Demand for Money

What is Money
• Money is whatever is generally accepted in
exchange. It is accepted in payment because
someone else will accept the same as means of
payment.
• Money is stock of asset held as cash,
current/savings a/c, and closely related assets.
• Liquidity is an important feature of money –
should be able to quickly convert the asset into
cash without loss in value
Components of money stock (RBI Definition)

• M0 =Currency in Circulation (general public,

commercial banks)+ Banks’ Deposits with the RBI
• M0 is also known as high powered money/ reserve
money/ monetary base
• M1 =Currency with the Public + Demand Deposits
with the Banking System (current a/c+ savings a/c)
• M1 is also called narrow money
• M3=M1+ time (fixed) deposits of the banking system
• Generally used measure is M3 money (broad money).
 Currency in circulation (Rs b)

Before demon: Rs 17.97 lakh

crores.
Jan.18, 2019. Rs 20.65 lakh crores.
in Oct. 2022 it was over 30 lakh
crores.
 Functions of money
• Medium of exchange. Money is used for making
payments for goods and services.
– In absence of money goods have to be exchanged for other
goods/services – barter system
– Barter requires double coincidence of wants. Money
removes this requirement – sale and purchase is separated in
time.
• Unit of account: Unit in which prices are quoted and
books of a/c are kept. For example, in Singapore the
unit of account is S$, in India it is Rs.
 Functions of money
• Store of value: Money is used to store wealth.
Money is non-perishable and hence wealth can
be stored in the form of money.
• Standard for deferred payments – amount to be
paid in future (say on a loan) is measured in Rs.

• “Money is a matter of functions four - a

medium, a measure, a standard, a store.”
 Demand for money
• Demand for money is demand for real
money balances (M/P). Implications:
1. Real money demand is unchanged when price
level changes
2. Nominal money demand increases in
proportion to price level.
• Question we want to answer -Why people
hold money as opposed to other assets
which give higher return?
 Motives for holding money
• Transactions motive: People hold money as a
medium of exchange to carry out transactions.
• Precautionary motive: To meet any unforeseen
expenses such as medical expenses or to buy
goods when they are offered at discount.
• Speculative motive: Money is a store of wealth.
Wealth can also be stored in the form of bonds
or other financial and real assets.
 Money demand and money supply
Theories of money demand
• Theories of money demand are built around the trade off
between benefits of holding more money as opposed the
interest costs (opportunity cost) of doing so.
• Baumol-Tobin’s transaction demand for money
• Keynesian theory
• The quantity theory of money
 Transactions demand for money

Baumol- Tobin’s approach: the transaction

demand for money
∙ Money is a kind of inventory. People hold
money to finance transactions.
∙ The cost of holding money is the opportunity
cost – interest forgone. Benefit is reduction in
transaction cost.
 Baumol- Tobin’s approach
Cash
Balance Salary is Rs.12,000 p.m. No savings
12000 One time cash withdrawal
(C) of Rs.12,000 at the
beg. of the month.
Equal spending every day.
6000 Avg. daily cash balance?

1
30
Days of the month
 Baumol- Tobin’s approach
Cash
Balance Salary is Rs.12,000 p.m
12000
One cash withdrawal (C)
of Rs.6K at the beg. of the
month, another 6K after 15
days.
6000 Equal spending every day.
3000 Avg. daily cash balance?

1 15 30
Days of the month
 Baumol- Tobin’s approach

Baumol- Tobin’s approach: the transaction demand

for money
∙ Total cost of holding money = r C/2 + tc.Y/C
Where, Y = income, C = cash obtained per trip, tc
transaction cost, r is the interest rate. ‘C/2’ is the
average cash held per day. ‘Y/C’ gives the number of
transactions in financial instruments
‘r C/2’ is the opportunity cost of holding money.
‘tc.Y/C’ is transactions cost.
• As C increases, Opp. cost (r C/2) increases, transaction
cost( tc.Y/C) decreases
 Baumol- Tobin’s approach
Objective is to min. the total cost of holding money by
choosing an appropriate level of cash withdrawal.
Total cost of holding money = r C/2 + tc.Y/C
∂ (Cost) / ∂ C = r/2 – tc.Y/ C2 = 0

Money demand is +vely related to income and

transaction cost and, -vely related to interest.
 Precautionary motive
• Uncertainty about receipt of payments and
expenditures
• Higher the uncertainty about receipts and
expenditures – Higher the demand for money.
• Not having money when you need – cost of
illiquidity
• Keeping money has opportunity cost - trade off.
 Speculative demand for money
• Looks at store of value function of money
• Money is a safe asset whose nominal value is
certain (capital certain asset).
• Bond is a risky asset whose nominal value is
subject to change (capital uncertain asset).
• People do not hold all their wealth in risky assets –
diversification (Tobin)
 Speculative demand for money
• Increase in risk of other assets increases the
demand for money
• Increase in return on other assets reduces
demand for money.
• Summary- factors influencing demand
– Income
– Interest/return on other assets
– Risk of other assets
 Empirical evidence
• The response of money demand to interest and
income is important – determines the slope of LM
– consequently effectiveness of monetary policy
Empirical evidence suggests that Demand for real
balances is
• negatively related to interest
• positively related to income
 Quantity theory
• Early theory of money demand
• MV=PY
• Income velocity (V) of money is the number of times
the stock of money turned over per year to finance
annual flow of income.
• If output is at full employment level & velocity is
constant (classical theory),
P=VM/Y, Price is proportional to money supply.
 Income velocity of money
• V=P.Y/M = Y/(M/P)
• M/P = L(Y,i) (money market equilibrium)
• V= Y/L(Y,i)
• Higher the interest lower the money demand,
higher the velocity
• Velocity has strong tendency to rise/fall with
rise/fall with market interest rates
 Velocity of money
• In USA M2 velocity has become relatively less
stable over time (since late 1970s).
• This has implications for conduct of monetary
policy
• MV=PY
• In % changes, this can be written as
• m + v = π + y . Where m= money growth, v change
in velocity, π = inflation , y = real GDP growth.
• π = m + v – y. If ‘v’ rises, for a given ‘m’, inflation
will rise.