The Demand and Supply of Money and Other Financial Assets

I've read a few bits recently about the demand and supply of money, in particular over the question of whether the quantity of money is determined by supply and demand. Nick Rowe puts the monetarist case very well and I'm going to try and paraphrase him here.

It's helpful to look at a simplified balance sheet, like that shown below.  Here we have lenders holding bank-issued money, borrowers with loans, and banks.  Banks have nil net worth, so money equals loans.

	Savers	Borrowers	Banks
Money	M		-M
Loans		-L	L

We can then hypothesise a money demand function that says that the demand for money balances is in some fixed proportion to nominal income.  Maybe this applies only in the long run, so that there is a gradual adjustment towards it, but in long run equilibrium the demand and supply of money will be equal, so we can write M = kPY.

What is the causal interpretation here?  Well, the quantity of money in existence is being determined in the loan market.  An increased demand or supply of loans leads to a greater supply of money.  Borrowers spend the money they borrow.  If this leads to lenders holding excess money balances then they will tend to spend these until income and money holdings are in balance again, basically until the condition M = kPY is met.

So in this limited framework, we might say that the quantity of money is supply determined and that the supply of money then determines nominal GDP.  We have skipped over the question of the extent to which loan volumes themselves depend on nominal GDP, but otherwise I tend to agree that this is a useful way of looking at these dynamics.  So saying here that the quantity of money is supply determined seems to me to be reasonable.

What I am less happy with is the idea that this is necessarily a story about money.  It is a story of money here, but that is because we have severely limited the number of monetary assets that appear.  So let's expand our balance sheet so that banks are now funded with transaction accounts (which we'll call money) and  what we'll call savings bonds, which cannot be used for exchange.

	Savers	Borrowers	Banks
Money	M		-M
Savings Bonds	B		-B
Loans		-L	L

Now, we find that an increase in lending adds to the total quantity of money and savings bonds.  But, in itself, it doesn't tell us the split between the two.  To determine that we need to know something about the relative demand for each.  So, once we allow for banks to have liabilities other than money, we can no longer really say that the quantity of money is essentially supply determined.  Of course, banks will have preferences as to their liability mix, so supply conditions will matter as well, but no more so than demand.

The further point here, is that once we allow for a financial sector with liabilities other than money, the same principal applies to lending by non-bank financial intermediaries (NBFIs).  So, we can imagine that what we have called banks in the balance sheet above instead includes all financial intermediaries.  We have banks that issue money and savings bonds and NBFIs that issue only savings bonds (but that might hold money or borrow through loans).  We now need to specify that what we have called money means instead just that money held outside the financial sector and loans means loans outside the financial sector.

Now there is no immediate difference between additional lending by banks as opposed to NBFIs.  Both will initially increase the amount of money held outside the financial sector, but how the balance between money and savings bonds develops then depends very much on the preferences of savers.

So I don't have much of a problem with an analysis that says that the quantity of financial assets is determined in the lending market and that that quantity then impacts on nominal GDP.  However, in a world with many different financial assets, which are often close substitutes, this does not imply that the quantity of any one particular asset (including money) is itself supply determined.