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Money Supply and Money Demand

There have been three great inventions since the beginning of time: fire, the wheel, and central banking.

— Will Rogers

The supply and demand for money are crucial to many issues in macroeconomics. In Chapter 4, we discussed how economists use the term money, how the central bank controls the quantity of money, and how monetary policy affects prices and interest rates in the long run when prices are flexible. In Chapters 10 and 11, we saw that the money market is a key element of the IS–LM model, which describes the economy in the short run when prices are sticky.

This chapter examines money supply and money demand more closely. In Section 19-1 we see that the banking system plays a key role in determining the money supply, and we discuss various policy instruments that the Bank of Canada can use to influence the banking system and alter the money supply. We also discuss some of the regulatory problems that central banks confront—an issue that rose in prominence during the financial crisis and economic downturn of 2008 and 2009. In Section 19-2 we consider the motives behind money demand, and we analyze the household’s decision about how much money to hold. We also discuss how recent changes in the financial system have blurred the distinction between money and other assets and how this development complicates the conduct of monetary policy.