Money supply is determined by central bank decisions and willingness of commercial banks to loan money. Money supply in effect is perfectly inelastic with respect to nominal interest rates. Thus the money supply function is represented as a vertical line – money supply is a constant, independent of the interest rate, GDP, and other factors. Definition: Money supply refers to the amount of domestic currency that circulates in a national economy during a specified period.Money supply includes cash, coins, and money held in savings and checking accounts for short-term payments and investments. Real Money Supply. Money supply expressed in base-year dollars, calculated by dividing the money supply by a price index. Related Terms: Accomodating Policy. A monetary policy of matching wage and price increases with money supply increases so that the real money supply does not fall and push the economy into recession. After-tax real rate of return. Money after-tax rate of return minus the inflation. Supply of Money. The supply of money in an economy is controlled by its central bank, for example, Fed in the US. The Fed may change the money supply by using open market operations or by changing reserve requirements. Demand and Supply Curve. The demand and supply curve for money can be represented as follows.

3.1 Demand for Money
The notion of a demand for money may strike you at first glance as bizarre. Don't you just want as much as you can get? Or isn't money what you use when you demand other goods? Here is where we have to remember that money is a stock not a flow, and that income and wealth are not money. Demand for money is a question of how much of your wealth you wish to hold in the form of money at any point in time. (Supply of money is also a stock concept.)

Your demand for money is how much of your wealth you wish to hold as money at any moment in time. It is thus a stock demand. Your wealth is a stock, and you must decide how to allocate that stock of wealth between different kinds of assets -- for example a house, income-earning securities, a checking account, and cash.

Why would you hold any of your wealth as money -- as cash or checking deposits? Those assets earn little or no interest. Wouldn't it be more sensible to hold all your wealth in the form of assets that yield income? Note that:

2. There is no intrinsic value in the money balances you hold except in their use as a medium of exchange. Generally, you acquire money in order to get rid of it -- to buy things. While you hold it, money does not keep you warm, entertain you, or provide any other benefit.

Economists identify two reasons why people will demand money balances, or desire to hold a certain stock of money even if there is no intrinsic value for the money balances they hold.

3.2 Transactions Motive for Holding Money
The most obvious answer is that we hold some money because it's convenient to buy stuff with. We'll call this first reason the transactions motive. Essentially, it's convenient to hold a certain average amount of money at any given time, depending on the kind of purchases you make and the size of your income.

One of the most important functions of money is that it is the universally accepted medium of exchange -- this is the main reason you hold money. Thus, one reason to hold money is to use it as a means of payment in transactions in the future. Now, if there was a perfect match between the moments you receive money in transactions and the moments you use money, you would not need to hold any money at all. If I were paid every Friday, and I could pay all my bills on the same day, then I would need to hold very little money.

Unfortunately, in the real world, there is not going to be an exact match between when I receive money and when I need to make payments. Let us say that as a work study student, you receive $500 every month as payment for your work. This payment comes once a month. But you need to pay for rent, food, movies, books, copying, pens etc. This is spread out over the month. So, on the first of the month, you deposit $500 in you bank account at Fulton bank, and then you withdraw this money and run your account down to zero over the course of the month. In the course of the month, you hove an average money holding of $250. Same thing happens the next month, and the next, over the year.

Money Supply Economics

Your average holding of money then, is $250: this is how much you have on average in your bank account over the course of a year.

If instead, you were paid $250 every two weeks, then you would hold $250 at the beginning of the two weeks, and run it down to zero over the course of two weeks, repeat this the next two weeks, and so on.

Can you see that on average, you would be holding $125 in your account?

In other words, the need you have for holding money balances will depend on the smoothness with which the time you get paid and the time you use the money to make payments mesh. Thus, the need to hold money balances is in part a result of the institutional payments mechanisms in the economy. An agrarian day laborer in India does not hold very much cash balances because she will get paid on a daily basis in small amounts and then use up the money she receives to pay for her transactions of purchasing food almost immediately. She will have a near zero holding of money balances. But in a system where people are paid with longer term contracts, regularized wages and salaries, and where they get paid in intervals of a week, a fortnight or a month, and where incomes are relatively stable, the need to hold money balances will be higher.

Even if there was not a perfect match between my receipts of cash and the moments in which I use it as a means of payments for transactions, if I could costlessly and immediately convert any bonds I hold into money, then there is no reason to hold money. I would hold all wealth as bonds, and sell a bond for money the moment I need to make a purchase, holding money for only an instant.

So for example, you are paid $500 per month. You hold an average balance of $250 as you start out the month with a $500 bank balance, and then run to down over the month. But what if you find that you can buy a $250 bond at the beginning of the month, and sell it in the middle of the month, earning an interest for half the month? When you get paid, you could put $250 in your checking account as a money holding, and buy a bond for $250. At the end of two weeks, when your $250 has been used up, you can sell the bond and deposit another $250 in your account. Your average money holdings have just dropped to $125, and you earn interest on $250 bonds every fortnight.

You can take this further an further. Why not deposit only $125, and buy $375 worth of bonds? Sell $125 of bonds every week, and earn interest for three weeks. In effect, the question is:

Why hold any money balances at all? Why not always hold bonds and only get hold of money the moment you need it to pay for transactions?

It is costly, in terms of time and resources, to keep moving in and out of bonds or other assets and money. Since this is the case, I will desire to hold a certain level of money balances on average, to meet my needs to pay for transactions. This is called the transactions demand for money.

If the interest payments I receive on bonds and other assets is high, then it is worth my while to move in and out of stocks and bonds and money, so that I can earn this interest payment instead of holding money balances. If the interest rate is not that high, then it is not worth it to move in and out of money and bonds in order to receive this interest payment.

Another way to look at it is that the interest rate describes the cost of holding money balances. This is because the interest rate tells you the amount of interest income you have to forego by holding money balances instead of lending out that money and holding an asset like a bond.

This is enough to generate a curve which plots the demand for money -- the amount you wish to hold as opposed to holding wealth as bonds

Define Real Money Supply