3. Money?
Assets which are commonly used and
accepted as a means of payment or a
medium of exchange or of transferring
purchasing power.
For policy purposes, “Money can be
defined as the set of liquid financial assets,
the variation in stock of which could impact
on aggregate economic activity.”
4. Functions of Money:
1. Medium of Exchange
2. Common measure of value
3. Standard of Deferred payment
4. Store of Value
5. Medium of Exchange
Money is an instrument that facilitates
ease of transfer of goods or services.
By acting as a medium of exchange it
commands purchasing power and its
possession enables us to purchase
goods and services to satisfy our wants
It overcomes the drawbacks of Barter
(exchange of goods & services for other
goods & services).
6. Common measure of Value
Money is the measuring rod for
everything. It acts as a common
denominator by permitting everything to
be priced in terms of money only.
Therefore, people are enabled to
compare different prices and thus see
relative values of different goods and
services.
7. Standard of Deferred payment
In general, payments are spread over a
period of time. Example- when goods
are bought under hire-purchase, they
are given to the buyer upon payment of
deposit and he then pays it in a number
of installments.
Hence, the use of money permits
postponement of spending from the
present to some future occasion.
8. Store of Value
Money permits people to store their
income.
Thus, it is used as a store of purchasing
power. It can be held over a period of
time and used to finance future
payments provided its own value is
stable.
9. Demand for Money depends on-
Quantity of nominal money people
would like to hold in liquid form.
Income levels.
Pricing levels- higher the prices, higher
will be the demand.
Higher the interest rates of return on
assets, lower would be the demand of
liquid money.
Innovations like ATM, etc. lowers the
demand for liquid money.
10. Theories of Demand for Money
1. The Quantity theory of Money-
Classical
2. The Cambridge Approach- Neo
Classical
3. The Keynesian theory- Liquidity
Preference
4. Inventory Approach
5. Friedman’s Restatement of Quantity
Theory
11. Quantity theory of Money: Classical
Approach
One of the oldest theory propounded by
Irving Fisher.
There is a strong relationship between
Money & Price level. Hence, quantity of
money is the main determinant of the
price level or value of money.
Higher the number of transactions
people want, higher will be the demand
for money.(Transaction Motive)
12. Fisher’s version also termed as ‘equation of
exchange’ or ‘transaction approach’ is stated
as:
MV=PT, (with actual money)
MV+M’V’=PT (with actual & credit
money)
M= Total amount of money in circulation
M’= Credit money in circulation
V=Transaction velocity of circulation or average
no. of times money is spent
V’= Velocity of circulation of credit money
P=Average Price level
T= Total no. of Transactions
13. The Cambridge Approach:
Neo-Classical Approach
Since sales & purchases do not occur
simultaneously, people need a ‘ temporary
abode’ of purchasing power as a Hedge
against uncertainty. Hence, demand for
money also involves Precautionary Motive.
Demand for money depends partly on
Income & partly on other factors. Higher
the income, greater the quantity of
purchases and hence, greater will be need
for money for uncertainties.
14. Demand for Money under Cambridge
approach is stated as:
Md=k PY
Md= Demand for Money
Y = real national income
P = average price level of currently
produced goods and services.
PY= Nominal income
k = Proportion of nominal income that
people want to hold as cash balances
{Fisher’s theory & Cambridge theory are
chiefly concerned with money as a means of
transactions stating Transaction Demand}
15. The Keynesian theory of
Demand for Money
Also known as Liquidity Preference theory,
was quoted by John Maynard Keynes.
Denotes people’s desire to hold money
rather than securities or long term interest
bearing investments.
Three motives to hold- Transaction Motive,
Precautionary Motive & Speculative Motive.
An increase in Income increases the
Transaction & Precautionary Demand for
money and rise in interest rate decreases
the speculative demand for money.
16. Transaction Motive
It relates to the need of cash for current
transactions for personal and business
exchange.
This need is further classified into-
Income motive & Business motive.
Transaction demand is directly related to
the level of income & nothing else.
Lr= k Y
Lr is transaction demand for money, k is
ratio of earnings kept for transaction
purposes & Y is the earnings
17. Precautionary Motive
Individuals as well as Businesses keep
a portion of income to finance the
uncertainties.
Such amount is depends on the size of
income, prevailing economic as well as
political conditions and personal
characteristics of individual.
Precautionary as well Transaction
motive cash balances are income elastic
and not very sensitive to interest rates.
18. The Speculative Demand for
Money
It reflects people’s desire to hold cash to
exploit any investment opportunities or to
take advantage of the future changes in the
rate of interest (return on bonds).
According to Keynes, People hold wealth in
majorly two ways i.e. Money & Assets.
Money has zero expected return while
assets will have Interests as well as
Expected Capital Gain.
Higher the interest rate(fall in bond prices),
lower the speculative demand for money &
vice-versa
19. Effect of Interest rates Variations:
(Rn= Current Market interest rate, Rc= Interest
expected by investors)
When Rn>Rc: Investors expects fall in interest
rate (Rise in Bond Prices) and now they will
convert cash into bonds to earn high rate of
return on bonds and capital gains due to price
rise.
When Rn<Rc: Investors expect a rise in
interest rates (fall in bonds prices) & hence,
they hold their wealth in cash to minimise loss
of interest forgone, avoiding capital losses and
return of money shall be higher than that of
bonds.
20. The Inventory Approach
This model assumes that there are two
media for storing value: money & interest
bearing alternative financial asset.
As businesses keep money to facilitate their
business transactions, people also hold
cash balance which involves an opportunity
cost in terms of lost interest. Therefore,
they hold an optimum combination of bonds
& cash balance i.e. an amount that
minimize opportunity cost.
21. Friedman’s Restatement of the
Quantity Theory
Demand for money is affected by the same
factors as demand for any other asset, i.e.,
Permanent income and Relative returns on
assets.
Permanent income here is Friedman’s
measure of wealth or expected present
value of all future income.
Demand for Money is like that of other
consumption goods is determined by
Income, Price, Opportunity costs & Inflation
