Lesson-20

DEMAND FOR MONEY FUNCTION IN INDIA.

Objective

After studying this lesson, you will be able to understand:

 Meaning of Demand function of money

 Problems in Estimation of Demand function of money
 Estimated Demand functions of money in India

20.1 Introduction
20.2 Problems in the Estimation
20.3 Indian Data- Demand function

(A) Amrita Shekel (2015) Estimated Demand function of money

(B) Basutkar, Tirupati (2014) Estimated Demand function of money
(C) Gupta (1976) Estimated Demand function of money
(D) Gian Kaur’s (1979) Estimated Demand function of money

20.4 Summary
20.5 Glossary
20.6 Model Questions
20.7 Further Readings

20.1: Introduction

Already studies the different theories of demand for money propounded by different
schools of economic thought. And also identified important determinants of demand for
money. In this lesson, made an attempt to explain how an empirical Demand Function
for Money in India would be estimated. The theoretical discussions outcomes are the
demand for money of a country is an increasing function of its wealth or its income, and
decreasing function of rates of returns from various non–monetary assets. Many
economists made attempts to estimate empirical demand functions for India. Among
them, Dew Laidler’s work of 1960 is an important contribution in the field of demand
function for money. In India also many economists like, A.M. Khusro (1976), A.K.
Lahiri (1977), A. Vasudevan (1977), S.B. Gupta (1977), Kaur (1998), SB Gupta, (1977)
done estimations on demand function of money in India.

20.2 Problems in Estimation of Demand function of money

Before we present their findings, it will be useful to enlist, the important theoretical and
statistical problems that arise in estimating the demand functions. They are as follows:

 What will be the measure of money supply that will be relevant currently, M 1, M2,
M3, or M4?

 Which income measure is to be considered – Is it GNP or NNP at factor cost or at

market prices? Further, should we take into consideration total income or only
monetary income?

 Should the demand function be specified in terms of nominal balances or real

balances?

 Which rate or rates of interest and returns should be taken into account?

 Is the ratio of agricultural income to NNP an important variable and should it be

incorporated in the demand function?
Let us briefly comment on the above issues:

Generally M1 is considered, However, Milton Friedman and others, including the

Chakravarty Committee hold that M3 is a better measure.

K Prasad (1969) and BV Bhattacharya (1975) preferred monetised income to total

income. However, in view of the limitations of the monetised income approach
and also due to other reasons, today the consensus is to consider total income or
wealth. Regarding GNP & NNP at factor cost and market prices, the opinion is
divided. Empirically, all these measures seem to work well. It appears that the net
figures are preferable to the gross figures.

Depending on the theory, one may specify the function in terms of real or nominal
balances. However, from a rational point of view, real balances concept is
appropriate because what people want to hold is certain purchasing power and not
a quantity of money.

In the asset portfolio of the public, money and a variety of assets compete with
each other. They yield different rates of return with different degrees of risk and
convenience. In view of this, one cannot rely on a single rate of return, but at the
same time, for empiricists, incorporation of all these returns in the function is
neither practicable nor meaningful (due to problems of multi-collinearity and loss
of degrees of freedom). Hence, each researcher has been found to be selecting a
few important representative rates of returns arbitrarily.

It is generally accepted that changes in distribution of income among classes,

sectors, households, urban–rural, and agricultural and non–agricultural sectors,
exert an influence on the demand for money. In India, studies have been
undertaken to estimate the impact of changes in sectoral distribution of income
between agricultural and non–agricultural sectors. To incorporate this aspect,
 researchers have included the ratio of agricultural income to total income, along
with a separate variable of income in their demand functions.

20.3 Indian Data – Estimation of Demand function of Money

(A) Basutkar, Tirupati: Money Demand in India (2004-2014)

Basutkar, Tirupati, the main objective of his paper on Money Demand in India is to
derive money demand function for the Indian economy over the period 2004-2014.
Secondly, it underscores the effectiveness of Broad Money (M3) as a significant
contributory factor towards the derivation of money demand function in India. Right
from the classical version of quantity theory of money to more modern Friedman’s
version, there exist plenty of approaches, both at theoretical and empirical levels, to
compute money demand function. Baumol (1952) and Tobin (1956) independently
developed a model based on the tradeoff between the liquidity and its cost.

However, according to Ericsson (1998)2, all these different empirical specifications

imply a long run relationship of the form:
M
= ƒ(Y, OC) (I)
P
�
Were, M denotes nominal money supply. P denotes the price level, Y [= ] denotes
W/PI
the level of economic activity in real terms and OC denotes the opportunity cost of
holding money. Following the Keynesian approach, Y represents the transaction and
precautionary motive for holding money, while the opportunity cost variable represents
the speculative motive. As a proxy for opportunity cost we will be using inter-bank call
rate. Based on the theories and literature we can predict the signs of the variables. The
real income component represented by Y is expected to have a positive sign as higher
real income levels will call for increased levels of real demand for money. OC is
expected to have a negative sign as an increase in interest rate will increase the
opportunity cost of holding real balance.

Empirically, the real demand for money function can be computed of as follows:
 Md (= M) = β1 + β2(Y) – β3(i) + u (II)
P
Following the Quantity Theory of Money approach, money supply should be equal to
money demand. Any excess in money supply will be reflected in the rise of inflation
rate.
Empirical Estimation of Money Demand function: Following the methodology

developed in section two, both narrow and broad money variables for 2004-2014 were
divided by WPI for the same period to arrive at the real money demand function for the
Indian economy. Nominal GDP were weighted with respect to WPI to arrive at real
GDP values for the said period. As for the opportunity cost of holding money, inter-
bank call rate for the stated period, were made use of. Derivation of regression equation
using the processed data revealed the following estimates:
Regression:
M1/WPI v/s Real_GDP, Call rate

Model Summary

R R Square Adjusted R Std. Error of the Durbin-Watson

Square Estimate
a
.972 .945 .930 4.713 1.105
a. Predictors: (Constant), Call rate, GDP b. Dependent Variable: M1/WPI

Model Unstandardized Coefficients T Sig.

B Std. Error
(Constant) 18.896 8.060 2.344 .052

1 GDP .002 .000 10.395 .000

Call rate -2.393 1.153 -2.076 .077

Derivation of demand function using narrow money (M1) data for 2004-2014 does not
yield a convincing equation especially with low Durbin–Watson statistic and a greater
than 5% p-value for call rate coefficient. The situation changes entirely when we use
broad money (M3) data.
Regression:
M3/WPI v/s Real_GDP, Call rate
 Model Summary

Model R R Adjusted R Std. Error of the Durbin

Square Estimate -
Square
Watson
1 .997 .995 .993 8.438 2.023
ANOVA

Model Sum of Df Mean Square F Sig.

Squares
Regression 95029.998 2 47514.999 667.342 .000b

1 Residual 498.402 7 71.200

Total 95528.400 9

Model Unstandardized Coefficients T Sig.

B Std. Error
(Constant) -94.193 14.430 -6.528 .000
1 GDP .011 .000 33.122 .000
Call rate -6.950 2.064 -3.368 .012

Regression equation:

Md = − 04.193 + 0.011(GDP) − 6.950(Call Rate) (III)

Both Durbin-Watson statistic and p-value for all the coefficients are within acceptable
range thereby making the money demand function using M3 more representative.

At the outset, Equation III confirms to the theoretical underpinnings of money demand
function, i. e. demand for money is positively correlated to GDP and negatively
correlated to interest rate. That with regards to Indian economy, real demand for money
increases by 0.011 points for every one point increase in real GDP and decreases by
6.950 for every one point increase in the call rate, the proxy for opportunity cost of
holding money.
In keeping with the objective, it can be stated with a fair degree of confidence that broad
money (M3) is far more significant in deriving money demand function as compared to
narrow money (M1) in India, over the period 2004-2014. From an empirical point of
view, if the policy objective is to influence money demand function in India, targeting
M3 may yield better results.
(B) Amrita Sarkhel etal: Estimation of the Money Demand function for India and
China (1995-2015)

Estimation of the Money Demand functions for India and China Amrita Sarkhel etal. the
main objective is to study the variation in money demand function of two developing
countries, India and China. To study the practical implementation of the money demand
function and how strongly demand for money is correlated to changes in interest rates
and national income.

We have extracted data from different sources for GDP(USD Billions), M1(USD
Billions), Interest rate( Call money rate%) and CPI and then we have done a regression
analysis with dependent variables being Real money demand and independent variable
being GDP and interest rate.

Comparing the behavior of money demand function with reference to GDP and Interest
Rate. We are using the below function for our calculation:

L(Y, r) = 𝑀 𝑃 𝑑 = L0 + L1 Y − L2 𝑟
M= M1= Money Supply P= Price level Y= Real GDP at market price r= Call Money
Rate L0=Autonomous demand L1= Income sensitivity of money demand L2= Interest
sensitivity of money demand.

We are estimating the money demand of India and China for the last 21 years (1995-
2015)
Sample Data for India: The money demand is estimated linearly using regression and
checked at 5% level of significance. Real GDP is taken at the end of the year with base
year as 2005. Money supply is taken on monthly average. Money supply is divided by
CPI to get real money balance. Interest rate is money call rate and it is average of
months. CPI is taken as monthly average SOURCES: Real GDP- International Monetary
Fund, USA CPI & M1- Trading Economics Interest Rate – OECD Database

L = 2.043+ 0.001Y – 0.130r (at equilibrium)

From the above statistical analysis, we can derive the money demand function of India as
above:

Sample Data for China: The money demand is estimated linearly using regression and
checked at 5% level of significance. Real GDP is taken at the end of the year with base
year as 2010. Money supply is taken on monthly average. Money supply is divided by
CPI to get real money balance. Interest rate is money call rate and it is average of
months. CPI is taken as monthly average

M/P = 5.2440 + 0.005Y – 0.553r (at equilibrium)

From the above statistical analysis, we can derive the money demand function of China
as above:

Interest sensitivity of demand for real money (L2) is lower for India (0.12) than china
(0.55) The income sensitivity of demand for real money ( L1) is lower for India (0.001)
than China (0.004) .The Autonomous Demand (L0) is lower for India (2.04) than
China(5.24)

At the outset, both the money demand functions of China and India are conforming with
the theoretical demand function i.e. Money demands is directly proportional to real GDP.
Money demand is inversely proportional to interest rate.
For both the countries, real money demand rises less than proportionately than the rise in
real income
Since the slope of the LM curve for India is steeper any changes in fiscal policy will be
less effective as compared to China.

Practical implementation of regression analysis. Money demand function varies from

country to country based on various macro- economic variables of the country
(C) Gupta’s Estimated Demand function of money (1950-76)

Demand function of money in India estimated by SB Gupta for the period 1950-76 is
presented in the fallowing. His regression equation is:

Log (M/P) d = -1.680 + 1019 Log Y - 0.119 Log P - 0.026 r12

(-1.390) (7.629) (-1.697) (-1.077)
R2 = 0.939
D = 1.455

The above function is linear one as it is in the log form. Gupta holds that the demand
function in logarithmic form gives a better result compared to the simple linear form
(except for interest rate variable). In the equation, (M/P) d denotes demand for real
balances, Y the real national income, P the market price level, r the twelve month time–
deposit rate of commercial banks, R2 the adjusted coefficient of determination, D the
Durbin-Watson statistic (as a measure of the first order serial correlation among the
residuals) and the figures in the brackets are t values of the coefficients.

The equation indicates a very good fit as the independent variables are able to explain
94% of the variations in the log (M/P); further, there is no serial correlation among the
residuals at 1% level of significance.

Main Findings:

 M1 in India is highly stable ( function of a few specifiable variables )

 Real income is the major determinant of demand for money in India.

 Income elasticity for money in India is nearly unity.

  Rate of interest is not a significant factor affecting the demand for money in India,
whereas, in the USA, it is found that Md is a decreasing function, of interest rate.

 A rise in the price level lowers the demand for money. Many countries, including
India which experience rapid inflation, are characterised by negative relation
between demand for money and expected rate of inflation, and therefore, It means
that higher the expected inflation rate, the lower will be the demand for money.

 In India, changes in the distribution of income between agricultural and non –

agricultural sectors effects the demand for money. If the ratio between
agricultural real incomes to NNP at market prices rises, demand for money
declines, and vice versa. This is partly due to imperfect monetarisation of
agricultural sector characterised by the prevalence of barter system.

(D) Gian Kaur’s Estimated Demand function of money (1950-85)

Another demand functions for money estimated by Gian Kaur on his PhD work, for
India, covering the period 1950-85. However, as the results were not found to be
statistically significant and consistent, he restricted the study period to 1950-80. In order
to test whether the demand for money remained stable, he divided the time span into to
sub-periods (1950-51 to 1962-63 and 1963-64 to 1979-80). The model used by him to
estimate the demand for money is also in log form and is presented below:

Log M = log A + B1 log Y + B2 log ri + B3 log P + Ut

Where ‘M’ is the desired amount of money holding. ‘Y’ is the income, ri, is the rates of
interest, ‘P’ is the price level, Ut is the disturbance term. B1, B2, B3 are the elasticities of
demand for money with respect to income, rate of interest and price level in that order.

Kaur estimated a number of demand functions both for M1 and M3 in real as well as in
nominal terms. He estimated an aggregate (i.e., money components taken as a whole)
function as also component–wise (currency, Demand Deposits & Time Deposits)
functions. The Reason for estimating component–wise functions are that over time
structural changes in the components of money supply are likely to take place. For e.g. in
India, the share of currency in the total money supply decreased from about 70% in the
1950s to 60% in the 1970, and further to 50% in the 1990s to 57% (in M 1). There
occurred significant changes in the relative shares of demand and time deposits in M 3 to
capture the impact of these changes, Kaur estimated component-wise functions.

Main Findings:

Whether money is defined inclusive or exclusive of time deposits, is another question that
one should dwell on. More than 90% of the changes in money demanded have been
explained by three factors, interest rate, and income and price level. However, the role of
interest rate and income elasticities differ substantially depending on the definition of
money balances used. Demand for money (both M1 and M2 i.e. narrow and broad
definitions respectively) was found to be highly income elastic. As noted in the findings
of Gupta, income elasticity was greater than unity, indicating that cash balances were
treated as a luxury good in India. The estimates of income elasticities are 1.048 and
1.583 for M1 and M3 respectively. The implication of higher income elasticity with
respect M3 is that as real incomes rise, the public prefer to hold their money more in the
shape of time deposits, rather than demand deposits and currency. With regard to the
impact of interest rate on the demand for money, a negative relation was noticed. The
negative relation holds well whether money is defined inclusive or exclusive of time
deposits (i.e. M1 or M2) and whether the interest rate pertains to the short-term or long-
term. However, for the 1 year commercial banks deposit rate and for the government
securities, the demand for real M1 and M3 balances was interest elastic.

With regard to the relation between the demand for real and nominal balance and price
level negative relation was found. It means that when price level rises, demand for real
balances decreases.

Kaur also tested whether the demand function for money in India was stable or unstable.
To test it, the method of dummy variables and BDE (Brown, Durbin and Evans) tests
were used. They revealed that more inclusive is the definition of money (i.e. M 3 rather
than M1), greater was the instability. Time deposits demand was found to be more
unstable than demand deposits demand. It means that the demand for real M 3 is more
unstable than the same for real M1. The only exception he found was with regard to the
demand for real currency balance (Note: the difference between nominal and real
balances is that nominal balances adjusted for prices will give real balances (M/P = Real
Balances). In other words, in Kaur’s period of study, the demand for real balance in
terms of M1 and M2 (i.e. M1 / P and M2 /P) was unstable and for real currency demand, it
was stable.

Based on the empirical studies, we may conclude that demand for money in India
depends, among other factors, mainly on three factors viz. Income, interest rate and price
levels. But we must also keep in mind all the statistical and conceptual limitation of such
empirical studies. Further, the study also brings out the fact that expected change in
prices and changes in the composition of rural urban income shares effect the demand for
money in India. It appears that the demand for money function in India is somewhat
unstable. However, the issue of stability or instability remains unsettled. For policy
purpose, there is need to study disaggregate broad sector-wise demand functions such as
the demand functions for the business, rural & urban households, government, etc.

20.4 Summary

In this lesson, an attempt was made to explain aspects regarding the Empirical Demand
Function for Money in India. If any economy wants to ensure efficiency of its monetary
policy, a prerequisite is the proposition of a relevant demand function for money.

There are many theoretical and statistical problems that arise in estimating the demand
functions and in the case of underdeveloped countries like India the task becomes even
more complex.
Based on the results of the empirical studies, we may conclude that demand for money in
India depends, among other factors, mainly on three factors viz. Income, interest rate and
price levels. But we must also keep in mind all the statistical and conceptual limitation of
such empirical studies. Further, the studies also brings out the fact that expected change
in prices and changes in the composition of rural urban income shares effect the demand
for money in India. It appears that the demand for money function in India is somewhat
unstable. However, the issue of stability or instability remains unsettled. For policy
purpose, there is need to study disaggregate broad sector-wise demand functions such as
the demand functions for the business, rural & urban households, government, etc.

20.5 Glossary

Empirical Demand Function

Monetized Income Approach

Elasticity of Money

Demand Deposits

Time Deposits

Narrow Money

Broad Money

20.6 Model Questions

Short answer Questions

1 What is Demand function of money?

2. Enlist the variables used in estimation

Essay answer Questions

1 What are the problems encountered in India in estimating empirical demand

Functions for money?

2 What are the determinants of demand for money in India?

3. Discuss the merits and demerits of both Tirupati and Gupta Empirical Estimation
of Demand function of money

20.7 Further Readings

1. Basutkar, Money Demand in India, Online at https://mpra.ub.uni-

muenchen.de/70495/ MPRA Paper r No. 70495, posted 05 Apr 2016 04:29 UTC

2. Amrita Sarkhel etal. “Estimation of Demand for money in India and China”Goa
Institute of Management. Goa

3. SB. Gupta : Monetary Planning for India, OUP, OUP, Delhi,

4. G Kaur : Monetarism Vs Keynesianism,

Himalaya Publishing House, Bombay, 1988, Ch. IV.

5. Indian Economic Journal Special Numbers on Monetary economics’ for various years.