Chapter 3

Money Demand and Money Supply

3.1. Introduction

In economics money is defined as an asset (a store of value) which functions as a generally accepted
medium of exchange, i.e., it can be used directly to buy any good offered for sale in the economy.
Money is characterized by being a fully liquid asset. An asset is fully liquid if it can be used directly,
instantly, and without any extra costs or restrictions to make payments. The following three functions
are sometimes considered to be the definitional characteristics of money: 1. It is a generally accepted
medium of exchange. 2. It is a store of value. 3. It serves as a unit of account in which prices are
quoted and books kept (the numeraire).

In the early society, the system of exchange was barter system where goods were exchanged in terms
of other commodities or goods. In the early periods, arrowheads, hides, shells etc. were used as money.
As the production, consumption and other economic activities of the world society became complex,
the system of exchange also became complex. Barter system was observed that it was not capable of
satisfying this complicated demand for exchange. It was not useful in making bulk exchanges and in
the process of exchange also barter system consumed lots of time and energy. However, by the
invention of money, things became simpler. Later on, paper currencies were used as money.

3.2. Money Supply

Money supply is the amount of money in circulation in a given economy. Total money supply
determines the wellbeing of a national economy to large extent. Any fluctuation in money supply
brings changes in the aggregate macroeconomic variables. This is the reason why theory of money
supply is so important in macroeconomic analysis.
Relatively a larger amount of money supply may lead to both negative and positive impacts in other
macroeconomic variables. Some of such impacts are larger inflation rate, lower interest rate, and lower
cost of borrowing or cheaper loan, lower saving and better investment. This makes money supply one
of the major policy instruments in the hands of governments. The policy packages prescribed related
to money supply is known as monetary policy and the variables changed in achieving the objectives are
known as monetary policy instruments.

What are the Major Components of Money Supply?

Determining the components of money is not an easy task as money is sometimes defined as anything
generally accepted as a medium of exchange. In a modern banking system, there are many assets which
can be termed as money. The levels/degrees of liquidity of these components of money supply are
different. For instance, Birr notes are more liquid than some financial documents such as cheques
owing to the fact that Birr can easily be exchanged for other goods than the cheque. Some of the
components of money supply popularly used are given as follows:

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M1 = currency with the public + demand deposit with the banking system or deposits in checking
account + checks for current conversion and use (e.g., travelers’ checks).
M2 = M1 + deposit in saving account + money market mutual funds.
M3 = M2 + Time deposits with the banking system (long time deposits) + financial securities such as
treasury bills, bonds and so on.

The component M1 is sometimes defined as ‘narrow money’ whereas the other components of money
such as M2 and M3 are defined as ‘broad money’. One can find some variations in the components of
money keeping different countries into account. That means, depending on the level of economic
development and related activities especially depending on the level of development of financial
market, the component of money supply differs from one country to another.

Creation of Money and Banking System

Changes in the money supply occur due to the actions of central bank of a country. The process of
money creation represents the process by which a given amount of money increases itself through
interaction between central bank and commercial banks and households. Any typical central bank has
three major monetary policy tools through which it controls the money supply. These monetary policy
instruments are: Reserve requirements, Open market operation and Discount rate.

1. Reserve Requirements

Usually, households and owners of financial resources save or deposit their money with commercial
banks. The central bank requires commercial banks to retain a certain percentage of their deposits as
a reserve in central bank. For example, suppose the total deposit made in CBE is 100 birr. If reserve
requirement of the central bank is 5%, then CBE has to deposit 5 birr in the central bank of Ethiopia.
The bank can use 95 birr for giving loans to the customers or borrowers. If central bank wants to
expand (reduce) money supply in the country, then it should decrease (increase) the reserve
requirement.

2. Open Market Operation

Open market operation is by far one of the most powerful instruments in the hands of central bank
of any country. Open market operation means the purchase and sale of government securities by the
central bank to maintain the proper level of money supply in an economy. Let us suppose central bank
wants to increase the money supply in the country. In order to increase money supply, the central
bank can buy government bonds from the public. By doing so, it gives money to the public and
effectively increasing money supply. On the other hand, by selling government securities to the public
central bank can reduce the supply of money in the economy. This is, however, only a single stage;
the growth of money supply depends on the activities of the individual who has received the money.
If the individual goes to the bank and deposit, the bank takes it as deposit and keeps a part as reserve

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requirement and gives the rest amount in loan. This results multiplier effect and ultimately supply of
money increases in the way we have described above under reserve requirement.

3. Discount Rate

The discount rate is the interest rate that the Central Banks charges when it makes loans to banks.
Banks usually borrow from the Central Banks when they find themselves with too few reserves to
meet reserve requirements. The lower the discount rate, the cheaper are borrowed reserves, and the
more banks borrow at the Central Bank’s discount window. Hence, a reduction in the discount rate
raises the monetary base and the money supply, vice versa.

Although these three instruments give the Central Banks substantial power to influence the money
supply, the Central Banks cannot control the money supply perfectly. Bank discretion in conducting
business can cause the money supply to change in ways the Central Banks did not anticipate. For
example, banks may choose to hold excess reserves—that is, reserves above the reserve requirement.
The higher the amount of excess reserves, the higher the reserve–deposit ratio, and the lower the
money supply. As another example, the Central Banks cannot precisely control the amount banks
borrow from the discount window. The less banks borrow, the smaller the monetary base, and the
smaller the money supply. Hence, the money supply sometimes moves in ways the Central Banks does
not intend. This means that commercial banks can affect the multiplier process. If the commercial
banks hold excess reserves above the reserve requirements, then the whole process will be slow and
money supply may not increase as we have seen above and expected. Households, investors and capital
owners (owners of money) also have significant effect on the effectiveness of monetary supply and
how fast the process of money creation to take place. More points on how or through what particular
variables these parties affect money supply are elaborated in the following simple money supply model.

A Simple Model of Money Supply

To show that there are parties other than the central bank such as households which affect money
supply and how they affect money supply we can use a simple money supply model. This model
involves three exogenous variables: monetary base, reserve and demand deposits.

1. Monetary Base (B): This is a total amount of money held by the public as currency (C) under
control of (or decided for what purpose to use by) the public; and the amount kept by banks as
reserves (R).
This relation is given by the following relation:
B= C + R
2. Reserve requirement: This is the proportion of deposits that commercial banks keep with central
bank. Reserve – deposit ratio (R/D) = rr is the ratio of reserves to the deposit kept with banks.
This component of the money supply is controlled by the Fed (central bank).

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3. Currency – Deposit Ratio = cr = ( C / D ) : This represents the preference of the public
(consumers and producers) about how much money to hold in the form of currency (C) and how
much to hold in the form of demand deposits (D) which is deposited in banks in checking account
from which they withdraw when they need. The sum of the two represents the money supply (M1)
in circulation either in the form of currency or deposit in banks given by the following relation.
M=C+D

Taking the ratio of the above two equations, we can obtain more precise equation for money supply.
𝑀 𝐶+𝐷
=
𝐵 𝐶+𝑅
By dividing both numerators and denominators by ‘D’, we obtain the following:
C +D
M
= D D = cr + 1
B C +R cr + rr
D D
By multiplying both sides by ‘B’ again we obtain:
 cr + 1 
M = B
 cr + rr 
 cr + 1 
Letting   = m, the simple money supply is given as follows:
 cr + rr 
M = mB = m ( C + R )
Where M = Money Supply and
 cr + 1 
m=   called money multiplier.
 cr + rr 
The meaning of the multiplier is that each birr of monetary base produces ‘m’ birr of money. When
B increases by a unit, money supply increases by ‘m’ factor or unit. The lower the reserve deposit ratio
( rr ), the more loans banks would make and the more money they would create from every birr. This
means, a decrease in rr leads to an increase in money supply.

For instance, if currency deposit ratio = 0.4 (currency = 40% of total deposit) and reserve requirement
 cr + 1  0.4 + 1
= 10 % of deposit then m =  =
 cr + rr  0.4 + 0.1
= 0.4 +1
0.4+ 0.1
m = 2.8
And then, this simple money supply function is given by M = 2.8B

The three major components/determinants of money supply in this simple money supply model (B,
cr, and rr) are again affected by different actors. ‘B’ is affected by Central Bank (government) action

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through R. The value of rr is also determined by the act of the Central Bank (government). ‘cr’ is
determined by the households behaviors. This implies that money supply is not determined by Central
Bank (government) decision alone but also by households’ decision too.

For instance, if households decide to deposit more money instead of holding, money supply increases
even if Central Bank (government) takes no action. This is because, this makes the money circulate
more and multiply more. If we take open market operation which is about purchases and sales of
government bonds by the Central Bank:
a) Government purchase of bonds expands monetary base (B), (government gives money to the
public).
b) Government sales of bonds (government collects money from the public) reduces monetary
base and thereby reduces money supply.
 cr + i   cr + i 
M = B => M =  (C + R ) .
 cr + rr   cr + rr 
The effect of open market operation is reflected in base money B = C + R. It affects the value of C.
Government sales of bonds reduces B = C  + R  C   Ms. Government purchase of bonds
increases B = C + R C Ms. If the money is deposited, which is the case mostly, the R part
of the monetary base will increase.

3.3. Demand for Money

We now turn to the other side of the money market and examine what determines money demand.
We start with the quantity theory (Cambridge approach)1, which assumes that the demand for real
balances is proportional to income. That is, the quantity theory assumes
( M / P)d = kY ,
where k is a constant measuring how much money people want to hold for every dollar/Birr of
income. We then considered a more general and realistic money demand function that assumes the
demand for real money balances depends on both the interest rate and income:
( M / P) d = L(i, Y )
We used this money demand function when we discussed the link between money and prices when
we developed the IS–LM model.

There is, of course, much more to say about what determines how much money people choose to
hold. Just as studies of the consumption function rely on microeconomic models of the consumption

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Fisher’s version is: MV = PT; Where M is the nominal stock of money in circulation and V is the transactions velocity
of circulation of money (that is, the average number of times the given quantity of money changes hands in
transactions); P is the average price of all transactions and T is the number of transactions that take place during the
time period.

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decision, studies of the money demand function rely on microeconomic models of the money demand
decision.

Recall that money serves three functions: it is a unit of account, a store of value, and a medium of
exchange. The first function—money as a unit of account—does not by itself generate any demand
for money, because one can quote prices in dollars without holding any. By contrast, money can serve
its other two functions only if people hold it. Theories of money demand emphasize the role of money
either as a store of value (portfolio theory) or as a medium of exchange (transaction theories).

Portfolio Theories of Money Demand

Theories of money demand that emphasize the role of money as a store of value are called portfolio
theories. According to these theories, people hold money as part of their portfolio of assets. The key
insight is that money offers a different combination of risk and return than other assets. In particular,
money offers a safe (nominal) return, whereas the prices of stocks and bonds may rise or fall. Thus,
some economists have suggested that households choose to hold money as part of their optimal
portfolio.

Portfolio theories predict that the demand for money should depend on the risk and return offered
by money and by the various assets households can hold instead of money. In addition, money demand
should depend on total wealth, because wealth measures the size of the portfolio to be allocated among
money and the alternative assets. Considering these, we might write the money demand function as

( M / P)d = L(rs , rb , E ,W )

where rs is the expected real return on stock, rb is the expected real return on bonds, E is the
expected inflation rate, and W is real wealth. An increase in rs or rb reduces money demand, because
other assets become more attractive. An increase in E also reduces money demand, because money
becomes less attractive. An increase in W raises money demand, because greater wealth means a larger
portfolio.

From the standpoint of portfolio theories, we can view our money demand function, L(i, Y), as a
useful simplification. First, it uses real income Y as a proxy for real wealth W. Second, the only return
variable it includes is the nominal interest rate, which is the sum of the real return on bonds and
expected inflation (that is, i = rb + E ). According to portfolio theories, however, the money demand
function should include the expected returns on other assets as well.

Are portfolio theories useful for studying money demand? The answer depends on which measure of
money we are considering. The narrowest measures of money, such as M1, include only currency and
deposits in checking accounts. These forms of money earn zero or very low rates of interest. There

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are other assets—such as savings accounts, Treasury bills, certificates of deposit, and money market
mutual funds—that earn higher rates of interest and have the same risk characteristics as currency and
checking accounts. Economists say that money (M1) is a dominated asset, as a store of value, it exists
alongside other assets that are always better. Thus, it is not optimal for people to hold money as part
of their portfolio, and portfolio theories cannot explain the demand for these dominated forms of
money.

Portfolio theories are more plausible as theories of money demand if we adopt a broad measure of
money. The broad measures include many of those assets that dominate currency and checking
accounts. M2, for example, includes savings accounts and money market mutual funds. When we
examine why people hold assets in the form of M2, rather than bonds or stock, the portfolio
considerations of risk and return may be paramount. Hence, although the portfolio approach to
money demand may not be plausible when applied to M1, it may be a good theory to explain the
demand for M2.

Transactions Theories of Money Demand

Theories of money demand that emphasize the role of money as a medium of exchange are called
transactions theories. These theories acknowledge that money is a dominated asset and stress that
people hold money, unlike other assets, to make purchases. These theories best explain why people
hold narrow measures of money, such as currency and checking accounts, as opposed to holding
assets that dominate them, such as savings accounts or Treasury bills. Transaction theories of money
demand take many forms, depending on how one models the process of obtaining money and making
transactions. All these theories assume that money has the cost of earning a low rate of return and the
benefit of making transactions more convenient. People decide how much money to hold by trading
off these costs and benefits.

To see how transactions theories explain the money demand function, let’s develop one prominent
model of this type. The Baumol–Tobin model was developed in the 1950s by economists William
Baumol and James Tobin, and it remains a leading theory of money demand.

Baumol-Tobin Model of Cash Management

This theory is concerned with the calculation of the optimal number of time of cash withdrawal from
banks and optimal amount of cash to hold during any given period. This depends on the benefit and
cost of holding money.
➢ Benefit of holding money: This is convenience of making transactions i.e., avoiding making
trips to banks every time they wish to buy something.
➢ Cost of holding money: This is the foregone interest income that they would have received
had they left their money in the saving account.
There are different cash management possibilities (plans) depending on the number of times one
withdraws money from banks per given period of time; (once, twice, etc. per period of time). Here,
we assume the price level is constant so that real spending is constant over the period.

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To use ‘Y’ amount of money per period one should withdraw Y/N amount each time where N is the
number of withdrawals per period of time. Thus, in general the average holding is given by Y/2N
(Normalizing the length of the period to 1). The question here is: What is the optimal number of times
we should go to the bank to minimize cost and maximize benefit?

With the same amount of money withdrawn in a year = Y, as the number of withdrawals increases, it
is advantageous that less money is held on average, so individual foregoes less interest income. On the
other hand, this increases inconvenience of making trip to the bank and related costs of withdrawal
and foregone wage income (let this cost be = F).
The average amount of money held = Y/2N
Trip and related costs = FN
Interest foregone = i (Y / 2 N ) = iY / 2 N
Total cost = ( iY / 2 N )+ FN
iY
Total cost: C = + FN
2N
The optimal value of N is calculated by optimizing this cost function. That is, the minimum point of
the function is obtained by the first order derivative of the total cost with respect to N.
dC − iY
= +F=0
dN 2N 2
Multiplying both sides by 2N2 we obtain:
iY
-iY + 2 N2F = 0 => N2 =
2F
=> N* = iY
2F
Thus, the optimal average money holding will be given by:
Y Y Y
* = =
2N 2 iY 4iY
2F 2F
Y2 YF
= =
2iY 2i
F
𝑀 YF
Or ( 𝑃 )𝑑 = = L(i,Y,F)
2i

This identity tells us that individual holds more money as:

a. The fixed cost of trip and withdrawal, F, is getting higher (positive relationship)
b. The expenditure per period (Y) is increasing (positive relationship) and /or
c. The interest rate is getting lower. (Negative relationship)

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These relations are microeconomic justifications for the behavior of individual about money demand.
This model can be considered as a model of demand for currency because it explains the amount of
money held outside banks as currency.

One implication of the model is that any change in the fixed cost of trip to bank and withdrawing, F
alters the money demand function; i.e., it changes quantity of money demanded for any given income
(Y) and interest rate (i).

The value of the fixed cost (F) is affected by:

a. Spread of automatic teller machine. This reduces F as it minimizes the time required for
withdrawal.
b. Introduction of internet banking. This also reduces F.
c. Increase in real wage rate. This increases the foregone wage income and so it increases F.
d. Increase in banking fees also increase F directly.

Although the Baumol-Tobin model gives us a very specific money demand function, it doesn’t give
us reason to believe that this function will necessarily be stable over time. Keynes introduced the
motives of holding money.

i. Transaction Demand for Money

For the economy as a whole, we can expect the total demand for money for transactions purposes to
depend directly on money nominal income. Using functional notation, we can write as
Mt = f (Y)
Where Mt is the transactions demand for money; Y is income

ii. Precautionary Demand for Money

This demand for money arises due to uncertainty of future receipts and expenditures. This is to meet
the unexpected expenses. This demand for money can also be linked to income. As income increases,
people tend to keep more money for precautionary purpose. Thus, one can say that precautionary
money demand is also a function of income and can be written as: Mp = f (Y ) . Since both transaction
and precautionary demand for money are functions of income and precautionary money is finally used
for transaction purpose, we can club together and write as: M t = f (Y ) ; where Mt includes both
transaction and precautionary demand for money.

iii. Speculative Demand for Money

So far, we have seen that money is demanded basically for transaction and till now classical theory is
true. However, Keynes introduced another motive of holding money called speculative motive. If
the future rate of interests is known with certainty, there would be no speculation. However, in real
world situation, people gain or loss due to the fluctuation of interest rates. For example, if the current
rate of interest is 6 percent but a person is expecting it to be 8 percent soon then he/she would keep
more money to take advantage of the current lower interest rate before it increases. Moreover, by

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waiting until the interest rate reaches 8 percent, bonds with higher yields can be purchased at lower
price. In other words, since interest rate and bond prices are inversely related, the person is able to
purchase bonds at a lower price. Since speculation depends on the interest rate (they are inversely
related), we can write the relation as M s = f (r ) ; where ‘r’ is the rate of interest.

Combining all the demands for money, we can write a general Keynesian formula for demand for
money as:
Md = Mt + Ms or
= k(Y) + h(r), since Mt = f(Y) and Ms = f(r)
Md = L(Y, r)
This relation simply means that money demand is a function of income (Y) and interest rate (r). Money
demand increases as income increases and decreases as interest rate increases. Thus, money demand
is positively related to income and negatively related to interest rate. We can, therefore, know what
the total demand for money will be for every possible combination of Y and r.

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