18-10-2023

Errol D’Souza

The Demand for Money

In Macroeconomics the financial wealth of households
Errol D’Souza and firms is made up of the stock of money
and government bonds they hold.

A bond is a legal promise to repay a debt. A bond-

holder receives regular interest or coupon
payments until the bond’s maturation date.

A coupon bond pays the owner of the bond a fixed

interest payment also known as the coupon
Indian Institute of
Advanced Study payment every year until the maturity date.
Rashtrapati Niwas
Shimla

Turin School
of Development

Email: errol@iimahd.ernet.in

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Errol D’Souza

A coupon bond that pays a coupon of INR C per period, Present discounted value of coupon payments
has a face value of INR F at maturity, and which received on a perpetuity is -
takes n years to mature, will have a present value
of all the cash flow payments for such a bond C C C
+ + + ..............
(1 + i ) (1 + i ) 2 (1 + i ) 3
given by –
C C C C F The sum we ought to be willing to pay for the bond
+ + + ....... + +
(1 + i ) (1 + i )2 (1 + i )3 (1 + i )n (1 + i )n today should equal this discounted current
value of coupon returns -
PB : price of bond
A perpetuity is a non-maturing coupon bond that has
C C C
no final date of maturity and as a result they PB = + + + ..............
1 + i (1 + i ) 2 (1 + i ) 3
make no repayment of principal such as the INR
F made on a standard coupon bond

A perpetuity pays INR C as coupon per year forever.

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C C
Present discounted value of coupon payments (1 + i ) PB = C + + + ........
1 + i (1 + i ) 2
received on a perpetuity is -
C C C
C C C PB = + + + ..............
+ + + .............. 1 + i (1 + i ) 2 (1 + i ) 3
(1 + i ) (1 + i ) 2 (1 + i ) 3

iPB = C
The sum we ought to be willing to pay for the bond
today should equal this discounted current
C
value of coupon returns - or, PB =
i
PB : price of bond
C C C If the nominal interest rates rise, bond prices will
PB = + + + ..............
1 + i (1 + i ) 2 (1 + i ) 3 fall and people holding bonds will incur a
nominal capital loss
Multiplying throughout by (1 + i )
C C
(1 + i ) PB = C + + + ........
1 + i (1 + i ) 2

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Net wealth of the private sector is its net claims on Interest rate referred to here is the nominal interest rate
agents outside that sector – the stock of money
and the stock of government bonds Nominal price of money is always equal to one unit of
money for example, $1, INR 1, 1 yen
Bt C
Wt = M t + Nominal price of a bond can change over time as PB =
it
i
Wt : Nominal wealth
A bond earns a capital gain if the nominal price
of a bond increases over an interval of time, or a
Mt : Stock of money held by private sector at time t
capital loss if the nominal price of a bond falls
Bt : Stock of bonds held at time t In contrast, a note of Re.1 has the same nominal value
over an interval of time
Assume the coupon on a bond is INR 1.
Because bonds earn a nominal interest return, it is the
Then, price of a bond is PB = 1
i nominal interest rate that influences the desired
B
Nominal value of stock of bonds PB Bt = t holding of money and not the real rate
it

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Nominal and real interest rates Nominal and real interest rates

Suppose a farmer lends 5 sacks of rice Suppose a farmer lends 5 sacks of rice

After a year the borrower is to repay 6 sacks of rice After a year the borrower is to repay 6 sacks of rice
6−5 6−5
Then, the real interest rate is given by 100 = 20% Then, the real interest rate is given by 100 = 20%
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If the cost of a sack of rice is INR 300, then, the

farmer could equivalently have lent INR 1500

Farmer could stipulate that the borrower repays

INR 1800 a year later
1800 − 1500
Then, the interest rate is given by 100 = 20%
1500

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As long as the price of rice stays the same in each year, It is only on charging a 40 per cent nominal rate of
a loan denominated in units of the commodity is interest that the farmer receives the INR 2100
equivalent to a loan denominated in rupees that represents the purchasing power of six
sacks of rice
Suppose, however, the price of a sack of rice goes up
to INR 350 In commodity (real) terms, the real rate of interest,
however, is still
To get back six sacks of rice the next year, the farmer 6−5
r= 100 = 20%
would have to receive INR (350 x 6) = INR 2100 5

Nominal interest rate he would have to charge is -

2100 − 1500 600

i= 100 = 100 = 40%
1500 1500

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it : Nominal interest rate at time t it : Nominal interest rate at time t

Pt : Price level at time t Pt : Price level at time t

Nominal amount received by lender next period is Nominal amount received by lender next period is
then given by Pt (1 + it ) then given by Pt (1 + it )

Let the price level of commodities at time t + 1 be

given by Pt +1

Then with the repayment amount received from the

borrower the number of units of commodities
that can be purchased in t + 1 is -
Pt (1 + it )
Pt +1

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The real interest rate then is - The real interest rate then is -

Pt (1 + it ) Pt (1 + it )
1 + rt = 1 + rt =
Pt +1 Pt +1

1 + it
=
Pt +1
Pt

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The real interest rate then is - The real interest rate then is -

Pt (1 + it ) Pt (1 + it )
1 + rt = 1 + rt =
Pt +1 Pt +1

1 + it 1 + it
= =
Pt +1 Pt +1
Pt Pt
1 + it 1 + it
= =
1+ t 1+ t

where the inflation rate is given by  t = (Pt +1 Pt ) − 1 where the inflation rate is given by  t = (Pt +1 Pt ) − 1

1 + it i −t
Hence, rt = −1 = t
1+ t 1+ t

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i −t
rt = t it = rt +  t
1+ t

Writing this expression in terms of it The Fisher effect describes the full adjustment of
the nominal interest rate to a change in the
it = rt +  t + rt  t inflation rate

We ignore the term rt  t which is negligibly small, being
the product of two decimal numbers.
it = rt +  t
The nominal interest rate then is the sum of the
real rate of interest plus the rate of inflation
Lenders can be expected to raise their nominal interest
rate when inflation rises so that their real rate of
return will not be affected
Borrowers will accept this raising of the nominal
interest rate on the understanding that a higher
nominal rate is a compensation to the lender for
the fact that the loan will be repaid in currency
of reduced real value

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In the second period, the individual earns an interest

on the holdings of bonds given by i1 (B1 i1 ) = B1
We restrict ourselves to a two period set up. In the
Second period budget constraint in nominal terms
first period,
is then given by -
Nominal
Nominal
B B 
Consumption Savings
P2Y2 + B1 = P2 C2 + (M 2 − M 1 ) +  2 − 1 
 i2 i1 
B 
P1Y1 = P1C1 + (M 1 − 0 ) +  1 − 0 
 i1 

as individuals in a two period set up begin the first

period with no initial endowment of assets,
M 0 = 0, B0 i0 = 0
Then, period 1 budget constraint is
B1
P1Y1 = P1C1 + M 1 +
i1

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In the second period, the individual earns an interest Second period budget constraint -
on the holdings of bonds given by i1 (B1 i1 ) = B1
B1
P2Y2 + B1 = P2 C 2 − M 1 −
Second period budget constraint in nominal terms i1
is then given by -
To obtain the lifetime budget constraint we add together
B B  the first period budget constraint to the present
P2Y2 + B1 = P2 C2 + (M 2 − M 1 ) +  2 − 1 
 i2 i1  discounted value of the second period budget
constraint
The second period is a terminal period and the
individual will not plan to hold any assets
beyond this point of time.

 B 
P2Y2 + B1 = P2 C2 + (0 − M 1 ) +  0 − 1 
 i1 

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B
Second period budget constraint - P1Y1 = P1C1 + M 1 + 1 1st period constraint
i1
B1 P2Y2 B1 P2 C 2 M1 B1
P2Y2 + B1 = P2 C 2 − M 1 −
i1
+ + = −
(1 + i1 ) (1 + i1 ) (1 + i1 ) (1 + i1 ) (1 + i1 )i1
− 2nd period constraint

To obtain the lifetime budget constraint we add together P2Y2 P2 C2  M 1   B1 B1 B1 

(P1Y1 ) + = P1C1 + +  M 1 − + − − 
the first period budget constraint to the present (1 + i1 ) (1 + i1 )  (1 + i1 )   i1 (1 + i1 ) (1 + i1 )i1 
discounted value of the second period budget
constraint

Present discounted value of second period budget

constraint is -
P2Y2 B1 P2 C 2 M1 B1
+ = − −
(1 + i1 ) (1 + i1 ) (1 + i1 ) (1 + i1 ) (1 + i1 )i1

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B B
P1Y1 = P1C1 + M 1 + 1 1st period constraint P1Y1 = P1C1 + M 1 + 1 1st period constraint
i1 i1
P2Y2 B1 P2 C 2 M1 B1 P2Y2 B1 P2 C 2 M1 B1
+ + = −
(1 + i1 ) (1 + i1 ) (1 + i1 ) (1 + i1 ) (1 + i1 )i1
− 2nd period constraint + + = −
(1 + i1 ) (1 + i1 ) (1 + i1 ) (1 + i1 ) (1 + i1 )i1
− 2nd period constraint

P2Y2 P2 C2  M 1   B1 B1 B1  P2Y2 P2 C2  M 1   B1 B1 B1 
(P1Y1 ) + = P1C1 + +  M 1 − + − −  (P1Y1 ) + = P1C1 + +  M 1 − + − − 
(1 + i1 ) (1 + i1 )  (1 + i1 )   i1 (1 + i1 ) (1 + i1 )i1  (1 + i1 ) (1 + i1 )  (1 + i1 )   i1 (1 + i1 ) (1 + i1 )i1 

P2Y2 P2 C2  (1 + i1 )M 1 − M 1   (1 + i1 )B1 − i1 B1 − B1  P2Y2 P2 C2  (1 + i1 )M 1 − M 1   (1 + i1 )B1 − i1 B1 − B1 

or, (P1Y1 ) + = P1C1 + +  +  or, (P1Y1 ) + = P1C1 + +  + 
(1 + i1 ) (1 + i1 )  (1 + i1 )   (1 + i1 )i1  (1 + i1 ) (1 + i1 )  (1 + i1 )   (1 + i1 )i1 

P2Y2 P2 C 2 i1 M 1
or, (P1Y1 ) + = P1C1 + +
(1 + i1 ) (1 + i1 ) (1 + i1 )

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P2Y2 PC iM
B (P1Y1 ) + = PC + 2 2 + 1 1
P1Y1 = P1C1 + M 1 + 1
i1
1st period constraint (1 + i1 ) 1 1 (1 + i1 ) (1 + i1 )
P2Y2 B1 P2 C 2 M1 B1
+ + = −
(1 + i1 ) (1 + i1 ) (1 + i1 ) (1 + i1 ) (1 + i1 )i1
− 2nd period constraint
Y1 +
P2Y2 PC
= C1 + 2 2 + 1
i M1
P1 (1 + i1 ) P1 (1 + i1 ) (1 + i1 ) P1

P2Y2 P2 C2  M 1   B1 B1 B1 
(P1Y1 ) + = P1C1 + +  M 1 − + − − 
(1 + i1 ) (1 + i1 )  (1 + i1 )   i1 (1 + i1 ) (1 + i1 )i1 

P2Y2 P2 C2  (1 + i1 )M 1 − M 1   (1 + i1 )B1 − i1 B1 − B1 
or, (P1Y1 ) + = P1C1 + +  + 
(1 + i1 ) (1 + i1 )  (1 + i1 )   (1 + i1 )i1 

P2Y2 P2 C 2 i1 M 1
or, (P1Y1 ) + = P1C1 + +
(1 + i1 ) (1 + i1 ) (1 + i1 )

Dividing throughout by P1 ,

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P2Y2 PC iM P2Y2 PC iM
(P1Y1 ) + = PC + 2 2 + 1 1 (P1Y1 ) + = PC + 2 2 + 1 1
(1 + i1 ) 1 1 (1 + i1 ) (1 + i1 ) (1 + i1 ) 1 1 (1 + i1 ) (1 + i1 )

P2Y2 PC i M1 P2Y2 PC i M1
Y1 + = C1 + 2 2 + 1 Y1 + = C1 + 2 2 + 1 Budget
P1 (1 + i1 ) P1 (1 + i1 ) (1 + i1 ) P1 P1 (1 + i1 ) P1 (1 + i1 ) (1 + i1 ) P1 Constraint

The real interest rate is - The real interest rate is -

P (1 + i1 ) P1 (1 + i1 )
1 + r1 = 1 1 + r1 =
P2 P2
P2 1 P2 1
or, = or, =
P1 (1 + i1 ) (1 + r1 ) P1 (1 + i1 ) (1 + r1 )

Substituting into the above budget constraint -

Y2 C2 i1 M1
Y1 + = C1 + +
(1 + r1 ) (1 + r1 ) (1 + i1 ) P1

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Y2 i M1 C2 Y i1 M 1 C2
Y1 + − 1 = C1 + Y1 + 2 − =C +
or, (1 + r1 ) (1 + i1 ) P1 (1 + r1 ) or, (1 + r1 ) (1 + i1 ) P1 1 (1 + r1 )

Two-period budget constraint when we explicitly Two-period budget constraint when we explicitly
allow for the accumulation of assets between allow for the accumulation of assets between
periods periods

Difference from the two period budget constraint

when analyzing Consumption is the presence
of term i1M1 (1 + i1 )P1
Cost of holding money is interest that would have
been earned on bonds of amount i1 (M 1 P1 )
if bonds were held instead of money
Present discounted value of lost interest on bonds
is i1M1 (1 + i1 )P1

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Y2 i1 M1 C2
Y1 + − = C1 + There is thus a trade-off between holding money and
(1 + r1 ) (1 + i1 ) P1 (1 + r1 )
enjoying the consumption that is possible from
There is thus a trade-off between holding money and the purchasing power of this money
enjoying the consumption that is possible from
the purchasing power of this money To understand this tradeoff rewrite the above equation
with the term in C1 on the left hand side -
To understand this tradeoff rewrite the above equation
with the term in C1 on the left hand side -  Y2 C2  i M1
C1 =  Y1 + − − 1
 (1 + r1 ) (1 + r1 )  (1 + i1 ) P1
 Y2 C2  i M1
C1 =  Y1 + − − 1
 (1 + r1 ) (1 + r1 )  (1 + i1 ) P1 When the individual holds no money balances
M 1 P1 = 0 and C1 is given by -

 Y2 C2 
C1 =  Y1 + − 
 (1 + r1 ) (1 + r1 ) 
This is point A in the diagram on the next slide -

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Consumption C
 Y2 C2  i M1
C1 =  Y1 + − − 1
 (1 + r1 ) (1 + r1 )  (1 + i1 ) P1
A
Y2 C2
Y1 + −
(1 + r1 ) (1 + r1 ) If the individual does not consume in period 1 and
saves the entire income in the form of money
balances, then, C1 = 0, and the lifetime
budget constraint is -

 Y2 C2  i M1
 Y1 + − − 1 =0
 (1 + r1 ) (1 + r1 )  (1 + i1 ) P1
M
O
P M 1 (1 + i1 )  Y2 C2 
or, =  Y1 + − 
Real
Money
P1 i1  (1 + r1 ) (1 + r1 ) 
Balances

This is point B in the diagram

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Consumption C Consumption C
Joining points A and B
A
give combinations of
Y1 +
Y2
−
C2
Y1 +
Y2
−
C2
A present consumption and
(1 + r1 ) (1 + r1 ) (1 + r1 ) (1 + r1 )
money balances that are
possible over the two time
periods

B
B
M M
O O
P P
Real Real
(1 + i1 )  Y + Y2 − C2  Money (1 + i1 )  Y + Y2 − C2  Money
i1  (1 + r1 ) (1 + r1 )  Balances i1  (1 + r1 ) (1 + r1 )  Balances
1 1

Income Constraint when allocating savings to money balances Figure 6.1: Income Constraint when allocating savings to money balances

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Consumption C distance OA Consumption C distance OA

Slope of budget line = Slope of budget line =
distance OB distance OB

 Y C2 
Y1 +
Y2
−
C2
A Y1 +
Y2
−
C2
A  Y1 + 2 − 
(1 + r1 ) (1 + r1 ) (1 + r1 ) (1 + r1 )  (1 + r1 ) (1 + r1 ) 
=
(1 + i1 )  Y + Y2 − C2 
i1  (1 + r1 ) (1 + r1 ) 
1

B B
M M
O O
P P
Real Real
(1 + i1 )  Y Y2 C2  Money (1 + i1 )  Y Y2 C2  Money
i1  1 + (1 + r ) − (1 + r )  i1  1 + (1 + r ) − (1 + r ) 
 1 1  Balances  1 1  Balances

Figure 6.1: Income Constraint when allocating savings to money balances Figure 6.1: Income Constraint when allocating savings to money balances

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Consumption C distance OA Consumption C

Slope of budget line =
distance OB

 Y C2 
Y1 +
Y2
−
C2
A  Y1 + 2 −  Y1 +
Y2
−
C2
A
(1 + r1 ) (1 + r1 )  (1 + r1 ) (1 + r1 )  (1 + r1 ) (1 + r1 )
=
(1 + i1 )  Y + Y2 − C2 
i1  (1 + r1 ) (1 + r1 ) 
1

i
i1 Slope =
= 1+ i
(1 + i1 )

B B
M M
O O
P P
Real Real
(1 + i1 )  Y + Y2 − C2  Money (1 + i1 )  Y + Y2 − C2  Money
i1  (1 + r1 ) (1 + r1 )  Balances i1  (1 + r1 ) (1 + r1 )  Balances
1 1

Figure 6.1: Income Constraint when allocating savings to money balances Figure 6.1: Income Constraint when allocating savings to money balances

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Determinants of real money demand - This depends on the agents’ preferences for cons-
umption and holding money balances.
Cost of holding money is that an agent opts to forgo
an income from interest earnings Utility depends on consumption as in the final
analysis we are interested in the consumption
Benefit to the household and firms of holding money, made possible by income
however, is that it provides liquidity without
which transactions minus the inconvenience
of barter would not be possible Utility depends on money balances as money has
value because it is used to exchange goods
This tradeoff is given by the budget line and services. As money is a medium of
exchange we should measure money in
Which point on the budget line would an agent units of output, M P
choose?
 M
U = U  C, 
 P

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 M
U = U  C ,  = constant
 P
Consumption C
Decision problem -
Optimal demand for real
d

Y1 +
Y2
−
C2
A
money balances is M *
(1 + r1 ) (1 + r1 ) P
 M 
Max U  C1 , 1 
C1 ,( M 1 P1 ),( B1 i P )  P1 
1 1

i
Y2 i1 M1 C2 Slope =
E 1+ i
such that Y1 + − = C1 +
(1 + r1 ) (1 + i1 ) P1 (1 + r1 )

Individual chooses consumption, nominal money

B
balances, and nominal bond holdings, to O
M
maximize utility subject to the budget Md* P
Real
P (1 + i1 )  Y + Y2 − C2  Money
constraint. i1 
1
(1 + r1 ) (1 + r1 )  Balances
Nominal interest rate and price level are Figure 6.2: Equilibrium Money Balances Held
taken as given

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