KEYNESIAN DEMAND FOR MONEY - LIQUIDITY PREFERENCE

TRANSACTIONS DEMAND - this is money used for the purchase of goods and services. The
transactions demand for money is positively related to real incomes and inflation. As an
individual's income rises or as prices in the shops increase, he will have to hold more cash to
carry out his everyday transactions. The quantity of nominal money demand is therefore
proportional to the price level in the economy. 

(note:  the real demand for money is independent of the price level)

PRECAUTIONARY BALANCES - this is money held to cover unexpected items of

expenditure. As with the transactions demand for money, it is positively correlated with real
incomes and inflation.

SPECULATIVE BALANCES - this is money not held for transaction purposes but in place of
other financial assets, usually because they are expected to fall in price. 

There is an inverse relationship between the rate of interest and the speculative demand for
money.

The total demand for money is obtained by summating the transactions, precautionary and
speculative demands. Represented graphically, it is sometimes called the liquidity preference
curve and is inversely related to the rate of interest.

FUNCTIONS OF MONEY:

Various functions of money can be classified into three broad groups:

(a) Primary functions, which include the medium of exchange and the measure of value;

(b) Secondary junctions which include standard of deferred payments, store of value and transfer
of value; and

(c) Contingent functions which include distribution of national income, maximization of

satisfaction, basis of credit system, etc. These functions have been explained below:

1. Medium of Exchange:

The most important function of money is to serve as a medium of exchange or as a means of

payment. To be a successful medium of exchange, money must be commonly accepted by people
in exchange for goods and services. While functioning as a medium of exchange, money benefits
the society in a number of ways:
(a) It overcomes the inconvenience of baiter system (i.e., the need for double coincidence of
wants) by splitting the act of barter into two acts of exchange, i.e., sales and purchases through
money.

(b) It promotes transactional efficiency in exchange by facilitating the multiple exchange of

goods and services with minimum effort and time,

(c) It promotes allocation efficiency by facilitating specialization in production and trade,

(d) It allows freedom of choice in the sense that a person can use his money to buy the things he
wants most, from the people who offer the best bargain and at a time he considers the most
advantageous.

2. Measure of Value:

Money serves as a common measure of value in terms of which the value of all goods and
services is measured and expressed. By acting as a common denominator or numeraire, money
has provided a language of economic communication. It has made transactions easy and
simplified the problem of measuring and comparing the prices of goods and services in the
market. Prices are but values expressed in terms of money.

Money also acts as a unit of account. As a unit of account, it helps in developing an efficient
accounting system because the values of a variety of goods and services which are physically
measured in different units (e.g, quintals, metres, litres, etc.) can be added up. This makes
possible the comparisons of various kinds, both over time and across regions. It provides a basis
for keeping accounts, estimating national income, cost of a project, sale proceeds, profit and loss
of a firm, etc.

To be satisfactory measure of value, the monetary units must be invariable. In other words, it
must maintain a stable value. A fluctuating monetary unit creates a number of socio-economic
problems. Normally, the value of money, i.e., its purchasing power, does not remain constant; it
rises during periods of falling prices and falls during periods of rising prices.

3. Standard of Deferred Payments:

When money is generally accepted as a medium of exchange and a unit of value, it naturally
becomes the unit in terms of which deferred or future payments are stated.

Thus, money not only helps current transactions though functions as a medium of exchange, but
facilitates credit transaction (i.e., exchanging present goods on credit) through its function as a
standard of deferred payments. But, to become a satisfactory standard of deferred payments,
money must maintain a constant value through time ; if its value increases through time (i.e.,
during the period of falling price level), it will benefit the creditors at the cost of debtors; if its
value falls (i.e., during the period of rising price level), it will benefit the debtors at the cost of
creditors.
4. Store of Value:

Money, being a unit of value and a generally acceptable means of payment, provides a liquid
store of value because it is so easy to spend and so easy to store. By acting as a store of value,
money provides security to the individuals to meet unpredictable emergencies and to pay debts
that are fixed in terms of money. It also provides assurance that attractive future buying
opportunities can be exploited.

Money as a liquid store of value facilitates its possessor to purchase any other asset at any time.
It was Keynes who first fully realised the liquid store value of money function and regarded
money as a link between the present and the future. This, however, does not mean that money is
the most satisfactory liquid store of value. To become a satisfactory store of value, money must
have a stable value.

5. Transfer of Value:

Money also functions as a means of transferring value. Through money, value can be easily and
quickly transferred from one place to another because money is acceptable everywhere and to
all. For example, it is much easier to transfer one lakh rupees through bank draft from person A
in Amritsar to person B in Bombay than remitting the same value in commodity terms, say
wheat.

6. Distribution of National Income:

Money facilitates the division of national income between people. Total output of the country is
jointly produced by a number of people as workers, land owners, capitalists, and entrepreneurs,
and, in turn, will have to be distributed among them. Money helps in the distribution of national
product through the system of wage, rent, interest and profit.

7. Maximization of Satisfaction:

Money helps consumers and producers to maximize their benefits. A consumer maximizes his
satisfaction by equating the prices of each commodity (expressed in terms of money) with its
marginal utility. Similarly, a producer maximizes his profit by equating the marginal productivity
of a factor unit to its price.

8. Basis of Credit System:

Credit plays an important role in the modern economic system and money constitutes the basis of
credit. People deposit their money (saving) in the banks and on the basis of these deposits, the
banks create credit.

9. Liquidity to Wealth:
Money imparts liquidity to various forms of wealth. When a person holds wealth in the form of
money, he makes it liquid. In fact, all forms of wealth (e.g., land, machinery, stocks, stores, etc.)
can be converted into money.

SUPPLY OF MONEY:

Population's spending power represented by the quantity of liquid assets (usually cash) in an
economy that can be exchanged for goods and services. Increase in money supply (relative to the
output of goods and services) leads to inflation, higher employment, and high utilization of the
manufacturing capacity. Its decrease leads to deflation, unemployment, and idle manufacturing
capacity. It can have different meanings depending on the degree of liquidity chosen to define an
asset as money. Measures of money supply (called monetary aggregates) have different criteria
in different countries, and are categorized from the narrowest to the broadest.

They include,
M0: sum of currency in circulation (notes and coins) plus banks' reserves with the central bank.

M1: currency in circulation plus current (checking) accounts plus deposit accounts transferable
by checks.

M2: currency in circulation plus savings accounts and non-interest bearing bank deposits.

M3: M1 plus all private-sector (non-government) deposits and certificates of deposit; M3C: M3
plus foreign-exchange deposits with banks.

M4: M1 plus private-sector bank deposits and money market investments.

M5: M4 plus building-society deposits. Also called money stock.