Why investing in bonds imply a decrease in money demand?

Question

In the description of so-called money market, we have demand,Md, for liquid money from individuals (and firms) and supply,Ms, of liquid money, likely from central banks. Now it is assumed that if interest rate,r, would increase, the demand for money,Md, would decrease due to people's preference of bonds(or other high yield securities) over money at high interest rate.

This doesn't make sense; whereas it is true that "households" would buy bonds in exchange for money at higher r, bonds are simply transfers of money, from households to firms or governments. So the aggregate money in the economy remains constant, as firms/governments would utilize the bonds' money in the economy. Thus, if we consider the economy as a whole, the "demand" for money does not change with people opting for bonds.

If we only consider the households' demand for money, then the analysis in money theory and LM curve would be inaccurate; In the discussion of LM curve, we have MV=PY and M/P =Md(Y,r). M/P essentially denote the "real money" supply from central bank. In the first formula MV=PY derived from money theory, If M/P hold constant, Y, also known as the aggregate income, is also constant; This is consistent if we consider the economy as a whole. However, in the second formula, It is understood that the money demand Md(Y,r) account for only the "households". It is unreasonable to discuss the dynamic between money supply and money demand when we have the whole economy in consideration on one hand and have only a sector of the economy weighted on another hand.

To sum up, I can understand that higher interest rate could encourage people to save up, thus effectively reduced the amount of money in circulation so reducing the "demand" but I do not see how opting for bonds decrease the demand for money unless only a sector of the economy is taken into consideration. Can someone provide some insight into this?

Answer 1

There are a few sub-questions in this question, and I will not attempt to answer all of them. These “economics 101” models are extremely abstract, and it takes a lot of effort to relate them to observed economic behaviour. (I worked in fixed income research for 15 years, and cannot recall industry research ever referring to them.)

“Households” stand in for the entire private sector. (In these models, firms’ financial asset holdings are normally assumed to be zero, as otherwise, they would also have to solve a multi-period optimisation to maximise profits. This breaks the models, as there are then two sectors with competing multi-period optimisations.)

Financial assets are issued by the government sector (Treasury/central bank), although the models may allow reverse borrowing by households by allowing them to have negative bond holdings (which little literal sense in the real world).

Since you asked about it in comments, I will add some details to the institutional structure. In these models, like in the real world, the Treasury is the financial arm of the government. (In some countries, labelled the Ministry of Finance.) It owns the central bank, and leaves its cash on deposit at the central bank. Since this deposit is a liability between two related entities, it does not show up in the money supply numbers. If we consolidate the accounting, the deposit is money the entire government owes to itself, and so it disappears from the balance sheet. And to repeat: this is not just a model simplification, it is how real world statistical agencies do the accounting for the money supply. Note that governmental liabilities are only the narrowest components of the money supply (“M0”), wider aggregates (“M3”) include private sector instruments - which do not appear in this class of models.

The household money demand equation is just a portfolio allocation decision: given a portfolio size, what is the breakdown between money and bonds? The greater the interest rate, the greater the percentage held in bonds.

The central bank is the counterparty to the household sector portfolio decision. When it buys bonds, money returns to the central bank. Since money is a liability of the central bank, it does not hold it as an asset, so the money is “destroyed” - the stock of money contracts.

The money cannot go to the Treasury or firms, since the model construction does not allow for it.

This site wants to keep opinions out of answers. However, it is clear that there are a lot of issues with how (neo-)classical models handle “money”, as most “money” (broad money supply aggregates) are private sector liabilities (e.g., bank deposits). There is a large post-Keynesian literature on money and finance, the key words to look for is “endogenous money”. These critiques of the classical models might help you relate them to real world behaviour, as the post-Keynesians like to explain the deficiencies of the classical models. I cannot think of any immediate reference, but you could search. In anymevent, it would be easier to find an existing critique than attempt to re-invent your own monetary theory.

Answer 2

One thing to consider is that, when the Federal Reserve in the United States tries to manipulate the money supply, it does so through either putting more of its money into the market through bond purchases (supplying banks with money to lend) or holding money from the market through bond sales (leaving the money essentially dormant). It is not so much that bond creators receive money when people turn to bonds with higher interest rates but rather that the bonds change hands to people (households, firms, banks) who would have actually circulated money in some way if they held it in liquid form. The missing link is the central bank's money holdings.