Kevin has edited encyclopedias, taught history, and has an MA in Islamic law/finance. He has since founded his own financial advice firm, Newton Analytical.
How Does the Money Market Work?
While it may sound strange to think about money being subject to supply and demand, it actually makes quite a bit of sense. For starters, very few people would go as far to say that they couldn't use more money if it were available to them. Also, people pay a price for money, although we tend to call it an interest rate instead. With that in mind, let's try to draw a supply and demand graph for money. Start with the x-axis and y-axis. The x-axis, where quantity supplied normally is, would stay the same - after all, we're talking about the quantity of money supplied. For the y-axis, we'd normally put price, but to make things easier, we'll just call that axis the interest rate axis.
But what about the actual lines? The demand line for money looks like any other demand line - it has a positive slope that starts low and rises. The supply curve for money, on the other hand, looks different. It's a straight vertical line. This is because there is only one supplier for money in the United States, and that's the Federal Reserve Bank. It is up to the Fed, as it is commonly called, to decide when it's time to make new money. Okay, fine, so it's not a perfect straight line, as there are counterfeiters, but you get the idea.
Demand for Money
Like I said earlier, just about everyone could use more money if they had access to it. But why? Remember, money is ideally only good as a medium of exchange - you shouldn't be able to turn the physical pieces of money into anything more valuable than the face value of the note or coin. So what do people use money for? Economists characterize the way that people use money in one of four large umbrellas.
Transactional demand refers to needing money to buy and sell things. That 10-dollar bill in your wallet for lunch satisfies this demand.
Precautionary demand is having money in case of emergencies. If you have a couple of 100-dollar bills tucked away someplace no one else knows about, then that money goes towards precautionary demand.
Speculative demand is money you hold onto because you think the money itself will be worth more money later. That sounds confusing, but remember there are multiple currencies - if you think that Euros will rise in value and buy a $100 worth hoping to sell them for more later, then your $100 went towards speculative demand.
Finally, there is the portfolio demand of money, which largely is held by investors to balance out their portfolios. Investors don't just plan for the future 20 or 30 years from now, but also have to have resources that allow relatively quick access.
Supply for Money
The money supply also has three different flavors, and the differences between these can help the Fed understand how quickly money is moving through the economy. These parts of the money supply are designated as M1, M2 and M3.
M1 is the money that is considered most liquid, or able to be spent. Consumers face no waiting penalty or waiting period to spend the money in their checking accounts or the cash in their possession.
M2, on the other hand, may have some penalty or waiting period, but not a very long one. It also includes all of M1. Think of a savings account. You're only supposed to withdraw money from a savings account occasionally - that's why it pays an interest rate. However, it's still there if you need it.
Finally, there is M3, which is all the money in M1 and M2, but also any money in a long-term investment like a certificate of deposit, or CD. You can get money out of a CD, but you have to pay a penalty and often wait a few days. This is not very liquid. However, all of this money is considered more liquid than other assets, like real estate, gold and silver or even businesses.
Let's take a minute to review. Remember, money is just like any other good and is subject to supply and demand. The price we pay for money is called an interest rate. Also, while the demand curve for money resembles any other demand curve, the supply curve is vertical, since there is only one legal supplier of money in a given market. The demand for money has four components, transactional, precautionary, speculative and portfolio, while the supply of money is described as M1, M2 or M3, depending on the liquidity of the money in question.
After watching this lesson, you should be able to:
- Describe how money in the market works
- Identify and explain each of the four components of money demand
- Examine the different parts of the money supply (M1, M2, M3)
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