Study Notes on Demand and Supply of Money

Demand and Supply of Money

Demand for Money

  • People's demand for money focuses not on nominal money holdings but on real money balances, which refer to the value of money balances in terms of purchasing power or the goods and services they can buy.

  • Classical Economists' View:

    • Money regarded solely as a means of payment or medium of exchange.

  • J.M. Keynes' Perspective:

    • Emphasizes money as a store of value.

    • Money viewed as an asset that people hold to leverage shifts in its value, particularly regarding interest rates.

    • Key concept introduced by Keynes: Speculative Motive for holding money, which explains that individuals hold money to take advantage of changing interest rates.

Keynes's Theory of Demand for Money

  • Introduced the term Liquidity Preference, which describes the demand for money to hold, indicating how much income or resources a person wishes to keep in readily available cash or non-interest-paying bank deposits.

  • Definitions:

    • Liquidity Preference: The public's desire to hold cash rather than invest.

  • Reasons for Holding Liquidity despite Earning Interest:

    • Individuals prefer liquidity due to three motives:

    1. Transactions Motive: Demand for money to facilitate current transactions for individuals and businesses.

    2. Precautionary Motive: Desire to maintain cash balances for unforeseen circumstances.

    3. Speculative Motive: The wish to retain cash to capitalize on future market changes, affecting interest or bond prices.

Examples of Speculative Behavior

  • Bond Price Expectations:**

    • If bond prices are anticipated to increase (interest rates expected to fall), investors will purchase bonds to sell when prices rise.

    • Conversely, if bond prices are thought to decrease (interest rates expected to rise), investors will sell bonds to prevent loss.

  • There exists an inverse relationship between the money held for speculative purposes and prevailing interest rates:

    • Lower interest rates yield less opportunity cost for holding cash, while higher rates encourage lending or investing money instead.

Liquidity Trap

  • Definition: Situation where interest rates are extremely low, prompting individuals to prefer cash holdings over bond investments, rendering monetary policy ineffective.

Supply of Money

  • Defined as the total amount of money available to the public at a certain time (a stock concept).

    • Always signifies money held by households, firms, and non-bank institutions, excluding producers (e.g., RBI, government, commercial banks) to prevent double counting.

  • Importance of Money Supply:

    • Integral in determining price levels (inflation) and interest rates for deposits and loans.

Measurement of Money Supply

  • Standard money supply is composed of two main elements:

    1. Currency with the Public

    2. Demand Deposits with the Public

  • The Reserve Bank of India (RBI) measures money supply through indicators: M0, M1, M2, M3, M4.

Components of Money Supply

  • M3: Most widely recognized measure of money supply, referred to as Aggregate Monetary Resources / Aggregate Money Supply.

    • NM0 (Monetary Base): Currency in circulation + Banker's deposits with the RBI + Other deposits with the RBI.

  • NM1: Defined as Currency with the public (coins, currency notes, etc.) + Net demand deposits held by the public with commercial banks.

    • Known as narrow money as it emphasizes the medium of exchange function.

    • 'Net' Definition: Only public deposits with banks counted, excluding interbank deposits.

  • NM2: Computed as NM1 + Post Office saving deposits.

    • Not as liquid as commercial bank savings due to restrictions on withdrawal frequency and amounts.

  • NM3: Defined as NM1 + Net time deposits of the public with banks.

    • Recognizes time deposits as a store of value and considered broad money due to its wider definition.

  • NM4: NM3 + Total post office deposits (excludes national savings certificates).

    • Ranks components by liquidity:

    • Most liquid: Currency

    • Followed by: Demand deposits

    • Next: Savings deposits with post office

    • Least liquid: Time deposits

Creation of Money

  • NM0 (High Powered Money): Issued under the RBI Act by RBI’s ISSUE DEPARTMENT, where assets must match liabilities.

    • Comprised of currency issued by RBI and bank reserves, forming the basis for credit creation.

Money Multiplier Effect

  • Cash Reserve Ratio (CRR): Leads to Fractional Reserve Banking (the practice of lending deposited money, assuming not all customers will withdraw it simultaneously).

  • The money multiplier effect can be illustrated as:

    • High Powered Money (NM0) = 100

    • Loaning at 10% reserve rate ('R'):

    • Bank #1 advances 90 from 100 deposit, keeps 10 in reserve.

    • Subsequent banks similarly lend as follows:

      • Bank #2 lends 81 from 90, keeps 9 in reserve.

      • Bank #3 lends 72.9 from 81, keeps 8.1 in reserve.

    • Total Money created from an initial deposit of Rs. 100:

    • Calculation: New deposit / Reserve requirement = Rs. 100 / 0.10 = Rs. 1000.

    • Money Multiplier: (1/CRR)

    • Money Supply Formula: Money Multiplier × High-powered money.