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Supply & Demand of Money
Money• Money is the greatest invention of mankind
• In Economics, money is the most important invention
• Money acts as a medium of exchange, measure of
value, store of value
• All economic activities revolve around money
• Modern Economy is called as “Money Economy”
Supply of Money• Supply of Money refers to total amount of money in circulation at
a particular point of time i.e. total stock of money held by Public
• Public refers to individuals, business firms & govt
• Supply of money refers to that stock of money with Public which
is in circulation i.e. Disposable form only
• Stock of money which is kept as reserve by banking & govt is NOT
included in money supply
• Supply if Money can be defined as “total amount of money in
circulation in an economy at a given point of time”
Supply of Money• Supply of money is viewed in 2 ways – stock and flow variable
• When money is measured at a point of time it is stock
• When money is measured over a period of time it is termed as
flow concept
• A unit of money passes through no of hands in the process of
transactions
• The average no of times a unit of money passes from 1 hand to
another during a given period of time is called Velocity of
Circulation of Money
Constituents of Money Supply • There are various approaches regarding
components of money supply i.e. what items
should be considered under money supply
• Major Approaches
– Traditional Approach
– Modern Approach
Traditional Approach • It is based on medium of exchange function of
money. Its a narrow concept
• Main constituents of money supply as per this
– Coins & Currency Notes
– Deposits withdrawal by means of cheques i.e. Bank
money
Traditional Approach• Coins & Currency Notes
– Legal Tender of money
– Issued by Central bank of the country (RBI) – monopoly in issuing coins & currency
– Currency & Coins are called as High Powered Money as issued by Central bank &
Central govt
– Some countries have treasury also involved in issuing coins & currency notes
– In India, Rs. One coin is issued & managed y Central govt whereas, other coins &
currency notes are issued by RBI
– While issuing Currency Notes India follows Minimum Reserve System
– Under this system, RBI has to maintain minimum amount of Gold reserves i.e. Rs. 200
crore out of which gold is worth 115 crore and rest 85 crore in terms of foreign security
– By maintaining this reserve, RBI can print any amount of currency notes
– It was adopted in 1957 by RBI
Traditional Approach• Bank Money
– It refers to demand deposits with the commercial banks, which can be
withdrawn by cheque
– These deposits can be transferred to others or can be used to make
payments through cheques
– Hence deposit can be used as a medium for exchange through cheques
– Deposits are of 2 types – Demand Deposits & Time Deposits
– Demand Deposits can be withdrawn through cheques
– Time Deposits can be withdrawn only maturity period
– According to traditional approach only demand deposits should be
included in money supply
Modern Approach • It is a wider concept
• As per this concept, money supply should include both
money & near money assets
• Thus this approach consists of coins, currency notes,
demand deposits, time deposits, deposits with non-
banking financial intermediaries, shares, bonds & bills of
exchange i.e. all those assets which have liquidity are
considered under money supply
Determinants of Money Supply
• Money Supply consists of coins, currency notes &
demand deposits
• Coins & Currency notes are issued by central bank,
demand deposits are created by commercial banks
• In developing countries, amount of coins &
currency notes is more than that of bank money &
vice versa in developed countries
Determinants of Money Supply• Extent of Monetization – money supply depends on the extent of
monetization
• Community’s Choice
– People's choice in terms of mode of payment – if cash transactions are
done then supply of money is less as transaction is over then & there.
However, if payment is made by cheque then banks can create credit &
supply of money will increase
• Cash Reserve Ratio
– Banks have to hold certain amount of its deposits as Reserves with central
bank as reserve so that they do not run out of cash to meet payment
demand of their depositors
Determinants of Money Supply• Monetary base
– Refers to variety of assets owned by central bank which
forms the basis of issue of currency notes
– Larger monetary base, higher supply of currency notes &
vice versa
– It is dependent upon 3 components
• Monetary Gold Stock
• Reserve Assets
• Credit Outstanding of Central bank
Determinants of Money Supply• Budgetary Policy of Govt – Public Revenue, Expenditure &
Debt
– Revenue (Taxation) – if tax is more than money supply will be less
as money will transfer from public to govt & vice versa
– Expenditure – incurred by govt for public – hence money supply is
more
– Debt – when govt expenditure is more than its income then it will
start borrowing which will result in public debt. If govt borrows
money from public then money supply is less and when it repays
then money supply is more
Demand for Money • Demand for Money arises due to 2 major
functions of money – medium of exchange,
storage of value
Keynesian Approach – Demand for Money • J.M Keynes gave this theory in his book – General Theory of
Employment, Interest & Money
• His approach emphasizes on both the functions of money
• As per him, people demand money as it is most liquid asset & can be
converted into any type of asset at any given point of time
• Desire of people to hold liquidity cash is called “liquidity preference”
• Liquidity preference depends upon 3 motives
– Transaction Motive
– Precautionary Motive
– Speculative Motive
Keynesian Approach – Demand for Money
• Transaction Motive
– Money is required for day to day transactions by business & individuals
– Income is received once but expenditure is continuous hence money is to
be maintained
– Amount of money to be maintained depends upon the level of income,
time interval between 2 pay checks etc.
– Demand of money depends upon level of income, price level, spending
habits etc.
– Higher the income & price level, demand of money will be high & vice
versa
– Business firms demand money for procurement of raw material,
transportation cost, salary/wage payment etc.
Keynesian Approach – Demand for Money • Transaction Motive
– Business similar to individuals get payment once & have
continuous expenses
– The money maintained by business for this purpose depends upon
its turnover
– Higher turnover, high demand of money & vice versa
– Transaction Motive Demand is sum of demand for money by
individuals & business
– Demand of money is influenced by level of income & is not affected
by interest rate
– Hence, income is elastic & interest is inelastic
Keynesian Approach – Demand for Money
• Precautionary Motive
– It is desire of people to hold cash to meet unforeseen
emergencies
– Individuals & business both maintain certain cash reserves for
emergency purpose
– Precautionary motive is also influence by level of income &
business turnover & is not affected by interest rate
– Hence, Income elastic & interest inelastic
– Demand for transaction motive & precautionary motive is
termed as demand for active cash
Keynesian Approach – Demand for Money
• Speculative Motive
– Refers to demand for idle cash
– Based on storage value of money
– People hold cash reserves for speculation i.e. to take advantage of fluctuations
in the rate of interest or prices in securities
– Demand for idle cash is based on rate of interest i.e. Rate of interest is elastic
– If rate of interest is high, less money will be demanded for speculative motive
& vice versa
– While holding idle cash, income in terms of interest is forgone as idle cash by
itself will not earn any return
– Hence demand for money for speculative purpose depends on rate of interest
Total Demand of Money • It is the summation of demand for money of all 3 motives
• Demand for money in transaction & precautionary motive – income is
elastic & interest is inelastic
• Demand for money in speculation motive – income is inelastic & interest is
elastic
• Keynesian Approach was criticized by economists on the basis that he only
included assets in form of bond or cash whereas in reality people hold a
combination of both
• Keynes in transaction motive considered interest as inelastic, modern
economists argue that interest is elastic in this motive
Questions • Explain the concept of money supply in detail
• Throw light on traditional approach & modern approach to
supply of money
• Discuss the various determinants of money supply
• Explain Demand of Money with reference to Keynesian
Approach
• Any one Motive for demand of money can come as a short
Note
