Role of Money Demand in Transmission of Money Policy


Money plays an important role in helping decide the monetary policy. Monetary policy means varying the supply of money in the market. When there is a huge demand for money in the market the central bank tends to increase the supply to meet the demand. However when the money becomes more in the market the bank acts in a manner that reduces the amount of money in circulation and this forms the basis of monetary policy. Changes in the value of money will always have a far reaching effect in the economy i.e. in wealth creation and wealth sustainability. The effective quantity of money is total cash of credit multiplied by the average velocity of circulation, i.e. the speed at which notes pass from hand to hand and bank balances from one account to another. The relative extent to which people prefer to use money as a store of value rather than as a medium of exchange is thus taken into consideration. It therefore follows for example, that an increase in the volume of cash and credit created by the banking system maybe offset by a decline in the velocity of circulation of money; and that a fall in the effective volume of money may produce either a reduction in the price level or a fall in the volume of business and employment.

The existence of four variables means that cause and effect in the relationship between money, prices and employment can be accounted for only by having regard to other factors. There are several forces that determine the value of money and the general price level. The general price level in a community is influenced by the following factors:

  1. The volume of trade
  2. The quantities of currency
  3. The volume of credit, and
  4. The velocity of circulation of currency

These four factors change independently as well as in relation to each other. Money is used in exchanging goods. The greater the volume of exchange required to be made, the greater is the demand for money and hence the greater will be the value of one unit of money, and vice versa. It is well known that the value of anything depends on its supply.

Policies of Central Bank

Central bank has many policies which assist in controlling the flow of money in the market. The policies of central bank in management of flow of money in the market include open market operations and minimum rending rate. The main issue of monetary policy by central bank is to reduce the total spending by raising the cost of borrowing as well as limiting availability of money for loans. Open market operations use various tools such as special deposits and directives in restricting the flow of money. An open market operation consists of selling of government securities in the stock exchange. When customers pay the money is withheld thus increasing commercial banks reserve rates. it involves increasing the national debt by the bank. Thus, the central bank wishes to decrease the money supply, the sales of treasury bills are restricted by converting the desired amount of short-term debt into funded debt. Consequently the banks must seek alternative liquid assets to reduce deposits.

Drawback to the effectiveness of this process is that the banks may maintain their liquidity by increasing their holdings of commercial bills. These bills are bought from the discount houses and are just as liquid as treasury bills.

Special deposits are the drawback can be overcome to some extent by special deposits as a form of control. These special deposits do not count as part of the liquid assets and so in order to raise them, the banks have to call in part of other advances.

Issuing directives open market operations and calls for special deposits are insufficient in themselves to achieve over full control over bank advances. Therefore, the central bank may supplement its action by issuing directives to strict loans.

Bank rate is also used to influence the interest rates thus affecting the cost of borrowing. Technically, bank rate is the minimum rate which the central bank is prepared to rediscount bills of exchange brought to it by members of money market. However, the chief importance of bank rates rests in its function as the sheet of anchor of interest rates throughout the country.

Changes in the banks influence other rates. When bank rate is raised, borrowing becomes expensive and demand for loans is reduced, thereby reducing purchasing power.

Objectives of the central bank policies

The main objective of central bank policy is to ensure that the supply of money in the market is stocked to ensure there is sustainable growth. If the interest rates in the market and the flow of money is not controlled the inflation may go very high thus destroying economic growth by discouraging investment and consumption in the long run. The monetary policy is good in the short run. The central bank has been assisting the federal government in ensuring a stable economy. It also helps in creating more jobs for the Americans hence employment problems is slowly resolved. It is very important that currency would remain stable as much as possible since it is a determining factor in the stability of the nation’s economy. Therefore, the central bank plays a vital role as it performs responsibilities that are economically essential.

In order to further domestic and international objectives, a comprehensive reform of the payment system which includes the unified national check collection system was done by means of Federal Reserve Act. The Federal Reserve has active involvement in processing checks and other forms of retail payments. This is to help the banking industry accelerate the check collection process. This can be facilitated because Federal Reserve uses high-speed sorting equipments and machine-readable routing and account numbers. Elliott McEntee affirmed that Federal Reserve indeed played a very important role in payment systems and it has encouraged improvement in payment systems. According to McEntee, the Federal Reserve thinks of offering electronic payment methods which would help in the reduction of check volumes (Browne, p. 3).

Overhauling the stunted discount market is the major provision of this act. This could be beneficial in the sense that it will add liquidity to the internal payment systems as well as facilitate the development of the U.S. dollar as the international currency. Furthermore, legalizing bankers’ acceptances and foreign branching can manifests the intention to allow international trade financing of the large American banks. Multiple outputs can be generated by this legislation. For example, it allows the newly created Reserve Banks to influence internal credit markets, exchange rates and gold flows (Broz, p. 27). The role of the Federal Reserve has been expanded by the Congress. In 1946, the Congress mandated Federal Reserve to promote maximum employment by using all its resources. In 1978, Congress expanded the role of the Federal Reserve with the Full Employment and Balanced Growth Act (Hill, p. 50).

Federal current primary objectives include (a) issuing and controlling of bank notes and coins. New notes and coins are put into circulation in return for old ones which are removed by the commercial banks as they deteriorate. (b) The bank acts as banker to the government. In the course of this work, it keeps accounts, arranges loans and provides means of payment. All government revenue is paid into the exchequer account and payments for goods and services received by the government are made out of this account. The bank also keeps the account of a number of government departments. Loans are raised in a number of ways;

  1. Ways and means advances made by the bank to the treasury are comparable to the overdrafts provided by businesses by the commercial bank. This direct form of borrowing forms only a very small proportion of government borrowing.
  2. Short-term loans are raised by selling treasury bills in the money market.
  3. Long-term loans are obtained by selling new issues of government stock in the capital market. Repayment dates can be anything between 5 and 30 years and sometimes no time is fixed for their redemption. Registers of stock holders are kept by the bank which also pays the interest and arranges transfers and repayments when due. Thus the management of the national debt (except that controlled by the national savings bank) is entrusted to the bank.
  4. Other functions
  1. Management of the exchange equalization account to maintain the value of the shilling in foreign exchange market.
  2. Advice on general financial matters such as the level or interest rates of the volume of bank credit.
  3. Maintenance relations with international monetary authorities (such as international monetary fund) and with the central banks of the countries.
  4. The bank acts as banker to the commercial banks by holding a proportion of their cash reserves. This enables the banks to settle any indebtness to each other created by the daily clearing of cheques, by transfer between their accounts at the banks.
  5. The bank acts as lender for the last resort to the money market through its willingness to lend freely at bank rate on the security of first class bills of exchange.
  6. The bank is responsible for the management of the governments monetary policy.

The current problems of financial institutions is both liquidity and solvency. Although the magnitude of liquidity is lower. The current crisis is solvency because banking institutions gave out mortgage and the mortgage owners have failed to honour and the banks are providing huge provisions for bad debts. Their liquidity asset deposit with Federal Reserve have been affected, this is why we can say it is partly liquidity since they have some liquid assets with the federal reserves. They have also some liquidity problems since the mortgage owners have failed to honour the principle amount and interest meaning that the banks are also facing liquid problems. It is important for banks to have stable liquidity assets to be able to meet obligations to the customers. banks with liquid problems will not be able to guarantee loans and overdraft as well as have fun to give customers when withdrawing their deposits. The principle functions of banks include:

  1. To accept deposits from customers, to hold money for them in safe keeping, and to meet withdrawals either on demand or after short period of notice.
  2. To act as an agent of payment. By operating the cheque system, the banks provide a mechanism whereby individuals or businesses can make payments or receive money, without an exchange of cash.
  3. To grant loans and overdrafts on approved security. A commercial bank will advance money to an individual or a company as a loan or as an overdraft.
  4. To discount bills of exchange and promissory notes. When a transaction of this kind is takes place the bank in effect buys the bill of promissory note and credits the customers account with its face value less the banks charges.
  5. Agency services, such as the collection of foreign cheques , bills of exchange, dividend warrants and other credit instruments.
  6. Miscellaneous services, including the transaction of foreign exchange business provisions of information as to overseas trade facilitate and markets, the issue of travelers cheques, letters of credit, etc.


  1. Bach, G. L. (1950). Federal Reserve Policy-Making: A Study in Government Economic Policy Formation. New York, Knopf.
  2. Browne, Lynn Elaine (2001). The Evolution of Monetary Policy and the Federal Reserve System over the Past Thirty Years: An Overview. New England Economic Review, p. 3.
  3. Broz, J. Lawrence (1997). The International Origins of the Federal Reserve System. Ithaca, NY., Cornell University Press.
  4. Goodfriend, Marvin (1994). Why We Need an ‘Accord’ for Federal Reserve Credit Policy. Journal of Money, Credit & Banking, vol. 26, is. 3, p. 572.
  5. Hill, Patrice (1999). What the Fed Does and Doesn’t Do. World and I, vol. 14, is. 4, p. 50.
  6. Shull, Bernard (2005). The Fourth Branch: The Federal Reserve’s Unlikely Rise to Power and Influence. Westport, Connecticut, Praeger.
  7. (2006). Money Panics and the Establishment of the Federal Reserve System. Social Education, Vol. 70, Is. 2, p. 69.

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