Principles Of Economics &

Management
MODULE - 2
UNIT5 - MONEY
Definition of Money
Money, in simple terms, is a medium of exchange. It is instrumental in the exchange
of goods and/or services.
Further, money is the most liquid assets among all our assets. It also has general
acceptability as a means of payment along with its liquid nature.
Usually, the Central Bank or Government of a country creates and issues money.
Also called cash money, this is a legal tender and hence there is a legal compulsion
on citizens to accept it.
Credit money is another form of money which the banks create through loan
transactions.
Functions of Money
There are many static and dynamic functions of money as follows:
Static Functions of Money
These functions are:
A medium of Exchange – In an exchange economy, money plays an intermediary role.
It makes the exchange system smooth and convenient.
A measure of Value – The value of a product or service is determined on the basis of
the money needed for its possession. This helps in making the exchange a mutually
profitable activity.
The Standard of Deferred Payments – Money plays an important role in lending and
borrowing. Money is taken as a loan and repaid after a time-gap.
Store of Value – You can store the purchasing power of money and keep a part of it for
future use – monetary savings. You can use your current income for current
consumption as well as future consumption through savings.
Dynamic Functions of Money:
These functions are:
Money can activate idle resources and put them into productive channels.
Therefore, it helps in increasing output, employment, and also income levels.
Further, it helps in converting savings into investments.
The creation of new money governments of modern economies can spend more than
what they earn.

Value of Money
The value of money simply implies its exchange value. It means the number/amount
of goods and/or services that you can obtain in exchange for a single unit of money.
Further, the value of money is inversely proportional to the price of goods/services.
Therefore, if the price level increases, the value of money decreases and vice-versa.
APPROACHES FOR DEMAND FOR MONEY:

Theory 1# Fisher’s Transactions Approach to Demand for Money:

In his theory of demand for money Fisher and other classical economists laid stress on the
medium of exchange function of money, that is, money as a means of buying goods and
services. All transactions involving purchase of goods, services, raw materials, assets
require payment of money as value of the transaction made.

Symbolically, Fisher’s equation of exchange is written as under:

MV = PT …(1)
Where, M = the quantity of money in circulation
V = transactions velocity of circulation (average number of times a unit of money is used
for transactions of goods, services and assets)
P = Average price
T = the total number of transactions.

MV = Supply of Money
PT = Demand for Money for the transactions made in the economy
The Cambridge Cash Balance Theory of Demand for Money:
Cambridge Cash Balance theory of demand for money was put forward by Cambridge
economists, Marshall and Pigou. This Cash Balance theory of demand for money places
emphasis on the function of money as a store of value or wealth.

Marshall and Pigou put forward a view that individual’s demand for cash balances (i.e.
nominal money balances) is proportional to the nominal income (i.e. money income).
Aggregate demand for money can be expressed
as:
Md = kPY
Where, Y = real national income
P = average price level of currently produced
goods and services
PY = nominal income
k = proportion of nominal income (PY) that people
want to hold as cash balances.

In their approach, rate of interest, wealth as the

factors determine the proportionality factor k, that
is, the proportion of money income that people
want to hold in the form of money, i.e. cash
balances.
Theory 2# Keynes’ Theory of Demand for Money:
Keynes decomposes Money Demand into Consumption, Investment and Government
spending. Keynes in his General 'Theory used a new term "liquidity preference" for the
demand for money.
Keynes suggested three motives which led to the demand for money in 'an economy: (i)
the transactions demand, (ii) the precautionary, demand, and (iii) the speculative demand.

1. The Transactions Demand for Money:

People hold money or cash balances for transaction purposes, because receipt of money
and payments do not coincide. A certain amount of ready money, therefore, is kept in
hand to make current payments. This amount will depend upon the size of the individual’s
income, the interval at which the income is received and the methods of payments
prevailing in the society.

2. Precautionary Demand for Money:

Precautionary motive for holding money refers to the desire of the people to hold cash
balances for unforeseen contingencies. People hold a certain amount of money to provide
for the danger of unemployment, sickness, accidents, and the other uncertain perils. The
amount of money demanded for this motive will depend on the psychology of the
individual and the conditions in which he lives.
3. Speculative Demand for Money:
The speculative motive of the people relates to the desire to hold one’s resources in
liquid form in order to take advantage of market movements regarding the future
changes in the rate of interest (or bond prices).
The cash held under this motive is used to make speculative gains by dealing in bonds
whose prices fluctuate. If bond prices are expected to rise which, in other words,
means that the rate of interest is expected to fall, businessmen will buy bonds to sell
when their prices actually rise. If, however, bond prices are expected to fall, i.e., the
rate of interest is expected to rise, businessmen will sell bonds to avoid capital losses.
Most bonds pay fixed interest rate that becomes more attractive if interest rates fall,
driving up demand and the price of the bond. Conversely, if interest rates rise,
investors will no longer prefer the lower fixed interest rate paid by the bond,
resulting in a decline in its price.
Given the expectations about the changes in the rate of interest in future, less money
will be held under the speculative motive at a higher current rate of interest and more
money will be held under this motive at a lower current rate of interest.
The reason for this inverse correlation between money held for speculative motive and
the prevailing rate of interest is that at a lower rate of interest less is lost by not lending
money or investing it, that is, by holding on to money, while at a higher current rate of
interest holders of cash balance would lose more by not lending or investing.
Liquidity Trap:
It will be seen from Fig. 15.2 that the liquidity preference curve LP becomes quite flat i.e.,
perfectly elastic at a very low rate of interest; it is horizontal line beyond point E” towards
the right. This perfectly elastic portion of liquidity preference curve indicates the position of
absolute liquidity preference of the people. That is, at a very low rate of interest people will
hold with them as inactive balances any amount of money they come to have.
This portion of liquidity preference curve with absolute liquidity preference is called
liquidity trap by the economists because expansion in money supply gets trapped in the
sphere of liquidity trap and therefore cannot affect rate of interest and therefore the
level of investment. According to Keynes, it is because of the existence of liquidity trap
that monetary policy becomes ineffective to tide over economic depression.
But the demand for money to satisfy the speculative motive does not depend so much
upon what the current rate of interest is, as on expectations about changes in the rate of
interest.
Aggregate Demand for Money: Keynes’ View:
Md= M1 + M2.
Md= total demand of money
M1 = that part of M held for transactions and precautionary motive
M2 = that part of M held for the speculative motive
We can write this in a functional form as follows:
M1 = L1(Y) …(i)
where Y stands for income, L1 for demand function, and M1 for money demanded or
held under the transactions and precautionary motives.
M2 = L2(r) …(ii)
Where r stands for the rate of interest, L2 for demand function for speculative motive.
Since total demand of money Md = M1 + M2, we get from (i) and (ii) above
Md = L1(Y) + L2(r).

Thus, according to Keynes’ theory of total demand for money is an additive demand
function with two separate components. The one component, L1(Y) represents the
transactions demand for money arising out of transactions and precautionary
motives is an increasing function of the level of money income. The second
component of the demand for money, that is, L2(r) represents the speculative
demand for money, which depends upon rate of interest, is a decreasing function of
the rate of interest.
• The transactions component of the demand for money is proportional to income.
• Precautionary motive is also proportional to income.
• Speculative motive is negatively related to the level of interest rates
Theory 3# Tobin’s Portfolio Approach to Demand for Money:

According to Tobin’s approach, individuals simultaneously hold both money and

bonds but in different proportion at different rates of interest, yields a continuous
liquidity preference curve.
This downward-sloping liquidity
preference function curve shows
that the asset demand for money in
the portfolio increases as the rate of
interest on bonds falls.

At a higher rate of interest, their

demand for holding money (i.e.,
liquidity) will be less and therefore
they will hold more bonds in their
portfolio. On the other hand, at a
lower rate of interest they will hold
more money and less bonds in their
portfolio.
Theory 4# Baumol’s Inventory Approach to Transactions Demand for Money:
•Baumol asserts that individual hold inventory of money because this facilitates
transactions (i.e. purchases) of goods and services.
•Individuals have to keep optimum inventory of money for transactions purposes.
Individuals also incur cost when they hold inventories of money for transaction
purposes.
•They incur cost on these inventories as they have to forgo interest which they could
have earned if they had kept their wealth in saving deposits or fixed deposits or invested
in bonds. This interest income forgone is the cost of holding money for transaction
purposes. In this way Baumol and Tobin emphasised that transaction demand for money
is not independent of the rate of interest.
•According to him, it is for convenience and capability of it being easily used for
transaction People hold money for transaction purposes “to bridge the gap between the
receipt of income and its spending.” As interest rate on saving deposits goes up people
will tend to shift a part of their money holdings to the interest-bearing saving deposits.
•According to Baumol, the cost which people incur when they hold funds in money is the
opportunity cost of these funds, that is, interest income forgone by not putting them in
saving deposits.
Theory 5# Friedman’s Theory of Demand for Money:

He treats money as one type of asset in which wealth holders can keep a part of their
wealth. Business firms view money as a capital good or a factor of production which
they combine with the services of other productive assets or labour to produce goods
and services. Thus, according to Friedman, individuals hold money for the services it
provides to them.
•Friedman considers the demand for money merely as an application of a general
theory of demand for capital assets.
•Like other capital assets, money also yields return and provides services. He analyses
the various factors that determine the demand for money and from this analysis
derives demand for money function. Note that the value of goods and services which
money can buy represents the real yield on money.

Friedman’s nominal demand function (Md) for money can be written as:
Md /P = f(W, h, rm, rb, re, P, ∆P/P, U)
where Md stands for nominal demand for money and Md/P for demand for real
money balances, W stands for wealth of the individuals, h for the proportion of
human wealth to the total wealth held by the individuals, rm for rate of return or
interest on money, rb for rate of interest on bonds, re for rate of return on equities, P
for the price level, ∆P/P for the change in price level (i.e. rate of inflation), and U for
the institutional factors.
1. Wealth (W):
The major factor determining the demand for money is the wealth of the individual
(W). In wealth Friedman includes not only non-human wealth such as bonds, shares,
money which yield various rates of return but also human wealth or human capital.
By human wealth Friedman means the value of an individual’s present and future
earnings. Whereas non-human wealth can be easily converted into money, that is,
can be made liquid.

2. Rates of Interest or Return (rm, rb, re):

Friedman considers three rates of interest, namely, rm, rb and re which determine the
demand for money. rm is the own rate of interest on money. Note that money kept in
the form of currency and demand deposits does not earn any interest.
But money held as saving deposits and fixed deposits earns certain rates of interest
and it is this rate of interest which is designated by rm in the money demand function.
Given the other rates of interest or return, the higher the own rate of interest, the
greater the demand for money.
The opportunity cost of holding money is the interest or return given up by not holding
these other forms of assets.
As rates of return on bond (rb) and equities (re) rise, the opportunity cost of holding
money will increase which will reduce the demand for money holdings. Thus, the
demand for money is negatively related to the rate of interest (or return) on bonds,
equities and other such non-money assets.
3. Price Level (P):
Price level also determines the demand for money balances. A higher price level means
people will require a larger nominal money balance in order to do the same amount of
transactions, that is, to purchase the same amount of goods and services.
As the price level goes up, the demand for money will rise and, on the other hand, if
price level falls, the demand for money will decline. As a matter of fact, people adjust
the nominal money balances (M) to achieve their desired level of real money balance
(M/P).

4. The Expected Rate of Inflation (∆P/P):

If people expect a higher rate of inflation, they will reduce their demand for money
holdings. This is because inflation reduces the value of their money balances in terms of
its power to purchase goods and services.
If the rate of inflation exceeds the nominal rate of interest, there will be negative rate of
return on money. Therefore, when people expect a higher rate of inflation they will tend
to convert their money holdings into goods or other assets which are not affected by
inflation.
On the other hand, if people expect a fall in the price level, their demand for money
holdings will increase.
5. Institutional Factors (U):
Institutional factors such as mode of wage payments and bill payments also affect the
demand for money. Several other factors which influence the overall economic
environment affect the demand for money. For example, if recession or war is
anticipated, the demand for money balances will increase.
Besides, instability in capital markets, which erodes the confidence of the people in
making profits from investment in bonds and equity shares, will also raise the demand for
money. Even political instability in the country influences the demand for money. To
account for these institutional factors Friedman includes the variable U in his demand for
money function.
 CONCEPT OF MONEY SUPPLY
• Money supply refers to the amount of money which is
in circulation in an economy at any given time.
• It is the total stock of money held by the people
consisting of individuals, firms, State and its
constituent bodies except the State treasury, Central
Bank and Commercial Banks.
• The cash balances held by the Federal and federating
governments with the Central Bank and in treasuries
are not considered as part of money supply because
they are created through the administrative and non-
commercial operations of the government. Further
money supply refers to the disposable stock of money.
• Money supply viewed at a point of time is
the stock of money held by the people on a
given day whereas money supply viewed
overtime is viewed as a flow.
• Units of money are spent and re spent
several times during a given period.
• The average number of times a unit of money
circulates amongst the people in a given year
is known as Velocity of Circulation of Money.
• The flow of money is measured by
multiplying the stock of money with the
velocity of circulation of money.
 CONSTITUENTS OF MONEY SUPPLY
• There are two approaches to the constituents of money
supply. They are the traditional and the modern
approaches.
• 1. Traditional Approach: According to the traditional
approach, the money supply consists of currency money
consisting of coins and notes and bank money consisting
of checkable demand deposits with commercial banks.
The currency money is considered high powered money
because of the legal backing of the State. The Central
Bank of a country issues currency notes and coins
because it has the monopoly of note and coin issue. The
supply of money in a country depends upon the system
of note issue adopted by the country.
2. The Modern Approach:
• According to the modern approach, money
supply includes currency money and near
money.
• Money supply therefore consists of coins,
currency notes, demand deposits of
commercial banks, time deposits of
commercial banks, financial assets,
treasury bills and commercial bills of
exchange, bonds and equities.
 RESERVE BANK OF INDIA’S APPROACH TO
THE MEASUEMENT OF MONEY SUPPLY:
• These four alternative measures of money supply are
labelled M1, M2, M3 and M4.
• M1 (Narrow Money)
• M1 includes all the currency notes being held by the public
on any given day. It also includes all the demand deposits
with all the banks in the country, both savings as well as
current account deposits. It also includes all the other
deposits of the banks kept with the RBI. So
• M1 = CC + DD + Other Deposits
• M2
• M2, also narrow money, includes all the inclusions of M1 and
additionally also includes the saving deposits of the post
office banks. So
• M2 = M1 + Savings Deposits of Post Office Savings
 RESERVE BANK OF INDIA’S APPROACH TO
THE MEASUEMENT OF MONEY SUPPLY:
• M3 (Broad Money)
• M3 consists of all currency notes held by the public,
all demand deposits with the bank, deposits of all the
banks with the RBI and the net Time Deposits of all
the banks in the country. So
• M3 = M1 + time deposits of banks.
• M4
• M4 is the widest measure of money supply that the
RBI uses. It includes all the aspects of M3 and also
includes the savings of the post office banks of the
country. It is the least liquid measure of all of them.
• M4 = M3 + Post office savings
 DETERMINANTS OF MONEY SUPPLY
1. Size of the Monetary Base: Money supply depends
upon the size of the monetary base. The monetary
base refers to the group of assets which empowers
the monetary authorities to issue currency money.
Money supply changes with changes in the monetary
base. The monetary base of an economy consists of
monetary gold stock, reserve assets such as
government securities, bonds and bullion, foreign
exchange reserve with the central bank and the
amount of central bank’s credit outstanding. In the
present times, gold stock is not considered as part of
the monetary base.
2. Community’s Choice: The relative amount of cash and
demand deposits held by the people also influences the
supply of money. If the people prefer to make cheque
payments much more than cash payments, the total money
supply maintained by a given monetary base would be
larger and vice versa.

• Since money deposited in commercial banks generates

derivative deposits and expand the supply of bank money
through the credit multiplier, people’s preference of bank
money to cash would increase the supply of money.
However, the choice of the community is determined by
factors such as banking habits, per capita income,
availability of banking facilities and the level of economic
development. If these factors are developed, the money
supply would be larger and vice versa.
3. Extent of Monetization: Monetization
refers to the use of money as a medium of
exchange.
• The choice of the community for money as
a liquid asset depends upon the extent of
monetization of the economy.
• If monetization is high, demand for money
would be high and vice versa.
4. Cash Reserve Ratio: The Cash Reserve Ratio
refers to the ratio of a bank’s cash holdings
to its total deposit liabilities. It determines
the coefficient of the credit multiplier. The
CRR is determined by the Central Bank of a
country.
• Lower the CRR, greater will be value of the
credit multiplier and therefore greater will
be the supply of bank money and vice
versa.
5. Monetary Policy of the Central Bank: The
monetary policy of the Central Bank of any country
will be according to the macroeconomic conditions.
Thus under inflationary conditions, the Central Bank
may follow restrictive monetary policy and thereby
reduce the supply of bank money by pursuing both
qualitative and quantitative measures of controlling
money supply.

Similarly under recessionary conditions the Central

Bank may follow expansionary monetary policy and
thereby raise the supply of money in the economy.
6. Fiscal Policy of the Government:
• Fiscal Policy is defined as a policy concerning the income
and expenditure of the government.
• When the government raises revenue by imposing fresh
taxes or by raising the existing level of taxes, it helps to
reduce money supply.
• Similarly, market borrowing by the government reduces
money supply and raises the market interest rates. This is
known as the crowding out effect of government
borrowing.
• When the government spends the money so raised,
money supply increases.
• The opposite will be the impact of a surplus budget but
surplus budgets are a rarity in modern times.
7. Velocity of Circulation of Money: Velocity of
circulation of money refers to the average
number of times a unit of money as a
medium of exchange changes hands during a
given year. Money supply is measured as
total money in circulation multiplied by the
velocity of circulation (MxV). Thus higher the
velocity of circulation of money, higher will
be the money supply and vice versa.
 VELOCITY OF CIRCULATION OF MONEY
• The velocity of circulation of money determines the flow of
money supply in an economy in a given period of time,
normally such a period is one year.
• The average number of times a unit of money changes
hands is known as the velocity of circulation of money.
• The supply of money in a given period is obtained by
multiplying the money in circulation with the coefficient of
velocity of circulation i.e.,
• M x V where M refers to the total amount of money in
circulation and V refer to the velocity of circulation of
money in the given period.
 Factors Determining Velocity of Circulation of Money
1. Time Unit of Income Receipts: The more frequently people receive income, the
shorter will be the average time period of holding money and greater will be the
velocity of circulation of money.
• Thus if in a given society large number of people receive income on daily basis,
the velocity of circulation of money would be higher than the one in which
people receive income on weekly, fortnightly or monthly basis.
2. Method and Habits of Payment: The velocity of circulation of money would be
high if large number of people prefers to make payment on instalment basis. As
a result, the same unit of money will change hands more often than when
payments are made in full.
3. Regularity of Income Receipts: If in a society people receive income on a regular
basis, they will spend their current income without bothering about future and
hence the velocity of circulation of money would be high. However, if future
income receipts are uncertain, people will not spend more money in the present
and hence the velocity will be less.
4. Saving Habits of the People: If the marginal propensity to save is high in a society,
then the people will be spending less in the present and hence the velocity will
be less. Similarly, if the marginal propensity to consume is high the people will
spend more and the velocity of circulation of money will be high.
5. Income Distribution: Income distribution may be more equal or more
unequal in a society. If inequalities of income are high in a society with
the top 20 % taking away a major portion of the national income, velocity
of circulation of money would be low because the richer sections of the
society will be holding more idle cash balances. However, if income
distribution is more equal or less unequal, the bottom 40% of the people
will receive more incomes and spend more thereby increasing the
velocity of circulation of money.

6. Development of Banking and Financial System: If the banking and

financial institutions in a country are well developed, mobilization of
savings can be effectively carried out and more credit made available to
the needy. This not only prevents hoarding of cash balances but also
increases the velocity of circulation of both currency and bank money.
7. Business Cycle: During the prosperity phase of the business cycle,
investment, output, income, employment and prices rise. Thus the
velocity of circulation of money would be high during the prosperity
phase. However, during the downturn of the business cycle, investment,
output, income, employment and prices begin to decline thereby
reducing the velocity of circulation of money.

8. Liquidity Preference of the People: If the liquidity preference of the

people is high i.e., if they wish to hold a greater part of their income in
the form of idle cash balances, the velocity of circulation of money would
be low and vice versa.

9. Speedy Clearance of Cheques and Transfer of Funds: A more advanced

banking system would help speedy clearance of checques and transfer of
funds from one account to another account, thereby increasing the
velocity of circulation of money.