3.4.2The demand for money

A second factor limiting banks’ ability to expand the total stock of bank deposits

is the demand for money. Be careful to distinguish this from the demand for lend-

ing we have just discussed. The demand for bank lending gives rise to a ow (of

new bank loans). If the ow of new loans exceeds the rate at which existing loans

are being repaid, there will be an increase in the stock of bank deposits. The ques-

tion at issue here is the willingness of people to hold an expanding stock of bank

deposits. Plainly, the simplest case is that where people are willing to hold exactly

that expanding stock of deposits which results from other people’s decisions to

borrow. Both sets of demand conditions are consistent. But suppose this were not

the case.

Imagine rstly that we have a demand for bank lending at some level set by the rate

of interest charged on that lending, other conditions for the moment being given.

We might refer to this as the ex antedemand for bank lending. Suppose secondly

that we have a demand for money, ex ante, which is less than that required to hold

the growing stock of bank deposits. How is the position to be reconciled?

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3.4 Constraints on bank lending

Remember to begin with that the demand for bank lending is a demand which

results from a desire to buy goods or services. Therefore, quite obviously, there is no

problem about the new deposits being wanted at this stage. Neither can there be a

problem at the next stage. The borrower passes the newly created deposit to the seller

of the goods who is willing to take it in payment. Indeed, it is worth emphasising

that from the seller’s point of view, he is simply receiving ‘money’; he has no way

of knowing when, where or how it was created.

Momentarily at least, the deposit is willingly accepted by the seller. Now comes the

crux of the issue. The seller has given up goods in exchange for an increase in his bank

deposit. There has been a rearrangement of his wealth. A decision now has to be

made about whether this rearrangement is acceptable for the time being or whether

some further rearrangement might be more satisfactory. The seller may be entirely

happy with the position or, as we began this discussion by assuming, he may decide

that he does not want to hold so much wealth in the form of money. If this is indeed

the case, he has obviously a wide range of choices available to him. Even limiting the

choice to alternative nancial assets still opens up many opportunities. He might

prefer a building society deposit or a National Savings instrument or government

bonds or equities. Buying any of these reduces his holdings of money.

Now we have to break out from this story of the individual and imagine that

what we have described is general. A general attempt to reduce money holdings in

this way adds to the demand for these alternative nancial assets, pushing up prices

and pushing down yields. As this process goes on, two consequences will follow.

Firstly, as yields fall on these alternative assets, the attraction of money rises relative

to them. Secondly, these falling yields mean that it is becoming cheaper for rms

and individuals to borrow by issuing new claims like bonds and equities or going

to building societies, by comparison with borrowing from banks. The demand for

bank lending will fall, not because of a rise in the ‘own’ rate of interest on bank

loans but because the fall in interest rates elsewhere has caused a relative rise in

bank interest rates. Because the cost of alternative forms of borrowing has fallen,

the demand curve for bank lending shifts to the left. We should now be able to

see that an inconsistency between the demand for bank lending and the demand for

the money stock created by that bank lending is reconciled by two simultaneous

mechanisms.

Firstly, as yields fall on non-money instruments the demand for money will

increase. Secondly, as these yields and therefore the cost of non-bank borrowing fall,

the demand for bank lending is reduced.