THE MONEY MARKET

Step 3 in the transmission mechanism is the response of interest rates and credit conditions to changes in the supply of money. Recall from Chapter 25 that the demand for money depends primarily on the need to undertake transactions. Households, businesses, and governments hold money so that they may buy goods, services, and other items. In addition, some part of the demand for M derives from the need for a super safe and highly liquid asset. The supply is jointly determined by the private banking system and the nation’s central bank. The central hank, through open-market operations and other inst currents, provides reserves to the banking system. Commercial banks then create deposits
out of the central-bank. reserves. By manipulating reserves, the central bank can determine the money supply ~thin a narrow margin of error.