Money Demand and Supply:Operating Framework

Courtesy

School of Management, NIT Rourkela

MBA (Finance) and Ph.D (Finance Management)

Lectures

Learning Objectives

• To understand the concepts such as definition of money

• To know the determinants of demand and supply of money

• To understand the equilibrium in market for money

Every day we carry out several transactions ranging from purchase ofvegetables to buying bus tickets to purchase of shares

Money, as a medium of exchange is required to carry out any such

transactions

None of these items involved are free and hence a medium of

exchange is needed to buy them

You may say me that these transactions can be carried out without involving a medium of exchange bybarter of goods, i.e. , exchanging various goods and services for a certain amount of other goods and or services,it

has some inherentproblems

The barter of goods requires co-incidence of wants, i.e, if somebody wants to buy applesand to sell a hen and that too of an equal value. The exercise of finding a person lookingfor a same good of same value the other party wants is a very time consuming anddifficult task, especially when commodities to be exchanged is verylarge.

Hence, a number of commodities being used asmeans of payment

Under commodity money system, the commodities used as money had intrinsic value.i.e. these had value beyond their use as money and the utility , equivalent to the face value of commodities , directly perceived by theirusers.

Salt has utility incooking Goats are used for milk Gold and silver for ornaments

Copper used for making Utensils Cigarettes used for smokingBook used for reading

Why Money is needed?

• Though commodity money canavoid the problem of double co-incidence of wants it isinconvenient to use it because– Most of commodities are bulky– Require large space for storage

and– Significant transportation costs for

shifting from one place toanother

• Also, the commodities that areperishable add another problem

• They depreciate in value andhence, cannot be used as a storeof value

• Therefore they cannot be used asefficient means of payment.

The use of token or fiat money provides an

alternative to barterand commoditymoney.

Token money or fiat money has a negligible

intrinsic value, that is, its face value differs from value in use if it is not

used as money.

The use of tokenmoney has brought

efficiency in the system by

Avoiding the

coincidence of wants

Promoting trade

Enhancing output

Increasing productivity andwealth

Money supply can beeither

Exogenously set by central bank or

Endogenously determined by working of money

creating sectors such ascentral bank, government

and commercial banks.

The mismatch between demand for money or supply

of money affects

Prices Inflation Interest rate Output Employment

Hence , we need To understand the concepts such asdefinition of money, the determinants of demand andsupply of money, the equilibrium in market formoney

What do you mean by Money?

Money is often confused with income and wealth.

Money is not income. It is just a form in which individuals receive their earnings and income.

Money is not savings or wealth but just a medium in which these are retained.

Saving is unspent income, and wealth is accumulated savings

Only part of savings or wealth is kept in form of money ; the rest is invested in alternative assetssuch as shares , bonds, fixed deposits, land, building and many such assets.

Money is commonly defined by the functions attached to it, i.e., it is a commodity or token thatcan act as a medium of exchange , unit of account , store of value and standard of deferredpayment

Money Definitions and Functions

Functions of Money

Primary Function

Medium of Exchange

Secondary function

Unit of account

Store of ValueStandardof

Deferred payment

Medium of Exchange

• When money is used to intermediate the exchange of goods and services, it is performing a function as a medium of exchange.

• Money serves as an important medium of exchange in the economy, empowering people to purchase goods and services in an attempt to satisfy their unlimited needs and wants.

• Example:– For Amit, he wants chocolate cake (who doesn't?) and lots of

it.– Amit is a cafe owner in the town of Mumbai.

– Every time he buys a cake from Ashish's bakery, he exchanges the money he earned from his job for a cake.

Medium of Exchange: Example

• Sita wants to buy a shirt and sell a Saree.• Siva has a shirt to sell , but he is interested in buying a laptop• In such an economy no trade will take place between Sita

and Siva.• They need to spend time until, Sita finds Anjali who is willing

to sell a shirt and is looking for a saree and; Siva Finds Punitwho needs a shirt but willing to sell a laptop.

• This problem of double co-incidence of wants in a bartereconomy , can be avoided if Sita buys the shirt from Sivawith money and Siva uses this money to buy a laptop fromanyone willing to sell it.

• Purchase and sales decision can be separated.

Medium of Exchange

• For any items to be acceptable as medium of exchange need following characteristics– It should be divisible in smaller units of value

• Example: commodities like CAR cannot be medium of exchangebecause they cannot be divisible in smaller units without loss intheir value

– It should not be perishable• Example: commodities like SPINACH cannot act as a good medium

of exchange because it perishes very fast

– It should be highly liquid, i.e., it can be exchange quicklyin terms of other commodities without any loss in itsvalue• Example: Commodities like LAND cannot be a good medium of

exchange because they cannot be quickly sold unless seller iswilling incur heavy loss.

Unit of Account

It is a standard numerical unit of measurement of market value of goods, services, and other transactions.

It is a standard of relative worth and deferred payment, and as such is a necessary prerequisite for the formulation of commercial agreements that involve debt.

To function as a unit of account, money must be divisible into smaller units without loss of value, fungible (one unit or piece must be perceived as equivalent to any other), and a specific weight or size tobe verifiably countable.

Unit of Account: Example

• Siva while selling a shirt has to quote the price in terms of saree,refrigerator, vacuum cleaner, laptop and so on.

• On the contrary, while using money as a unit of account, the seller simplyneed to post one price.

• Siva, for example, can quote the price of his shirt as Rs 300 and Sita canquote the price of her saree as Rs 500.

• Sita can buy the shirt for Rs 300 from Siva, though he may not beinterested in buying the saree from Pallavi.

• Siva in turn can buy laptop, say for Rs. 7000 from Punit though Punit maynot be interested in purchasing the shirt from Siva.

• By establishing a ratio of exchange between any pair of goods moneymakes possible non-comparable goods or services comparable and makesrational economic calculations and choices by individual possible– Example: shirt= Rs 300; saree= Rs 500, therefore, shirt/saree=Rs300/Rs 500

=0.6 implying that one shirt can buy 0.6 units of a saree, or alternatively oneunit of saree can buy 1.66 units of shirt

Store of Value

To act as a store of value, money must be reliably saved, stored, and retrieved.

It must be predictably usable as a medium of exchange when it is retrieved.

Additionally, the value of money must remain stable over time.

A store of value is something that people keep in order to maintain the value of their wealth.

Example: Sita can keep her wealth in physical assets like gold, land, apartment etc and financial assets such as fixed deposits, bonds and shares

Store of Value

• Money also serves as temporary store of value.

• Money is one type of financial asset, hence storeof value competes with bonds, shares,debentures and real assets consisting of gold andreal estate.

• However these assets help one to earn interestand dividend hence they are preferred as store ofvalue over real money.

• But these assets are not money as they aregenerally not accepted as medium of exchange.

Standard of Deferred Payment

We at times defer the payment for our purchases, i.e. rather than paying in cash attime of purchase we take an undertaking to pay for them in the future. This isdeferred payment.

A standard of deferred payment is the accepted way, in a given market, to settle adebt – a unit in which debts are denominated.

Example: payment through credit cards, repayment of loans over a period of timeand purchase of car in instalments

The term "standard of deferred payment" is not as widely used as other terms forfunctions of money, namely medium of exchange, store of value, and unit ofaccount, though it is distinguished in some works.

Demand for Money

Motives for holding money

Transactionmotive

Precautionarymotive

Speculativemotive

Transaction Motive

The transactions demand for money is money people hold to pay for goods and services they anticipate buying.

When you carry money in your purse or wallet to buy a movie ticket or maintain a checking account balance so you can purchase groceries later in the month, you are holding the money as part of your transactionsdemand formoney.

Transaction demand for money is positively related to real income and price level. Example: If Siva’s income increases , the expenditure or transactions made by him will increase and hence demand for money to carry out the transaction increases.

Precautionary Motive

The money people hold for unexpected expenditure orcontingencies represents their precautionary demand for money.

Money held for precautionary purposes may include checkingaccount balances kept for possible home repairs or health-careneeds.

People do not know precisely when the need for suchexpenditures will occur, but they can prepare for them by holdingmoney so that they’ll have it available when the need arises.

Speculative Motive

People also hold money for speculative purposes.

Bond prices fluctuate constantly. As a result, holders of bonds not only earn interest but experience gainsor losses in the value of theirassets.

Bondholders enjoy gains when bond prices rise and suffer losses when bond prices fall. Because of this,expectations play an important role as a determinant of the demand forbonds.

Holding bonds is one alternative to holding money, so these same expectations can affect the demand formoney.

John Maynard Keynes, who was an enormously successful speculator in bond markets himself, suggestedthat bondholders who anticipate a drop in bond prices will try to sell their bonds ahead of the price dropin order to avoid this loss in asset value. Selling a bond means converting it to money.

Keynes referred to the speculative demand for money as the money held in response to concern thatbond prices and the prices of other financial assets mightchange.

Determinants of the Demand forMoney

Interest Rates

Real GDP The Price Level

ExpectationsTransfer

CostsPreferences

Interest Rates and the Demand forMoney

• When interest rates rise relative to the ratesthat can be earned on money deposits, peoplehold less money.

• When interest rates fall, people hold moremoney.

• The logic of these conclusions about themoney people hold and interest rates dependson the people’s motives for holding money.

The Demand Curve for Money

• The demand curve formoney shows thequantity of moneydemanded at eachinterest rate.

• Its downward slopeexpresses thenegative relationshipbetween the quantityof money demanded and the interest rate.

Other Determinants of the Demandfor Money

Real GDP

• A household with an income of $10,000 per month is likely to demand a larger quantity of money than a household with an income of $1,000 per month.

• That relationship suggests that money is a normal good: as income increases, people demand moremoney at each interest rate, and as income falls, they demand less.

• An increase in real GDP increases incomes throughout the economy.

• The demand for money in the economy is therefore likely to be greater when real GDP is greater.

The Price Level

• The higher the price level, the more money is required to purchase a given quantity of goods andservices.

• All other things unchanged, the higher the price level, the greater the demand for money.

Expectations

• The speculative demand for money is based on expectations about bond prices.

• All other things unchanged, if people expect bond prices to fall, they will increase their demand for money. If they expect bond prices to rise, they will reduce their demand for money.

Other Determinants of the Demandfor Money

TransferCosts

•For a given level of expenditures, reducing the quantity of money demanded requires more frequent transfers between non-money and moneydeposits.

• As the cost of such transfers rises, some consumers will choose to make fewer ofthem.

• They will therefore increase the quantity of moneytheydemand.

• In general, the demand for money will increase as it becomes more expensive to transfer between money and non-money accounts.

• The demand for money willfall if transfer costs decline.

• In recent years, transfer costs have fallen, leading to a decrease in moneydemand.

Preferences

• Preferences also play a role in determining the demand formoney.

•Some people place a high value on having a considerable amount of money on hand. For others, this may not beimportant.

An Increase in Money Demand

It shows an increase in the demand formoney. Such an increase could result from ahigher real GDP, a higher price level, a changein expectations, an increase in transfer costs,or a change in preferences.An increase in real GDP for example, willincrease the quantity of money demanded atany interest rate r, increasing the demand formoney from D1 to D2.The quantity of money demanded at interestrate r rises from M to M′. The reverse of anysuch events would reduce the quantity ofmoney demanded at every interest rate,shifting the demand curve to the left.

Supply of Money

• The supply curve of money shows the relationshipbetween the quantity of money supplied and the marketinterest rate, all other determinants of supply unchanged.

• The RBI, through its open-market operations, determinesthe total quantity of reserves in the banking system.

• Banks increase the money supply in fixed proportion totheir reserves. Because the quantity of reserves isdetermined by RBI policy, we draw the supply curve ofmoney as a vertical line, determined by the RBI’s monetarypolicies.

• In drawing the supply curve of money as a vertical line, weare assuming the money supply does not depend on theinterest rate. Changing the quantity of reserves and hencethe money supply is an example of monetary policy.

• The quantity of money supplied in the economy isdetermined as a fixed multiple of the quantity of bankreserves, which is determined by the RBI. The supply curveof money is a vertical line at that quantity.

The Supply Curve of Money

Effect of Changes in Money Demand

• A decrease in the demand for money due to a change in transactions costs, preferences, orexpectations, as shown in Panel (a), will be accompanied by an increase in the demand for bonds asshown in Panel (b), and a fall in the interest rate. The fall in the interest rate will cause a rightwardshift in the aggregate demand curve from AD1 to AD2, as shown in Panel (c). As a result, real GDP and the price levelrise.

Changes in the Money Supply

• The RBIincreases the money supply by buying bonds, increasing the demand for bonds in Panel (a) from D1 to D2 and the price of bonds to Pb

2.• This corresponds to an increase in the money supply to M′ in Panel (b).• The interest rate must fall to r2 to achieveequilibrium.• The lower interest rate leads to an increase in investment and net exports, which shifts the

aggregate demand curve from AD1 to AD2 in Panel (c). Real GDP and the price level rise.

Equilibrium in the Market for Money

• The money market is the interaction amonginstitutions through which money issupplied to individuals, firms, and otherinstitutions that demand money.

• Money market equilibrium occurs at theinterest rate at which the quantity ofmoney demanded is equal to the quantityof money supplied.

• "Money Market Equilibrium" combinesdemand and supply curves for money toillustrate equilibrium in the market formoney.

• With a stock of money (M), the equilibriuminterest rate is r.

• The market for money is in equilibrium if thequantity of money demanded is equal tothe quantity of money supplied. Here,equilibrium occurs at interest rate r.

Classification of sectors for Moneymeasurement

Money supply classification of sectors

Money creating sectors

Government- Central bank

Commercial banks

Money using sectors

Households - Non financial enterprises

Financial enterprisesother than banks - Rest of the

world

Measurement of Money

• The Reserve Bank of India defines the monetary aggregates as:– Reserve Money (M0): Currency in circulation + Bankers’ deposits with

the RBI + ‘Other’ deposits with the RBI = Net RBI credit to theGovernment + RBI credit to the commercial sector + RBI’s claims onbanks + RBI’s net foreign assets + Government’s currency liabilities tothe public – RBI’s net non-monetary liabilities.

– M1: Currency with the public + Deposit money of the public (Demanddeposits with the banking system + ‘Other’ deposits with the RBI).

– M2: M1 + Savings deposits with Post office savings banks.

– M3: M1+ Time deposits with the banking system = Net bank credit tothe Government + Bank credit to the commercial sector + Net foreignexchange assets of the banking sector + Government’s currencyliabilities to the public – Net non-monetary liabilities of the bankingsector (Other than Time Deposits).

– M4: M3 + All deposits with post office savings banks (excludingNational Savings Certificates).

Liquidity of various Assets and Money

CashDemand Deposits

FixedDepositsPostoffice deposits

SecuritiesPhysical assets (building, land)

Medium of Exchange Function

NarrowMoney

Store of Value of function

Broad Money

Money Supply Process

Primarymoney or basemoney

• Money issued by the monetaryauthorities

• It becomes the basis for credit and deposit creation and expansion in money supply

High powered money

• The base money is also called as the high powered money (H) because the magnitude of change in money supply due to change in the base money can be greatly magnified by the money multiplier, i.e. a small change in monetary base can result in large change in overall moneysupply

Secondary money

• The relationship between primary (i.e. the base money created by the monetary authorities), secondary money (i.e. deposits created by banks), and overall money supply is explained by analyzing a typical central bank balance sheet, the behavior of commercial banks and the credit creation and deposit expansion process by them hereinafter.

Central Bank Balance Sheet

Liabilities Assets

Paid Up capital Loan and advances (of which)Government Banks

Reserves Commercial sector (other financialinstitutions)

Currency in circulation (of which)Currency with the public Cash in hands of banks

Investments (of which)Government securities Foreign assets (net)

Bank Deposits Gold (Monetary)

Government Deposits Government Currency Liabilities (GCL) tothe public

Other liabilities Other assets

Total Liabilities Totalassets

Liability Side

•Paid Up Capital –authorized capital, issued capitaland paid up capital•Reserves- contingency reserves and revaluation reserves•Currency in circulation (of which) –developmentrequirements– Currency with the public– Cash in hands of banks• Bank Deposits- CRR•Government Deposits- central bank acts asbanker to govt.

Asset Side

•Loans and advances-Commercial sector (other financial institutions), other govt• Investments (of which)– Government securities– Foreign assets (net)

•Gold (Monetary )-exist only in b/s of central bank as central bank is authorised to issue currency• Government Currency Liabilities (GCL) to thepublic

References

• Economic Environment of Business By Veena Keshav Pailwar, PHI Publications

• Boundless. “The Definition of Money.” BoundlessEconomics. Boundless, 03 Jul. 2014. Retrieved 28Mar.2015from https://www.boundless.com/economics/tex tbooks/boundless-economics-textbook/the-monetary-system-27/introducing-money-114/the-definition-of-money-444-12541