Money Demand and Supply PDF

Money: Demand and Supply
Discipline Courses-I
Semester-I
Paper I: Principles of Economics(POE)
Unit-IV
Lesson: Money: Demand and Supply
Lesson Developer: Rakhi Arora and Vaishali Kappor
College/Department: Rajdhani College, University of Delhi
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Institute of Lifelong Learning, University of Delhi
Table of Contents:
1. Learning outcomes
2. Introduction
3. What is money
a. Origins of money
b. Functions of money
c. Quantity theory of money
4. Money demand
a. Motives for money demand
b. Money demand function
c. Other factors affecting demand for money
5. Money supply
6. Summary
7. Exercises
8. Glossary
9. References
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Learning outcomes:
After you have read this chapter, you should be able to:-
a) Define money
b) Explain different types of money ever since its evolution
c) Notify the various functions of money in economy
d) Define money demand.
e) List various factors of demand for money
f) Define money supply
g) State various measures of money supply
INTRODUCTION
All currency notes in circulation across the world are promissory notes. For instance, a
hundred rupee note states that, “ I promise to pay the bearer the sum of 100 rupees” along
with the signature of RBI governor, which makes it a legal tender and therefore is widely
accepted for making transactions.
To facilitate the transactions in India, RBI prints currency notes of different denominations.
But how does RBI know how many currency notes would be sufficient to make all the
transactions in the economy? RBI anticipates the requirements for printing notes on the
basis of the money demanded by the people.
This chapter broadly covers the evolution of money, its functions and quantity theory of
money in section one. It discusses in section two, the reasons for demanding money and
factors determining money demand and in section three, it explains the different
measuresof money supply.
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WHAT IS MONEY
A generally accepted medium of exchange is usually defined as Money. A medium of

exchange is anything that is widely accepted in a society in exchange for goods and
services. Money can serve other roles also apart from being a medium of exchange, which is
its defining function.
THE ORIGINS OF MONEY
The origins of money go far back in antiquity. Many primitive tribes seem to have made
some uses of it.
Money in POW camp
Unusual form of money developed in Nazi prisoner of war (POW) camps during
World War II. These prisoners were supplied with various goods like food,
clothing, cigarettes etc, but no attention to personal preferences was provided.
Then the endowments with the prisoners invoked them to trade with to trade with
each other to have a better bundle of goods.
Barter proved to be an inconvenient way to allocate goods because it requires

double coincidence of wants. Eventually, cigarettes became established currency
with which trades were made. Even non smoker happily accepted for they know
they could exchange it with for some other good is future. Within POW camp the
cigarette became the store of value, unit of account & the medium of exchange.
1. Metallic money
Different commodities have been used as money at some or other time but gold and silver
proved to have great advantages over stones or other metals. The metals were carried in
bulk before coins would have been invented. When a purchase was made, the requisite
quantity of the metal was carefully weighed on a scale. The invention of coinage eliminated
the need to weigh the metal at each transaction, but it created an important role for an
authority, usually a monarch, who made the coins by mixing gold or silver with base metals
to create convenient size and durability, and the authority affixed the seal that acted as
guarantee for the amount of precious metal contained in coin. It was convenient as long as
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everyone knew that the coin would be accepted at „face value‟.The face value was nothing
more than a statement that a certain weight goes gold or silver was contained therein.
However, coins often could not be taken at their face value. A form of counterfeiting i.e.
clipping a thin slice off the edge of the coin and keeping the valuable metal be came
common. This of course served to undermine the acceptability of coins even if they were
stamped. To get around this problem, the idea arose of minting the coins with a rough
edge; the absence of the rough edge would immediately indicate that the coin had been
clipped.
Some rulers were quick to seize the chance of getting a position to work a really profitable
fraud by ordering their subjects to bring their coins into the mint to be melted down and
coined afresh with a new stamp. Between the melting down and the recoining, however, the
rulers had only to toss some further inexpensive base metal in with the molten coins. This
debasing of the coinage allowed the ruler to earn a handsome profit by minting more new
coins than the number of old ones collected, and putting the extras in the royal vault.
Consider a fifty-fifty ratio of gold and cheap metal to be alloyed with it. Iffor instance,
subjects bought 50 coins to be minted; ruler will mix cheap metal in it and would have 100
minted coins: 50 to be returned and ruler will retain 50 such coins.
The result of this debasement was inflation. The subjects had the same number of coins as
before (50), and hence could demand the same quantity of goods. When rulers paid
Gresham’s law
The early experience of currently debasement led to the observation known as

Gresham’s law, which states that ‘bad money drives out good’.
In the mid of 16th century, when Queen Elizabeth I came to the throne of
England, the coinage was severely debased. To help trade, Elizabeth minted
new coins that contained full face value in gold. As soon as these new wins
were into circulation, they disappeared. Why?
Consider you possess one new & one old coin, each with same face value. If 5
you had to pay a bill you would use debased coin as you part with less gold this
way and if you wish to obtain certain amount of gold bullion by melting gold
their bills, however, the recipients of the extra coins could be expected to spend them. This
causes a net increase in demand, which in turn bid up prices.
It was the experience of such inflation that led early economists to stress the link between
the quantities of money and the price level. This relationship is popularly known as the
Quantity Theory of Money (QTM)itwill be discussed later in this chapter.
To this day the revenue generated from the power to create currency is known as seignior
age. Seignior age was not normally revenue generated by debasement; originally it was an
explicit duty, or tax levied on the mint. In the modern context the possibility of debasement
does not enter, so the Seignior ageis applied to the revenue that accrues to government
from the power to print banknotes (since bank notes have very low production costs relative
to their face value) and from another source that is commercial banks are forced to place
non interest bearing deposits at the central banks.
2. Paper money
The next milestone in evolution of money was when paper currency evolved. The source of
evolution of paper currency was goldsmiths. Initially, public began to deposit their gold with
goldsmiths since they had secure safes. Goldsmiths used to give their depositors a
promiseto hand over gold whenever demanded. Whenever depositor was required to make
any large purchase, depositor would go to goldsmith, reclaim some of the gold deposited
and hand it over to the seller of the goods. If the seller had no immediate need for the gold,
he would carry it back to the goldsmith for safekeeping on his behalf.
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But this seems illogical as initial depositor reclaimed gold and handed over to the seller, who
again deposited gold with the goldsmith. So why involve into risky business of physically
transferring the gold? As long as goldsmith is considered reliable and people had confidence
in goldsmith, the buyer only needed to transfer goldsmith‟s receipt to the seller. Then again
if this seller wishes to transact with the third party and he also finds goldsmith to be
reliable, this transaction could also be effected by passing goldsmith‟s receipt. This receipt
in this case was as good as transfer of gold itself.
When it came into being in this way, paper money represented a promise to pay so much
gold on demand. In this case the promise was made first by goldsmiths and later by banks.
Such paper money, which became bank notes, was backed by precious metal and was
convertible on demand into this metal.
Fractionally backed paper money
Early on many gold smiths and banks discovered that it was not necessary to keep a full
ounce of gold in the vaults for every claim to ounce circulating as paper money. At any one
time some of the bank‟s customers would be withdrawing gold, other would be deposing it
and most would be trading in bank‟s paper notes without indicating any need or desire to
convert them into gold.
As a result the bank was able to issue more money (initially notes, but later deposits)
redeemable in gold it the amount of gold that it held in its vaults. This was good business,
because the money could be invested profit in interest-earning loans (often called advances)
to in visuals and firms. The demand for loans arose, as it does today, because some
customers wanted credit to help the over hard times or to buy equipment for their business.
To this day banks have many more claims outstanding against them than they actually have
in reserves available to pay those claims. We say that the currency issued in a situation is
fractionally backed by the reserves.
The major problem with a fractionally backed convert the currency was maintaining its
convertibility into the precious metal by which it was backed. It would be imprudent to issue
too much paper money, which is unable to redeem its currency in gold when the demand for
gold isslightly higher than proportionate. It would then have to suspend payments, and all
holders of its notes would suddenly find that the notes were worthless. However the prudent
bank that kept a reasonable relationship between its note issue and its gold reserve would
find that could meet a normal range of demand for gold without any trouble.
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3. Fiat money
As time went on, note issue by private banks became less common and central banks,
which are (usually) state-owned institution, took control of the currency. Over time central
banks have assumed a monopoly in the provision of money (cash) to the economy. As a
result, they have the responsibility of controlling monetary conditions in the economy and
ultimately they determine the value of a nation‟s (or Group of nation‟s) currency.
Originally the central banks issued paper currency that was fully convertible into gold. In
those day‟s gold would be brought to the central bank, which would issue currency in the
form of gold certificate‟s the asserted that the gold as available on demand. The gold supply
thus set some upper limit on the amount of currency. However, central banks like private
banks before them, could issue more currency than they had in gold, because in normal
times only a small fraction of the currency was presented for payment at any one time.
Thus even though the need to maintain convertibility under a gold standard put an upper
limit on note issue, central banks had substantial discretionary control over the quantity of
currency outstanding.
Fiat money in primitive societies?
In primitive societies, stone money of Yap (ontiny Micronesiar island of Yap) and
seashells (in America & New Guinea) played the medium of exchange function of
money. Prominent Economists like kenyes, Friedman and Mankiwgive these as
an example of fiat money. The reason for the same is that stone money of Yap
and seashells are considered not useful and not convertible and those do not have
any other legal status. But DrorGoldberger puts a question mark on whether these
ever existed as fiat money in their respective societies. Dror Goldberger explains
that stone money of Yap & sea shells would not be considered as example of fiat
money as these were intrinsically valuable to their primitive users and considering
them as fiat money would be equivalent to ignoring the fact that money then
circulated had esthetic value and it had a religions use too.
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Almost all the countries abandoned the gold standard during the period from 1914-1928.
Then that the currencies were not convertible into gold, money derived its value from its
acceptability in exchange. Fiat money is widely acceptable because it is declared by
Government order or fiat to be legal tender. Legal tender is anything that by law must be
accepted than offered either for the purchase of goods or services or to discharge a debt.
Today almost all currency is fiat money.Fiat money is valuable because it is accepted by
convention and in law in payment for the purchase of goods or service and for the discharge
of debts.
Many people are disturbed to learn that present-day paper money is neither backed by nor
convertible into anything more valuable-that it consists of nothing but pieces of paper
whose value derives from common acceptance. Many people believe that their money
should be more substantial than this. Yet money is, in fact, nothing more than pieces of
paper.
If fiat money is acceptable, it is a medium of exchange. Further, if its purchasing power

remains stable, it is a satisfactory store of value. And if both of these things are true, it will
also serve as a satisfactory unit of account.
FUNCTIONS OF MONEY
Money acts as a medium of exchange and can also serve as a store of value and a unit of
account.
1. Medium of Exchange
Goods would have to be exchanged by barter (one good being swapped directly for
another) in the absence of money. The major difficulty with barter is that each transaction
requires a double coincidence of wants; i.e. a great deal of time is required to search an
eligible person for a viable transaction.Thus a thirsty economics lecturer would have to find
a brewer who wanted to learn economics before he could swap a lesson in economics for a
pint of beer.
The severity of this problem could be reduced by using money as a medium of exchange.
Output could be sold for money and could be used subsequently to purchase the commodity
of requirement from others. So a monetary economy typically involvers exchanges of goods
and services for money and of money for goods, but not of goods for goods.
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The double coincidence of wants, which is required for barter, is unnecessary, when a
medium of exchange is used.
By facilitating transactions, money makes possible the benefits of specialization and the
division of labor, which in turn contributes to the efficiency of the economic system.
Money must possess several characteristics to be able to serve as a medium of exchange. It

must have a known value i.e. readily acceptable. It‟s value must be high in relation to it‟s
weight, it must be divisible, as for making transactions having only a small value it would be
useless if money comes only in large denominations. It must be difficult, if not impossible to
counterfeit.
2. Unit of Account
As a unit of account, money is the basic unit for measuring economic value. In India, for
example virtually all prices, wages, asset values, and debts are expressed in rupees. Having
a single uniform measure of value is convenient. For example, pricing all goods in India in
rupees -instead of some goods being priced in yen, some in gold and some in Microsoft
shares-simplify comparison among different goods.
3. Store of Value
To store the purchasing power, money is the most convenient way. The money taken in
exchange for the goods sold today may be stored until it is required.However, money must
have a relatively stable value to be a satisfactory store of value. A rise in the price level
leads to decrease in the purchasing power of money because more money is required to buy
a typical basket of goods. When the price level is stable, the purchasing power of a given
sum of money is also stable, when the price level is highly variable, this is not so, and the
usefulness of money as a store of value is undermined.
Transactions and the Quantity Equation
Money is usually held to buy goods and services. People hold more money when they need
more money for making transactions. Thus, the number of rupees exchanged in the
transactions is related to the quantity of money in the economy.
The link between transactions and money is expressed in the Quantity equation in the
following manner:
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Money x Velocity = Price x Transactions
MxV = PxT …………………………………(1)
where,
T = the number of times goods/ services are exchanged for money in a year.
P = the price of a transaction and the number of transactions.
M = the quantity of money.
V = the velocity of money (i.e) the number of times money changes hands in a given year
Therefore, the right side of the equation tells about the transactions and the left side of the
equation tells about the money used to make transactions.
For example, suppose that 60 slices of cheese are sold in a given year at Rs.5 per slice.
and the quantity of money in the economy ( M * V) = Rs. 20
Then,
T = 60 slices per year,
P = Rs.5 per slice, and
Then,
The total number of rupees exchanged is:
P*T = Rs. 5/slice x 60 slices/year = Rs. 300/year
Therefore, by re-arranging the quantity equation, we can compute velocity as:
V=(P*T)/M
=(Rs.300/year)/(Rs.20)
V =15 times per year.
(i.e.) for Rs.300 of transactions per year to take place with Rs. 20 of money, each rupee
must change hands 15 times per year.
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The quantity equation basically shows that a change in one variable must lead to a change
in one or more of other variables so as to maintain the equality i.e. the quantity equation is
an identity.
From transactions to Income
As the number of transactions is difficult to measure in an economy, economists usually

replace T by the total output of the economy, Y. As the more the economy produces, the
more goods are bought and sold, therefore, we can say that transactions and output are
related. But they are not the same. However, a transaction is made when a used car is sold
by one person to another, which is proportional to the rupee value of the output.
If
Y = the amount of output
P = the price of unit of output,
Value of output = PY
Y = real GDP deflator,
PY = nominal GDP.
Therefore,
The quantity equation becomes:
Money x Velocity = Price x Output
M x V = P xY ………………………………..(2)
As Y is also total income, therefore, V in this version of the quantity equation is called the
Income velocity of money.
The income velocity of money tells us the number of times a rupee billenters someone‟s
income in a given period of time. We most commonly use this version of the equation.
The Money Demand Function and the Quantity Equation
When we express the quantity of money in terms of the quantity of goods and services, it
helps us analyze the affect of money on the economy. The amount M/P is called as the real
money balances, which measures the purchasing power of the stock of money.
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For example, an economy produces only cheese. If M=Rs.20, P=Rs.5 per slice, then M/P=4
slices of cheese. That is, at current prices, money stock in the economy is able to buy 4
slices.
A money demand function shows what determines the quantity of real money balances
people wish to hold. A simple money demand function is:
(M/P)d = kY
Where,
k = A constant that tells us how much money people want to hold for every rupee of
income.
This equation states that the quantity of real money balances demanded is proportional to
real income.
The money demand function and the demand function of a particular good are alike. The
convenience of holding real money balances is our good under consideration. Owning an
automobile makes it easier for a person to travel. Similarly, holding money makes it easier
for a person to make transactions. Hence, it can be said that as higher income leads to a
greater demand for automobiles, similarly, higher income also leads to a greater demand
for the real money balances.
On adding the following condition to the money demand function:
Demand for real money balances (M/P) d = the supply (M/P)
We get,
M/P =kY
Rearranging the terms, we get
M (1/k)=PY
And we get the Quantity equation as:
MV=PY,
Where,
V = 1/k.
It shows the link between the demand for money and the velocity of money.
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Cambridge Equation & Fisher Equation of Quantity Theory of Money:
Similarity & Difference
Fisher’s Quantity of Theory of Money establishes relation between money and

transactions by the equation:
MV=PT………………………………………..(i)
But, Cambridge economists linked money to income via quantity theory of money.
Md= kPY…………………………………..(ii)
Money demand is a function of the nominal income ie PY. A fraction of this nominal
income is demanded by the public to be held as cash.
On comparing the two we find, that Y in equation (ii) is the physical quantity of
output ( real income) and so is equal to transactions is the equation (i) this yields that
V = 1/k or k= 1/V i.e. one is the reciprocal of the other.
When k is large i.e. people wish to hold a lot of money for each rupee of income then V is
For example, stock of money that people is wish to hold equals one – fourth of value
small i.e. money changes hands infrequently. On the contrary, when k is small i.e. people
of total income (transactions) thus k is 0.25 and V the reciprocal of k, is 4 . If money
wish to hold only little money then V is large i.e. money changes hands frequently.
supply iswe
Therefore, to can
be one – fourth
deuce of value
that money of transactions,
demand parameter keach
and rupee must
velocity be usedV on
of money are
negatively related
average four to each other.
times.
THE ASSUMPTION OF CONSTANT VELOCITY
On making the assumption of constant velocity of money, the quantity equation becomes
the quantity theory of money.
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If the money demand function changes, the velocity does change in reality. For instance,
the average money holdings of the people were reduced when Automatic teller machines
were introduced. It means a good approximation is provided by the assumption of constant
velocity in various situations.
The assumption of constant velocity makes the quantity equation a theory of determination
of nominal GDP. The Quantity equation says:
𝑀𝑉 = 𝑃𝑌
Where
V barmeans that velocity is fixed.
Therefore, a change in the quantity of money (M) must cause a proportionate change in
nominal GDP (PY) i.e., if V is fixed, the quantity of money determines the rupee value of the
economy‟s output.
MONEY, PRICES AND INFLATION
The three building blocks that help us study the determination of the overall level of prices
are as follows:
1. The level of output, Y, is determined by the factors of production and the production
function.
2. The nominal value of output, PY, is determined by the money supply. This conclusion
is deduced from the Quantity equation and the fixed velocity of money.
3. The ratio of nominal value of output, PY, to the output level, Y, gives the price level.
What happens when the money supply is changed by the Central bank is explained by this
theory. Any change in the money supply causes proportionate change in nominal GDP as
the velocity is fixed. The change in nominal GDP gets represented in the change in the price
level as the factors of production and the production function have already determined the
real GDP. Therefore, the quantity theory of money states that the price level is proportional
to the money supply.
As the percentage change in the price level is nothing but the inflation rate, therefore, this
theory of price level is also a theory of the inflation rate. Consequently, the quantity
equation in percentage form is represented as follows:
% Change in M+ % Change in V= % change in P + % Change in Y……..(4)
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% Change in Mis under the control of the central bank.
% Change in Vreflects shifts in money demand (the assumption of constant velocity

implies % change in V=0).
% Change in P is the rate of inflation
% Change in Ydepends on growth in the factors of production and on technological

progress, which we can take as given.
This analysis states that the rate of inflation is determined by the growth in the money
supply except for a constant that itself is determined by the exogenous growth in the
output.
The demand for money
The amount of wealth what everyone in the economy wishes to hold in the form of money
balances is called the demand for money. Because people are choosing how to divide their
given stock of wealth between moneyand bonds, it follows what if we know the demand for
money we also know the demand for bonds. With a given level of wealth, a rise in the
demand for money necessarily implies a fall in the demand for bonds; if people wish to hold
1 billion of bonds. It also follows that if households are in equilibrium with respect to their
money holdings, they are in equilibrium with respect to their bond holdings.
MOTIVES FOR HOLDING MONEY (Money Demand)
1.The transactions motive
Money is required for making most of the transactions. Consumers pass the money to the
firms to make the payment for the goods and services produced by them and firms pass the
money to the employees for the labor services supplied by them to the firms. Money
balances that are usually held for this reason are called as the Transactions balances.
An imaginary world in which the receipts and disbursements of consumers and firms were
perfectly synchronized, it would be unnecessary to hold transactions balances. If every
time a consumer spent l0 she received as part payment of her wages, no transactions
balances would be needed. In the real, world, however, receipts and payments are not
perfectly synchronized.
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Consider the balances that are held because of wage. Suppose for purposes of illustration,
that firms wages every Friday and that employees spend all their on goods and services,
with the expenditure spread evenly over the week. Thus on Friday morning firms hold
balances equal to the weekly wage bill; on Friday the employees will hold these balances.
Over the week workers balances will be drawn down as of purchasing good and services.
Over the same the balances held by firms will build up as a result goods and services until,
on the following Friday firms will again have amassed balances equal to bill that must be
met on that day.
Transactions motive arises because payments and are not synchronized.
That determines the size of the transactions balances to hold? It is clear that in our example
total transactions very with the value of the wage bill. If the wage bill for any reason, the
transactions balances held and households for this purpose will also double, As it is with
wages, so it is with all other transactions the size of the balances held is positively related
to of the transactions.
The average value of money balances that people to hold over a particular period that is
relevant for economics, but we need to knows how money de and related to GDP rather
than to total transactions. In the value of all transactions exceeds the value of the final
output. When the miller buys wheat from the farmer and when the baker buys flour from
the miller, both are transactions against which money balances must be held, although only
the value added at each stage is part of GDP.
Generally there will be a stable, positive relationship between transactions and GDP. A rise
in GDP also leads to a rise in the total value of all transactions and hence to an associated
rise in the demand for transactions balances. This allows us to relate transactions balances
to GDP.
Transactions money demand = f (income)
2. Precautionary Motive
Sometimes, unpredictably your vehicle breaks down or you are required to make an
impromptu visit to sick relative. At times like these, certain expenditures crop up out of the
blue. As a precaution against cash crises, when receipts are abnormally low or
disbursements are abnormally high, firms and individuals carry money balances.
Precautionary balances usually grant a cushion against the ambiguity about the timing of
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the cash flows. The greater is the quantum of such balances, the larger would be the shield
against running out of cash balances due to provisional fluctuations in cash flows.
The seriousness of the risk of a cash crisis depends on the penalties that are inflicted for
beingcaught without sufficient money balances. A firm is unlikely to be pushed into
insolvency, but it may incur considerable costs if it is forced to borrow money at high
interest rates in order to meet a temporary cash crisis.
The precautionary motive arises because individuals and firms are uncertain about the
degree to which payments and receipts will be synchronized.
The protection provided by a given quantity of precautionary balances depends on the

volume of payments and receipts. A $100 precautionary balance provides a large cushion
for a person whose volume of payments per month is $800 and a small cushion for a firm
whose monthly volume is $250,000. To be able to provide the same degree of protection as
the value of transactions rises, more money is necessary.
The precautionary motive, like the transactions motive, causes the demand for money to
vary positively with the money value of GDP.
For most purposes the transactions and precautionary motives can be merged, as they both
show that desired money holdings are positively related to GDP. Indeed, they both show
money being held in relation to transactions, either planned or potential.
Precautionary money demand = f (income)
3. Speculative Motive
People usually hold money because of its characteristics of an asset. Some money is usually
held by the individuals and the firms to be able to evade the inbuilt uncertainty in
variableprices of other financial assets. Money held for this reason is called as the
speculative balance. This motive was first analyzed by Keynes, and the classic modern
analysis was developed by Professor James Tobin, the 1981 Nobel Laureate in economics.
Any holder of money balances forgoes the extra interest income that could be earned if
bonds are held instead. However, market interest rates fluctuate, and so do the market
prices of existing bonds (their present values depend on the interest rate). Because their
prices fluctuate, bonds are a risky asset. Many individuals and firms do not like risk; they
are said to be risk –averse.
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Wealth holders require balancing the extra interest income that could be earned by holding
bonds against the risk carried by bondsat the time of choosing between holding money and
bonds.At one extreme, if individuals hold all their wealth in the form of bonds, they earn
extra interest on their entire wealth, but they also expose their entire wealth to the risk of
changes in the price of bonds. At the other extreme if people hold all their wealth in the
form of money, they earn less interest income, but they do not face the risk of unexpected
changes in the price of bonds. Wealth holders usually do not take either extreme position.
They hold part of their wealth as money and part of it as bonds; (i.e.), they diversify their
holdings. The fact that some proportion of wealth is held in money and some in bonds
suggests that, as wealth rises, so will desire for money holdings.
Although one individual‟s wealth may rise or fall rapidly, the total wealth of a society
changes only slowly. For the analysis of short-term fluctuations in GDP, the effects of
changes in wealth are fairly small, and we will ignore them for the present. Specific
individuals may undergo large wealth changes in response to bond price changes, but with
inside wealth the total effect is negligible when leaders gain, borrowers lose; and when
lenders lose borrowers gain. Over the long term, however, variations in aggregate wealth
can have a major effect on the demand of money.
Wealth that is held in cash or deposits earns less interest than could be earned by holding
bonds; hence the reduction in risk involved in holding money carries an opportunity cost in
terms of forgone interest earnings. The speculative motive leads individuals and firms to
add to their money holding until the reduction in risk obtained by the last pound added is
just balanced ( in each wealth-holders view) by the cost in terms of the interest forgone on
that pound. A fall in the rate of return on bonds for the same level of risk will encourage
people to return on bonds for the same level of risk will encourage people to hold more of
their wealth as money and less in bonds. A rise in their rate of return for a given level of
risk will cause people to hold more bonds and less money.
The speculative motive implies that the demand for money will be negatively related to the
rate of interest.
Speculative Money demand = f (Income, Rate of interest)
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THE MONEY DEMAND FUNCTION
We express the effects of the price level, real income, and interest rates on money demand
as
Md= P x L(Y,i) ……………………………(5)
where
Md = the aggregate demand for money, in nominal terms;
P=the price level;
Y= real income or output;
i= the nominal interest rate earned by alternative, nonmonetary assets;
L= a function relating money demand to real income and the nominal interest rate.
Figure 1: Quantity of money Figure 2: Quantity of Figure 3: Quantity of

and rate of interest are money and price level are money and GDP are
inversely related. positively related. positively related.
Equation (5)states that nominal money demand, Md is proportional to the price level, P.
Hence, if the price level P doubles (given the real income and rate of interest) then, the
nominal money demand Md will become double, reinforcing the fact that real money
required to conduct the same real transactions will be twice.
Equation (5) also indicates that, for any given P, Md depends (through the function L) on
real income,Y and the nominal interest rate on non-monetary assets,i.An increase in real
20
income, Y, raises the demand for liquidity and thus increases money demand. An increase in
the nominal interest rate, i, makes non-monetary assets more attractive which reduces
money demand.
We could have included the nominal interest rate on money im in the above equation
because an increase in the interest rate on money makes people more willing to hold money
and thus increases money demand. Historically, however, the nominal interest rate on
money has varied much less than the nominal interest rate on nonmonetary assets (for
example, currency and a portion of checking accounts always have paid zero interest ) and
thus has been ignored by many statistical studies of equation thus for simplicity we do not
explicitly include im in the equation.
Md=PXL(Y, r+ e
) ………...…………………….(6)
e
Equation (6) shows that for any expected rate of inflation , increase in the real interest
rate increases the nominal interest rate and reduces the demand for money. Similarly, for
any real interest rate, an increase in the expected rate of inflation increases the nominal
interest rate and reduces the demand for money.
Nominal money demand, Md measures the demand for money in terms of rupees. If we
divide both sides of Eq. (6) by the price level, P, we get,
Md /P=L(Y, r+ e
). ………………………………….(7)
The expression Md /P is called real money demand or the demand for real balances. Real
money demand, Md /P depends on real income (or output), Y, and on the nominal interest
e
rate, which is the sum of the real interest rate, r and expected inflation, .The
function,L,that relates real money demand to output and interest rates in Eq. (3) is
calledthe money demand function.
OTHER FACTORS AFFECTING MONEY DEMAND
The additional factors influencing money demand are as follows:
1. Wealth:When wealth increases, part of the extra wealth may be held as money,
increasing, and total money demand. However with income and the level of transactions
held constant, a holder of wealth has little incentive to keep extra wealth in money rather
21
than in higher-return alternative assets. Thus the effect of an increase in wealth on money
demand is likely to be small.
2. Risk:Holding money isn‟t usually risky as it pays a fixed nominal interest rate (ZERO in
case of cash). However, the demand for safer assets including money may increase if the
risk of alternative assets such as stocks and real estate increases greatly.Therefore, money
demand in the economy increases with increased riskiness.
However, money doesn‟t always carry a low risk. In a period of erratic inflation, even if the
nominal return on money is fixed, the real return on money (the nominal return minus
inflation) may become quite uncertain, making money risky. Money demand then will fall as
people switch to inflation hedges (assets whose real returns are less likely to be affected by
erratic inflation) such as gold, consumer durable goods, and real estate.
3.Liquidity of Alternative Assets:The requirement to hold money reduces when the

conversion of alternative assets into cash becomes more quick and easy. The alternative to
money has become more liquid in financial markets in recent years due to the joint impact
of deregulation, competition and innovation. The introduction of individual cash
management accounts hasallowed individuals to switch wealth easily between high-return
assets, such as stocks, and more liquid forms. As alternative assets become more liquid, the
demand for money declines.
4. Payment technologies. Money demand also is affected by the technologies available

for making and receiving payments. For example, the introduction of credit cards allowed
people to make transactions without moneyat least until the end of the month, when a
cheque must be written to pay the credit card bill. Automatic teller machines (ATMs)
probably have reduced the demand for cash because people know that they can obtain cash
quickly whenever they need it. In the mid 2000s, check clearing becomes very efficient,
thanks to the check 21 law, which allowed for electronic clearing of images of checks. This
process greatly reduces the costs of clearing cheques and allows them to clear much more
quickly than before. In the future more innovations in payment technologies undoubtedly
will help people operate with less and less cash. Some experts even predict that ultimately
we will live in a “cashless society” in which almost all payments will be made through
immediately accessible computerized accounting systems and that the demand for cash will
be close to zero.
5.Elasticities of Money Demand: The theory of portfolio allocation helps economists

identify factors that should affect the aggregate demand for money. However, for many
22
purposes-such as forecasting and quantitative analyses of the economy- economists need to

know not just which factors affect money demand but also how strong the various effects
are. This information can be obtained only through statistical analysis of the data.
Over the past three decades, economists have performed hundreds of statistical studies of
the money demand function. The results of these studies often are expressed in terms of
elasticities(income & interest elasticities), which measure the change in money demand
resulting from changes in factors affecting the demand for money.
(A) Income elasticity of money demandis the percentage change in money demand
resulting from a 1% increase in real income. Thus, for example, if the income elasticity of
money demand is 2/3, a 3% increase in real income will increase money demand by 2%
(2/3X3%=2%).
(B) The interest elasticity of money demandisthe percentage change in money demand
resulting from a 1% increase in the interest rate. If interest rate increases from 5% to 6%,
it is not 1% increase in interest rate rather it is 20% increase in the return. So this has to
be kept in mind while dealing with interest elasticity of money demand.
Measures of Money
1. M1- transactions money
If we take the value of all currency(including coins) held outside of bank vaults and add to it
the value of all demand deposits, traveler‟s cheques, and other checkable deposits, it is
defined as the, M1, or transactions money (i.e.) this is the money that can be directly used
for transactions to buy things. It is also known as narrow money.
M1= currency held outside banks+ demand deposits +traveler’s cheques
+othercheckable deposits ……………….(8)
A checkable deposit is any deposit account with a bank or other financial institution on
which a check can be written. Checkable deposits include demand deposits: negotiable
order of withdrawal (now)accounts, which automatically transfer funds from savings to
checking (or vice versa) when the balance on one of those accounts reaches a
predetermined level.
23
M1 onJune 26, 2000was $1,103.3 billion in US.M1 is a stockmeasure, which is measured at

a point in time.It is the total amount of coins and currency outside of banks and the total
rupee amount in checking accounts on a specific day.
Definitions of Monetary aggregates in India
A. Monetary Aggregates
Weekly compilation
M0= currency in circulation + Bankers with
The RBI + Other Deposits with the RBI
Fortnightly Compilation
M1= currency with the public + Demand Deposits with the banking system +
other’s deposits with the RBI currency with the public + current deposits with the
banking system+ demand liabilities portion of saving deposits with the banking
system + other deposits with the RBI
M2=M1+ time liabilities portion of saving deposits with the banking system +
certificates of deposit issued by banks + term deposits (excluding FCNR
(B)deposits) with a contractual maturity of up to and including one year with the
banking system = currency with the public + current deposits with the banking
system + saving deposits with the banking system + certificates includingFCNR
(B)deposits) with a contractual maturity up to and including one year with the
banking system + other deposits with the RBI
M3=M2 +Term deposits (excluding FCNR(B) deposits) with a contractual maturity

of over one year with the banking system + call borrowing from non-depository
financial corporation by the banking system
B. Liquidity Aggregates
Monthly compilation
L1=M3+ all deposits with the post officer saving banks (excluding national
savings certificates)
L2=L1+Term deposits with term lending institutions and refinancing institutions 24
(FIS) + Term borrowing byofFIs+
Institute certificates
Lifelong of depositofissued
Learning, University Delhi by FIIs.
L2=L1+ public deposits of non-banking financial companies.
2. M2:
If we add near monies, close substitutes for transactions money, to m1 we get m2, called as
the broad money because it includes not–quite-money monies such as saving accounts,
money market accounts, and other money‟s.
M2=M1+saving accounts+money market accounts
+other near money ………………(9)
On June 26, 2000, M2 was $4,778.2 billion, considerably larger than the total M1 of $
1,103.3 billion. The main advantage of looking at M2 instead of M1 is that M2 is sometimes
more stable. When banks introduced new forms of interest-bearing checking accounts in
the early 1980s, M1 shot up as people switched their funds from savings accounts to
checking accounts. However, M2 remained fairly constant because, the fall in saving
account deposits and the rise in checking account balances were both part of M2, canceling
each other out.
One of the very broad definitions of money includes the amount of available credit on credit
cards (your charge limit minus what you have charged but not paid) as part of the money
supply.
SUMMARY
 Money is anything that serves as medium of exchange. Today almost all currency is
fiat money.Fiat money is neither convertible into anything nor has any face value but
it is yet valuable because it is accepted by convention and in law in payment for the
purchase of goods or service and for the discharge of debts.
 Money acts as a medium of exchange and can also serve as a store of value and a
unit of account.
 There is direct and one to one relationship between quantity of money and prices in
the economy. This is known as Quantity Theory of Money.
 Public hold cash or demand money for three reasons: for making day-to-day
transactions, saving it for the bad days and as an alternative to holding bonds.
 Money demand is function of real income (nominal income and prices) and interest
rate. Other factors that determine money demand are wealth, risk, liquidity of
25
alternative assets, payment technologies, and income and interest elasticity of

money demand.
 Money supply in an economy is at a date as it is a stock variable. If we just add cash
in circulation and demand deposits we get a narrow measure of money(M1) and if
near monies are also added to M1 then we get, broad measure (M2).
EXERCISES
SHORT ANSWER QUESTIONS
Q1. Which of the functions of money are satisfied(medium of exchange, unit of account and
store of value) by the following items?
a. Credit Card
b. Subway token
Q2. State whether you agree or disagree with the following statement and explain why:
a. If money supply increases by 10%, overall prices changes by less than 10%.
b. If an economy is experiencing inflation, then it is better to hold money balances.
c. Higher real income means a greater demand for money.
LONG ANSWER QUESTIONS
Q1. Describe the functions of money.
Q2. What is fiat money? How is it different from other types of money in early age?
Q3. Write the Quantity equation and explain it.
Q4. Define velocity. Discuss the role of velocity in the quantity theory of money.
NUMERICALS
Q1. Consider the following money demand function for an economy
Md= 1000+ 0.25y – 1000 i
a. Suppose that P = 100, Y = 1000 and i = 0.10.Find real money demand, nominal
money demand and velocity.
b. If suppose, price level doubles from p = 100 to p = 200 find real money demand,
nominal money demand and velocity.
26
Q.2 a. If income elasticity of money demand is 5 and if income charges by 3 % by

how much would money demand change?
b. If interest elasticity of money demand is 1/5 and if interest charges from 5% to

6% by how much would money demand change?
GLOSSARY
 Money:Money is an asset that is widely used and accepted as payment. Money

functions as a medium of exchange, a unit of account and a store of value.
 Fractionally backed money:When central banks or gold smith issue currency more
than the reserves or gold in their vault, money is known to be fractionally backed.
 Seignior age:Seignior age is the revenue that the government raises by printing
money.
 Fiat money:Fiat monies are intrinsically worthless and it is accepted by convention
and in law in payment for the purchase of goods or services and for the discharge of
debts.
 Quantity Theory of Money: Quantity Theory of Money assumes that velocity of stable
and production function determine real GDP and concludes that rate of growth of
money determines the inflation rate.
 Velocity: The income velocity of money tells us the number of times a rupee bill
enters someone‟s income in a given period of time.
 Money demand:The amount of wealth what everyone in the economy wishes to hold
in the form of money balances is called the demand for money.
 Narrow money: Sum of value of all currency(including coins) held outside of bank
vault, value of all demand deposits, traveler‟s cheques and other checkable deposits
is known as narrow money.
 Broad money: If we add near monies to m1 we get the broad money because it
includes not–quite-money monies such as saving accounts, money market accounts,
and other money‟s.
27
REFERENCES
1. N. Gregory Mankiw, Economics: Principles and Applications, India edition by South

Western, a part of Cengage Learning, Cengage Learning India Private Limited, 4th edition,
2007.
2. Andrew B. Abel and Ben S. Bernanke, Macroeconomics, Pearson Education, Inc.7th

edition, 2011.
3. Statistical Outline of India 2012-13, TATA services ltd.
4. www.rbi.org
5. Dror Goldberg, Famous Myths of "Fiat Money",Journal of Money, Credit and Banking, Vol.
37, No. 5 (Oct., 2005), pp. 957-967
28

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Money: Demand and Supply

c. Quantity theory of money

a. Motives for money demand

b. Money demand function

c. Other factors affecting demand for money

A generally accepted medium of exchange is usually defined as Money. A medium of

THE ORIGINS OF MONEY

Money in POW camp

Barter proved to be an inconvenient way to allocate goods because it requires

The early experience of currently debasement led to the observation known as

Fractionally backed paper money

Fiat money in primitive societies?

If fiat money is acceptable, it is a medium of exchange. Further, if its purchasing power

Money must possess several characteristics to be able to serve as a medium of exchange. It

Transactions and the Quantity Equation

Money x Velocity = Price x Transactions

MxV = PxT …………………………………(1)

P = the price of a transaction and the number of transactions.

M = the quantity of money.

and the quantity of money in the economy ( M * V) = Rs. 20

T = 60 slices per year,

P = Rs.5 per slice, and

The total number of rupees exchanged is:

P*T = Rs. 5/slice x 60 slices/year = Rs. 300/year

Therefore, by re-arranging the quantity equation, we can compute velocity as:

V =15 times per year.

From transactions to Income

As the number of transactions is difficult to measure in an economy, economists usually

Y = the amount of output

P = the price of unit of output,

Y = real GDP deflator,

The quantity equation becomes:

Money x Velocity = Price x Output

The Money Demand Function and the Quantity Equation

On adding the following condition to the money demand function:

Demand for real money balances (M/P) d = the supply (M/P)

Rearranging the terms, we get

And we get the Quantity equation as:

Cambridge Equation & Fisher Equation of Quantity Theory of Money:

Similarity & Difference

Fisher’s Quantity of Theory of Money establishes relation between money and

V barmeans that velocity is fixed.

MONEY, PRICES AND INFLATION

% Change in M+ % Change in V= % change in P + % Change in Y……..(4)

% Change in Mis under the control of the central bank.

% Change in Vreflects shifts in money demand (the assumption of constant velocity

% Change in P is the rate of inflation

% Change in Ydepends on growth in the factors of production and on technological

The demand for money

MOTIVES FOR HOLDING MONEY (Money Demand)

1.The transactions motive

Transactions motive arises because payments and are not synchronized.

Transactions money demand = f (income)

The protection provided by a given quantity of precautionary balances depends on the

Precautionary money demand = f (income)

Speculative Money demand = f (Income, Rate of interest)

THE MONEY DEMAND FUNCTION

Md= P x L(Y,i) ……………………………(5)

Md = the aggregate demand for money, in nominal terms;