ABSTRACT
Money affects output (real and/or nominal) to the extent that it is being spent. If, for example, people hold the increased money supply as cash, then it will not have any impact on expenditure and output. Therefore the monetary authority should be able to predict how much additional supply of money people will hold as cash balances and how much they will spend. Thus the demand for money and its stability hold a critical place in the discussion about the effectiveness of monetary policy. However, the existence of a stable money demand function is only a necessary condition for the reliability of monetary policy. It forms a part of the ‘transmission mechanism’ that links changes in the money supply to ultimate target variables. The other part of the transmission mechanism involves the way any disequilibrium in the money market impacts on aggregate demand. If people adjust by spending excess cash balances directly on goods and services, then there would be an immediate impact of monetary expansion on aggregate demand. However, if the monetary imbalance works its way through its impact on interest rates via the bond market, it becomes a lengthy and uncertain process.
