32 Money Supply and Demand

Dr. Meenu Saihjpal

Learning Outcome

After completing this module the students will be able to understand:

The concept of money
The concept of money supply
The concept of demand for money
The different theories of demand for money

2 The Concept of Money

Can you think of one important thing or a commodity which if withdrawn from the markets can make the whole world still?

Certainly, it is money. Money is the lifeline of any economy as the movement of the economy on the growth chart relies very heavily on money. Such is the importance of money that any sharp changes in this variable can lead to a crash of the economy. In most of the theoretical models of income, output and employment determination, the supply of money is assumed to be exogenously determined. However, this chapter elaborates the determination of the supply of money as well as the demand for money. But before that we need to define what exactly we mean by money.

Money is something that is used for exchange without converting it into any other thing. Though the invention of money is much older but the efforts to define money were made only after the Second World War. After the Second World War, due to financial innovations, many new financial instruments were added into the markets. This led the economists and financial experts to define money and also led to the emergence of a continuous controversy on the definition of money and money supply.

According to R. T. Froyen, “Money is whatever performs monetary functions”.

According to Edward Shapiro, “Money is anything that is generally acceptable in payment for goods, services and other valuable assets and for the discharge of debts”.

The above given definitions reveal that the economists have largely defined money in terms of the functions performed by the same. Since the functions keep on changing with the times, therefore, the definition has also undergone a change. However, the basic functions have remained the same which are explained below:

Functions of money:

1 Means of Exchange

2 Money as a measure of Value

3 Store of Value

Means of Exchange

Money is used as a medium of exchange. This implies that money is used to buy and sell commodities and services implying that money facilitates the exchange of commodities. This function of money is so significant that if money is withdrawn from the modern day world then the economies may not survive. Without money, the economy moves to a barter economy where the successful completion of exchange of commodities requires the ‘double coincidence of wants’. Double coincidence of wants requires that if, say, A is demanding ‘x’ which is offered for sale by B then A must have ‘y’ which is being demanded by

If this agreement is not meant then no trade is possible. And in today’s world where uncountable trade transactions take place and where it is impossible to have quick double coincidence of wants for every transaction, so, if money does not perform this function then the economies may come to a standstill.Therefore, in today’s world money is performing the most critical function- medium of exchange’.

Money as a Measure of Value

Money is used as a tool to measure the value of goods and services. The value of all the goods and services are measured in terms of money. If someone asks what is the total value of chocolates produced in India and also to compare it with the total value of the same product produced in U.S., then we need a common measure or unit of value through which we are able to represent the value of chocolates produced in India and such a measure should also be comparable at the international level. Further, if we are asked to compute the value of all the commodities produced in India and compare it with the value of all the commodities produced in U.S. then we need such a measure which is able to reflect the value of not one but all the commodities at the national and international levels. This function is performed by money. In different countries different units of value are used like Dollars, Pounds, Rupee etc.

The currency of an economy can be converted into the currency of the other economy and thus, facilitates comparison and trade transactions.

Store of Value

Store of value function of money implies that money allows us to store value which could be used in future. This function of the money makes it easier for us to store the value of the different types of commodities be it perishable or non-perishable for a long period of time. However, if the levels of prices rise sharply then the value of money may fall.

Thus, money is a set of liquid financial assets, the variation in the stock of which could impact on the aggregate economic activity (https://rbi.org.in/scripts/PublicationsView.aspx?id=9455#top, accessed on October 13, 2016).

3 The Concept of Money Supply

Supply of money is a stock concept; however, it leads to a flow. That’s why money supply is also called as money stock or stock of money. There are different views to define supply of money. As per the traditional school money supply covers currency in circulation and demand deposits. Monetarist school believes that money supply includes currency in circulation, demand deposits and time deposits. Liquidity approach has given a much broader definition of money; it defines money supply as currency in circulation, demand deposits, time deposits with the banks, savings bank deposits, shares and bonds. Thus, this group has given a wider definition. Lastly, the central bank approach has defined money supply as currency in circulation, demand deposits, deposits with the Non-Banking Financial Intermediaries and credit of the unorganised sector.

Since, money is a much wider concept as it performs many functions therefore; every economy releases different measures of money supply. The money released by the central bank is called as the high power money. In India, RBI being the Central bank, releases different measures of money supply. These measures have been revised from time to time. The latest measures are given in table 3.1.

Table 3.1: MEASURES OF MONEY SUPPLY IN INDIA

4 The Concept of Demand for Money

Demand for money implies money which is over and above the requirements for consumption and other daily requirements. It is the average amount of money held by individuals for transaction and precautionary motives over a period of time. Demand for money is different at different points of time. This variable is determined by frequency of income received, income of the consumer, uniform spending pattern and the rate of interest. When the frequency of the income received increases the demand for money decreases (vice-versa) implying a negative relationship between the two. When the income of the consumer increases the demand for money also increases (vice-versa) signifying a positive relationship. Further, as the spending pattern of the consumer becomes uniform, the demand for money also increases and vice-versa. All the theories on the demand for money agree on the point that the income elasticity of demand for money is positive which has also been proved empirically, however, the problem remains in its relationship with rate of interest. Given below are the different theories which explain the determinants of the demand for money:

Classical Quantity Theory of Money:

Quantity theory of Money was given by the Classical economists as a collection of ideas and not as a theory. Therefore, there are several versions of the theory, these are given below:

We shall discuss the version given by Irving Fisher. To understand the theory, we first need to understand the framework of assumptions under which the theory operates. These are given below:

Assumptions:

1 There is always full employment in the economy. Full employment implies that all those who want to work, get work and if there is any kind of unemployment then it is voluntary.

2 The wages, interest and prices are flexible. Flexibility implies that these variables can be increased and decreased easily i.e. there are no legal restrictions on increasing/decreasing wages, prices and interest.

3 Money performs only the function of medium of exchange. So, the store of value function of money was not accepted by the classical economists.

4 No interference by the government in the markets i.e. the market are free to operate and decide the pricing and output decisions without any hindrance from the government.

Fisher’s version of the quantity theory is expressed as:

MV= PT …………………………..(Equation 1)

Where,

M = money in circulation

V= velocity of money i.e. the number of hands a unit of money is exchanged

P = is the weighted average of all the individual prices

T = sum of the trade transactions per unit of time.

PT shows the demand for money i.e. money is demanded for carrying out trade transactions or for buying goods and services. At any given point of time, the number of trade transactions for any economy remains constant. Likewise, the velocity of circulation also remains constant at any given point of time; therefore, equation 1 can be rewritten as,

MV=PT

Or, M=P

Fisher said that there is a direct and proportional relationship between money supply and price level. So money supply determines the price level in the economy. His version of the theory is criticized on the grounds that it is a simple truth and he could not explain the reasons for this relationship and also for not covering the store of value function of money but nevertheless positive relationship between money supply and prices do exist even today.

Keynesian Demand for Money Theory

J.M.Keynes

Keynes added the store of value function of money and thus, propounded the demand for money theory.As per Keynes money is demanded for three reasons; these are given below:

Let us discuss these motives in detail:

i) Transaction motive:

The transaction demand for money comes from households and businessmen in order to carry out day to day transactions. When the consumers receive their income, they do not immediately spend the whole of their income. They keep aside certain money for meeting their day to day requirements for example: buying vegetables, paying off telephone or electricity bills etc. This demand for money is called as transaction demand. Transaction demand for money is dependent on:

Dms = f (Y, F, Sp)

Where,

Dms = demand for money for transaction purpose

f = function

Y = income of the consumer,

F = Frequency of income received

Sp = Spending pattern of the consumer

Frequency of income received implies how frequently the consumer receives his income i.e. yearly, monthly, weekly or daily. As per Keynes, if the frequency of income received increased, the demand for money for transaction purpose decreased. Thus, there was an inverse relationship between the two. If the consumer had a uniform spending pattern then the demand for money for transaction purpose increases indicating a positive relationship between the two. These two factors depend on the institutional factors and thus, do not change in the short run. Therefore, the demand for money for transaction purpose is determined by income in the short run, other factors (frequency of income received and spending pattern) remaining constant. This is given below:

Dms = f(Y)F,Sp

Keynes said that there existed positive relationship between demand for money for transaction purpose and income. As the income of the consumer increases the consumer carries out more transactions and thus, the demand for money for transaction purpose increases. However, the rate of interest elasticity of the demand for money for transaction purpose is zero meaning that any change in the market rate of interest does not bring any change in the demand for money for transaction motive.

ii) Precautionary motive

Keynes said that apart from the first motive, the consumers kept aside a certain portion of their income in order to meet certain unforeseen or unexpected exigencies say medical emergencies etc. The precautionary demand for money is dependent upon the income of the consumer. This is explained below:

Dmp = f (Y)

Where,

Dmp= demand for money for precautionary purpose.

Like the transaction demand for money, there is a positive relationship between the demand for money for precautionary motive and income of the consumer. The rate of interest elasticity of the demand for money for precautionary motive is zero meaning that any change in the rate of interest does not bring any change in this demand for money.

Therefore, M1 = Dms + Dmp

Since, Dms = f (Y)

and Dmp = f (Y)

Therefore, M1 = f (Y)

And the rate of interest elasticity of M1 is also zero. This is explained through figure 4.1. In the diagram on OX axis, we are measuring demand for money for transaction and precautionary purpose and on OY axis; we are measuring the rate of interest. M1 curve is the demand for money for transaction and precautionary motives. The diagram shows that when the rate of interest is Or1 the M1 demand for money is at OM1’. When the rate of interest increases to Or2, the M1 demand for money remains fixed at OM1’. Thus, any change in the rate of interest brings no change in the M1 demand for money.

iii) Speculative Demand for Money

Keynes differed from the classical economists on the issue of the inclusion of the speculative demand for money. Keynes believed that money was not only a medium of exchange but also a store of value. Therefore, he also included speculative demand for money as being one of the motives for demanding money. Speculative demand for money is the demand to keep money in cash form for speculative activities. To understand the Keynesian concept of speculative demand for money, we first need to understand the basic assumptions behind the model.

Assumptions:

1) Role of expectations of speculators in speculative holdings:

This type of demand for money is highly guided by speculations. Different speculators have different speculations about the future value of the assets. So the assumption is that the market will go as per the average expectations.

2) Two asset model:

Keynes assumed that there are two assets available in the market. This implies that the consumer can either have cash or bond. This also indicates that the consumer cannot have a diversified portfolio meaning that the consumer cannot have both cash and bond.

3) Quick switch from cash to bonds:

Investors can very easily switch from cash to bonds i.e. the investors can buy and sell bonds very quickly.

4) Cannot hold a diversified portfolio:

The investors can have either cash or bond but cannot have a mix of both cash and bond.

5) Timing of buying and selling bonds:

Speculators buy the bonds when the bond prices are low and sell the bonds when the bond prices are high.

6) Type of bonds:

Only government bonds are available in the market.

When the current bond prices are high, the current rate of interest is low. The expectation in the market is that the bond prices will fall and the rate of interest will increase. So the investors anticipate capital loss, so they sell bonds today and keep cash to buy bonds in future. So the current speculative demand for money (to keep cash today to buy bonds in future) increases. When the current bond prices are low, the current rate of interest is high. The expectation is that the bond prices will increase and the rate of interest will fall in future. Since the investors anticipate capital gains in future so they buy bonds today and so, their demand for money for speculative purpose (to keep cash today) will decrease today. Therefore, the Keynesian theory predicts a negative relationship between the speculative demand for money and the rate of interest. This is explained in figure 4.2.

The figure measures speculative demand for money on OX axis and rate of interest on OY axis. M2 curve is the speculative demand for money curve, which shows negative relationship between rate of interest and the speculative demand for money. When the rate of interest is Or2, demand for money for speculative purpose is low at OM2’. When the rate of interest decreases to Or1, the demand for money for speculative purpose increases to OM2’’. At a very low rate of interest, the curve becomes parallel to OX axis. This shows that the rate of interest will not fall below Or0 as this is the minimum interest expected i.e. Or0 is the cost of giving funds which must be received by the owner. This is called as liquidity trap.

Therefore, M2 = f (r)

Where, M2 = speculative demand for money

r = rate of interest

Therefore, total demand for money (Dm) is a function of income and rate of interest

Dm = f(Y, r)

If income (Y) remains constant then

Dm = f (r) Y

So, to find the total demand for money graphically, we add the fixed level of M1 demand for money (of figure 4.1) to the speculative demand for money curve (of figure 4.2). So that the resultant total demand for money curve will be flatter (Dm) as given in figure 4.3.

The total demand for money at or2 is oDm2. This total demand for money is obtained by adding the transaction demand for money to the speculative demand for money i.e. adding oM1’ in figure 4.1 to oM2’ in figure 4.2. Total demand for money has an inverse relationship with rate of interest just like the speculative demand for money.

Thus, to conclude we can say that the Keynesian theory is a much better theory than the classical theory as it explains the three motives for demanding money and it also highlights the store of value function of money. However, this theory restricts the investors to two asset model and he cannot also have a mix of both cash and bonds whereas in reality, the investors hold a diversified portfolio.

Post Keynesian Theories of Demand for Money

Because of the problems of the Keynesian theory, some of the economists tried to improve his theory, whereas, some others tried to put forward their own theories. One such theory is Baumol –Tobin’s Approach to Transaction Demand for Money. This theory is also called as Inventory Theoretic Approach. This theory makes improvement over the Keynesian demand for money. These two have clubbed all the three motives given for demanding money under ‘real cash balances’ and have also added another important determinant of demand for money which is the cost of transforming real cash balance into interest bearing bonds and vice-versa. Milton Friedman tried to improve the quantity theory of money. His theory also paved the way for conflict with the Keynesians and post-keynesian economists. He regarded money like any other capital good. Thus, all those determinants that explain the demand for capital good can also be applied to the demand for money. He has given an econometric explanation behind his theory.

5 Conclusion

In this chapter we have discussed the concept of money, concept of money supply and money demand. Though money is a very important variable in any economy yet defining money or what constitutes money or what causes the supply or demand for money is a difficult task. Different economists have given different theories on money supply and money demand which stress on the different functions of money. The existence of these theories in itself represents the wide functions performed by money and it also highlights the significance of this variable in any economy. Money is one such variable without which modern day economies may come to a standstill.

References:-

Dwivedi, D.N., Macroeconomics Theory and Policy, Tata McGraw Hill Education Private Limited, New Delhi, 2011.
Froyen,R. T., Macroeconomics- Theories and Policies, Pearson India, 2006.
Shapiro, E., Macroeconomic Analysis, Galgotia Publications, 2006.