What makes modern monetary theory so popular

Monetary theory

Table of Contents

  1. characterization
  2. Nature, origin of money and money supply
    1. Essence
    2. Emergence
    3. Money supply theory (money supply theory)
  3. Money Demand Theory (Money Demand Theory)
    1. Demand for money
    2. Approaches / concepts
  4. Monetary effects and transmission mechanisms
    1. Classic monetary theory
    2. Keynesian teaching
    3. Post-Keynesian Monetary Theory
    4. monetarism
    5. Liquidity Theory of Money
    6. Credit Theory Approach


Monetary theory encompasses the relationships between monetary variables and those between the money and goods economy, taking international interdependencies into account: It explains the role that individual variables, such as money, credit and interest, play in the economic process.

Nature, origin of money and money supply


The money is generally defined by its functions. According to this, everything is money that is accepted as a medium of exchange (function of money as a medium of exchange), as a store of value (function of money as a store of value) and as a unit of account (function of arithmetic mean of money) (money). Today, these functions are predominantly fulfilled by legal tender (central bank money) and deposits with commercial banks (especially sight deposits due to their daily maturity). Legal tender and bank money (money supply) can completely or partially lose their store of value and medium of exchange function and thus also their monetary character due to inflation. The decisive factor is therefore less the legal agreement on what means of payment is, but the safeguarding of monetary functions within the framework of the monetary order.


a) The creation of money is historical seen connected with the increasing division of labor. In order to make the exchange of goods more efficient, i.e. to reduce the high transaction and information costs of the natural exchange economy, generally accepted means of payment were developed. In modern monetary systems, the value of money is determined by the relationship between the circulation of money and the supply of goods: Instead of being tied to a material value (gold value), there is the work of the central bank and the trust of the population in the monetary order created by the state.

b) Money arises in a two-tier banking system composed of central bank and commercial banks in two ways:
(1) Creation of central bank money: Central bank money comes into circulation through purchases by the central bank, e.g. through the purchase of foreign currency or securities. The central bank finances such a purchase by providing central bank money (notes, coins, central bank balances).
(2) Money and credit creation by commercial banks (deposit money creation): Money creation through lending by commercial banks can be illustrated using an example. Assume that the commercial banking system consists of only two banks A and B. Bank A receives central bank money on the basis of a deposit E from the non-bank sector. On the basis of this deposit, bank A grants a bank customer credit to finance purchases of goods that the customer makes from a supplier who maintains his account with bank B. Then a transfer to bank B is made in the amount of the credit. Bank B receives central bank money in the amount of deposit E. At bank A there is an active exchange (central bank money for credit). The combined volume of central bank money has not changed at the two banks, but additional loans and deposits have arisen. Depending on the definition of the money supply, the deposits belong to a category of the money supply M1, M2 or M3.

The credit expansion and money creation can be repeated as often as desired, as long as no central bank money is withdrawn from the banks. In practice, however, money creation is limited by the statutory minimum reserve and cash withdrawals by non-banks.

Money supply theory (money supply theory)

Based on the determinants of deposit creation, the theory of money supply analyzes the determinants of the total amount of money offered to non-banks. The (nominal) money supply is represented here as the product of free liquidity (free liquidity reserves) and the money creation multiplier. In this context, the influence of payment habits and varying minimum reserve rates can be formally analyzed. Rising (falling) interest rates decrease (increase) e.g. the cash flow rate and thus have a restrictive (expansive) effect on the supply of money. Analogous relationships can be represented with regard to increasing (decreasing) minimum reserve rates; here the reserve ratio becomes the determining variable.

It can be seen that the central bank can theoretically influence the money supply in this basic model via the reserve ratio and the free liquidity of the commercial banks.

Money Demand Theory (Money Demand Theory)

Demand for money

As Demand for money is the term used to describe the (desired) cash management planned by non-banks. Cash holdings include not only the cash holdings, but also the deposits of non-banks with banks. Which deposits are to be counted towards the cash-keeping depends on the underlying concept of money supply; If, for example, the money supply M1 is to be explained from the interplay of money supply and demand, only the sight deposits are to be regarded as part of the planned cash desk alongside the cash.

Approaches / concepts

The money demand theory examines the reasons for which economic agents want to keep part of their wealth in the form of money instead of investing it in profitable property titles, and which factors determine the amount of the planned cash: a) The older quantity theory focuses on the transaction motive, that is, money is held to process payments. Since the deposits and withdrawals usually occur at different times, each economic entity has a certain amount of cash on hand, the average amount of which depends on the frequency of payments and the transaction volume. The (macroeconomic) demand for money is therefore determined by the payment habits, which are reflected in the speed of circulation of money, and by the transaction volume (trading volume). b) The Keynesian liquidity theory adds caution and speculative motives to the transaction motive as reasons for holding money: The precautionary motive explains the demand for money with the uncertainty of economic agents about the timing and amount of future payments. While the demand for money is based on the transaction and precautionary motive in the function of money as a medium of exchange, the holding of cash from the speculative motive is related to the value-keeping function of money: Although holding money does not generate any (or only small) interest income, it enables it in comparison to others Assets a relatively risk-free store of value (at a stable price level). The Keynesian liquidity theory simplifies the alternative between holding money and buying fixed-income securities. Since the prices of the securities in circulation fall when the market interest rate rises, risk-conscious investors must include possible price losses in their considerations. According to Keynes, every economic subject has a (usually different) idea of ​​the normal interest rate, and if it falls below this level, it expects the market interest rate to rise again, which means that exchange rates will fall. If the expected price losses exceed the fixed nominal interest payments, it is worthwhile to postpone the purchase of securities (for the time being) and to hold money instead. If this explanation is initially applied to the economy as a whole, it can be seen that the demand for money increases with falling interest rates. It is assumed that when the market interest rate falls, an ever larger number of economic agents expect interest rates to rise again (i.e. future price losses). As a result, the willingness to hold money increases, i.e. the demand for money increases as the interest rate falls. If the transaction motive is taken into account, the result is an increasing demand for money as the national income rises and the market interest rate falls. c) The Keynesian liquidity theory was further developed in the following period by the post-Keynesian money demand theory with the help of inventory and portfolio theoretical considerations. These approaches extend Keynesian liquidity theory towards a general theory of optimal wealth management under uncertainty. What these approaches have in common is that the demand for money is the result of individual optimization calculations. d) This connects them with the monetarist neo-quantity theory (Friedman). In contrast to this, money represents one of several decision-relevant assets (e.g. human capital, real assets), the benefit of which lies in liquidity. The economic subjects make a cash-value-oriented decision about the optimal distribution of the assets. In the optimum, the wealth is structured in such a way that the marginal utility of all individual wealth components is the same in the last use. In addition to the theoretical differences in the derivation of the money demand function, the Keynesian and monetarist views also differ in the assessment of the stability of the relationships between the money demand and the individual parameters. While the monetarists assume a stable relationship, at least in the long term, the Keynesians attest an unstable relationship.

Monetary effects and transmission mechanisms

A central subject of monetary theory is the question of how monetary impulses (especially central bank measures) are transferred to the real sector. For this purpose, money supply, interest rate and price level effects are derived from the interplay of money supply and demand, which trigger adjustment reactions in the real sector. However, there are serious differences of opinion about the concrete effects of monetary stimuli:

Classic monetary theory

After classical monetary theory The money supply determines the price level, but is completely neutral in terms of real economic developments (dichotomy of money).

Keynesian teaching

After Keynesian teaching (Keynesianism) an expansion of the money supply initially causes a rate cut, which stimulates investment activity. As a result, the total demand for goods rises above the income multiplier by a multiple of the additional investment. If underemployment prevails in the initial situation, there is an expansion of production and employment, whereas in the case of full employment, inflation occurs.

Post-Keynesian Monetary Theory

The post-Keynesian monetary theory expands this transfer mechanism by taking into account portfolio theoretical considerations: interest rate cuts lead to a restructuring of the assets. Financial assets are replaced by more profitable assets, which stimulates the demand for newly produced capital goods and thus investment activity. Post-Keynesians, however, do not attach great importance to this interdependency, but rather emphasize the opposite interdependency when assessing the causality between money supply and economic activity: The development of national income and production is largely determined by real economic factors (e.g. changed sales expectations), while the observable changes in the amount of money can be seen mainly as a reflex of fluctuations in income.


The opinion of the representatives of the monetarism. According to their ideas, the effects of economic activities on the money supply are of limited importance; the money supply largely determines the development of nominal national income. The monetarists have a clear answer to the important question in this context of how the monetary impulses are converted into real and nominal (price level) effects: If the money supply increases, expansive production and employment effects are to be expected in the short term as a result of falling real interest rates and real wages (because of the fundamental inflationary effect of the money supply increase and because then the profits of the companies and thus the investment activity tend to rise). However, as soon as the occurring price increases are recognized by the economic agents and factored into the wage and interest rates, production and employment levels fall back to the old level. The increased money supply then only increased the price level.

Liquidity Theory of Money

The takes another clear opposite position to monetarism Liquidity Theory of Money a. It assumes that the liquidity situation of the individual economic entities is decisive for the spending behavior, and accordingly the macroeconomic liquidity for the economy as a whole. The money supply is part of it, but just one of several determinants of macroeconomic liquidity. These include the possibility of borrowing (from commercial banks and other financial institutions or in the form of commercial loans), deposits with parametric institutions, other assets and subjective liquidity components such as the general spread of optimistic expectations, hopes and wishes.

Credit Theory Approach

A transmission concept that has significantly shaped the monetary policy of the Deutsche Bundesbank is credit theory approach. He emphasizes the granting of credit as an important link between the monetary and the real area. According to this, credit availability and costs are the two main monetary determinants of spending that can be influenced by the central bank. This view is supported by the fact that companies usually finance their net investments for the most part (often around 75 percent and more) with the help of loans. Monetary and credit policy consequently hopes to be able to reduce (increase) the expenditures, especially of companies, by restricting (expanding) the scope for lending by banks and making borrowing more expensive (cheaper).