Money Demand, Supply, and Theory - Explained

Demand for and supply of money Unit 5 - Chapter 24 Money Demand Reference: Case and Fair 4/4/2025 Prepared by Tanjot Singh, Department of Economics, Gargi College

What is money? Money is anything that is generally acceptable as a means of payment in the settlement of all transactions General acceptability unique feature of money Money is what money does Purchasing power 4/4/2025 Prepared by Tanjot Singh, Department of Economics, Gargi College

Functions of money Medium of exchange Measure of value /unit of account Standard of deferred payments Store of value 4/4/2025 Prepared by Tanjot Singh, Department of Economics, Gargi College

Kinds of money Fiat money (legal tender) Coins Currency notes Fiduciary (credit) money Deposits Bank deposits Demand and time deposits Post office deposits 4/4/2025 Prepared by Tanjot Singh, Department of Economics, Gargi College

Measures of money supply M1 = C + DD + OD M2 = M1 + savings deposits with post office savings banks M3 (AMR) = M1+ net time deposits of banks M4 = M3 + total deposits with post office savings organization 4/4/2025 Prepared by Tanjot Singh, Department of Economics, Gargi College

Quantity theory of money Variations in quantity of money impacts prices, money and real income, rate of interest Two approaches Quantity theory of money Keynesian theory Quantity theory Irving Fisher s transactions version Cambridge cash balances approach 4/4/2025 Prepared by Tanjot Singh, Department of Economics, Gargi College

Fishers QTM M*V = P*T M stock of money depends on monetary system V velocity of circulation average number of times a unit of money changes hands in a given period P average price of market transactions T physical volume of transactions Assuming V and T constant, direct relation between M and P Ms = Md Economics, Gargi College 4/4/2025 Prepared by Tanjot Singh, Department of

Cash balances approach Marshall and Pigou Md = K P y K behavioural constant ratio of money income people like to hold in the form of money measured in time units 0<K<1 P average price level y real income In equilibrium, Md = Ms K is reciprocal of V (turnover per time period) Economics, Gargi College 4/4/2025 Prepared by Tanjot Singh, Department of

Money market Money as an asset Money market Demand consumers general public Supply producers of money government, monetary authority and banking system Equilibrium in money market 4/4/2025 Prepared by Tanjot Singh, Department of Economics, Gargi College

Demand for money Sum total of all the money demanded by general public including households and firms Demand for money is demand for real balances i.e. purchasing power of money Why do people demand money? or What are the determinants of people s demand for money? Neoclassical theory cash balances approach Keynesian theory Economics, Gargi College 4/4/2025 Prepared by Tanjot Singh, Department of

Keynesian theory of Md Why do people demand money when there are other non-money financial assets that earn income for holders? Money demand due to two characteristics general acceptability as means of payment and perfect liquidity Motives for demanding money Transactions motive Precautionary motive Speculative motive 4/4/2025 Prepared by Tanjot Singh, Department of Economics, Gargi College

Contd. Md = f (Y, r) Y income r rate of interest Transactions & precautionary demand depends on Y similar to Cambridge approach Speculative demand most important contribution of Keynesian analysis to monetary theory depends on r Tobin s argument demand for money depends on expected yields and riskiness of the yields of other assets Economics, Gargi College 4/4/2025 Prepared by Tanjot Singh, Department of

Contd. Downward sloping aggregate demand for money w.r.t. rate of interest Liquidity trap a situation in which at a certain low rate of interest, demand for money becomes perfectly elastic People not willing to hold money in bonds and convert to cash Increase in money supply gets trapped as people hoard money 4/4/2025 Prepared by Tanjot Singh, Department of Economics, Gargi College

Contd. Demand for and supply of money affect economic activity through r and changes in real investment depending on r Determination of rate of interest intersection of demand for and supply of money Ms determined exogenously by the monetary authority 4/4/2025 Prepared by Tanjot Singh, Department of Economics, Gargi College

Supply of money Ordinary money (M) and high-powered money (H) M = C + D H = C + R Relation between M and H H is the monetary base that consists of currency and banks reserve deposits with central bank 4/4/2025 Prepared by Tanjot Singh, Department of Economics, Gargi College

Contd. H theory of money supply Hs is policy determined i.e. given exogenously to public and banks Hd = Cd + Rd Cd = c . D, where c is the currency deposit ratio, a behavioural ratio that expresses people s preferences between currency and deposits Rd required reserves and excess reserves Rd = r. D, where r is the reserve deposit ratio, ratio of reserves to total deposits of banks 4/4/2025 Prepared by Tanjot Singh, Department of Economics, Gargi College

Money multiplier Hd = Cd + Rd Hd = c. D + r. D = (c + r) D M = C + D = (1 + c) D In equilibrium, Hs = Hd Money multiplier = mm = M / H mm = (1 + c ) / (c + r) M = {(1 + c ) / (c + r)}. H mm depends on currency deposit ratio, c and reserve deposit ratio, r mm > 1 mm is larger the smaller is r mm is larger the smaller is c 4/4/2025 Prepared by Tanjot Singh, Department of Economics, Gargi College