=Q(1-c)m^d

Let demand for central bank be H^d and it has two components i.e. demand for currency and demand for reserve.

H^d = Cu^d + R^d

H^d=Cm^d+ Q (1-c) m^d

H^d=[C+ Q(1-c)] P Y L(i)

Let supply of central bank money be H. Therefore, at equilibrium demand for central bank money must be equal to supply of central bank money.

H^s= H

H^s= H^d

H= P Y L (i) [ C+ Q(1-c)]

source- google images

ALSO READ- http://theecogazette.com/2017/09/13/1161/ 

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