1. Demand for and supply
of money

2. What is money?
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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

3. Functions of money

Medium of exchange

Measure of value /unit of account

Standard of deferred payments

Store of value

4. Kinds of money
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Fiat money (legal tender)
 Coins
 Currency notes
Fiduciary (credit) money
 Deposits
 Bank deposits – Demand and time
deposits
 Post office deposits

5. 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

6. Quantity theory of money
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Variations in quantity of money impacts
prices, money and real income, rate of
interest
Two approaches
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Quantity theory of money
Keynesian theory
Quantity theory
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Irving Fisher’s transactions version
Cambridge cash balances approach

7. Fisher’s QTM
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M*V = P*T
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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

8. 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
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K is reciprocal of V (turnover per time
period)

9. Money market
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Money as an asset
Money market
Demand – consumers – general public
Supply – producers of money –
government, monetary authority and
banking system
Equilibrium in money market

10. Demand for money
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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

11. Keynesian theory of Md
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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
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Transactions motive
Precautionary motive
Speculative motive

12. Contd….
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Md = f (Y, r)
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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

13. Contd….
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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

14. Contd….
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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

15. Supply of money
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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

16. Contd….
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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

17. Money multiplier

Hd = Cd + Rd

Hd = c. D + r. D = (c + r) D

M = C + D = (1 + c) D
In equilibrium, Hs = Hd
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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