Macro Economics, B.K.

Patel, NSVK MBA College, Visnagar

#4. MONEY DEMAND AND SUPPLY

FUNCTIONS
LEARNING OBJECTIVES
1. TO UNDERSTAND THE ROLE OF MONEY IN THE ECONOMY
2. TO UNDERSTAND THE FACTORS, WHICH DETERMINE THE DEMAND
FOR AND SUPPLY OF MONEY.
3. AND TO UNDERSTAND THE MONEY CREATION

 THE TERM MONEY IS DEFINED IN CH#4.

 MONEY IS NOT A COMPONENT OF THE REAL WEALTH OF THE
NATION.
DEMAND FOR MONEY
 THERE ARE THREE MOTIVES FOR HOLDING MONEY
 TRANSACTION MOTIVE
 It is to hold money to carry out the day to day
operations.
 PRECAUTIONARY MOTIVE
 it is to hold money for future not-predictable
expenses, payment or transaction.(contingency)
 SPECULATIVE MOTIVE
 it is due to the uncertainty about the yield on
money and the alternative assets
 MONEY IS THE MOST LIQUID, AND UNIVERSALLY ACCEPTABLE
ASSET.
 MONEY IN FORM OF CURRENCY OR DEMAND DEPOSIT IS HELD
FOR THE FIRST MOTIVE WHILE TIME DEPOSITS ARE HELD FOR
THE LAST TWO MOTIVES IN ABOVE MENTIONED MOTIVES. THE
REASON IS DEMAND DEPOSITS ARE WITHDRAWN THROUGH
 Macro Economics, B.K. Patel, NSVK MBA College, Visnagar
CHEQUES, AND TIME DEPOSITS COULD BE WITHDRAWN AT ANY
TIME AT A LOSS OF INTEREST.
DETERMINANTS OF MONEY DEMAND
1. INCOME
 There is positive correlation between income
level and demand for money because there is
a positive correlation between income and
consumption, and one require money for
consumption
2. WEALTH
 Money is one of the asset in the form of
which, the people could hold their portfolio
of assets.
 There is a positive correlation between
wealth and demand for money as more the
wealth a person has, the more one would
save, and the larger would be the size of
one’s portfolio.
3. INTEREST RATE
 There is negative correlation between
interest rates and demand for money
 Holding money has opportunity cost as those
money could have been invested to earn
interest (return) instead of holding as
currency or in the form of demand deposits
in bank. The opportunity cost for time
deposits is the return from various bond, and
equity instruments. Therefore higher interest
rate is a de-motivating factor for holding
money or demand for money.
 Macro Economics, B.K. Patel, NSVK MBA College, Visnagar
 There is negative relationship between
demand for money and the rate of inflation.
 There are some other views also which argue
that the transaction, and precautionary
demand for money is a direct function of
income only while the speculative demand
for money is an inverse function of interest
rates only. Because there is shoe-leather
cost in holding money for transaction and
precautionary motive in the form of
investments in high interest bearing
instruments.

COMPONENTS OF MONEY SUPPLY

1. CURRENCY
 The currency is issued by the central
(federal) bank in India and the ministry of
finance. (Only one rupee notes and coins).
 The issuer has monopoly power for printing
currency, which is granted by the
constitution
 The issued currency is a liability for the
central bank, which has to be backed by
assets like gold, foreign exchange, and
government securities.
 Since 1957 RBI is required to have a
minimum of Rs. 2000 millions in form of
gold and forex reserves, of which 1150
millions must be in form of gold. All the
 Macro Economics, B.K. Patel, NSVK MBA College, Visnagar
remaining amount could come from
government securities.
2. BANK DEPOSITS
 Currency is held partly by public and partly
banks.
 If banks work as store room of money, the
money supply in economy would just equal
currency.
 There is big difference between money
supply and the volume of currency because
the banks are commercial entities, fractional
reserve system, and multiple creation of
deposits.

MULTIPLE CREATION OF DEPOSITS

 BANKS ACT AS A BRIDGE BETWEEN SURPLUS ECONOMIC UNITS
AND DEFICIT ECONOMIC UNITS.
 SURPLUS ECONOMIC UNITS ARE THOSE WHO HAVE POSITIVE
SAVINGS(surplus of income over consumption). DEFICIT
ECONOMIC UNITS ARE THOSE WHO HAVE NEGATIVE SAVINGS
(difference between fund available and fund required for
operations, growth, expansion, or development )
 THE TERM MULTIPLE CREATION OF DEPOSITS COULD BE
EXPLAINED THROUGH THE FOLLOWING EXAMPLE1
 SUPPOSE THE CASH RESERVE RATIO2 IS 20%. (FRACTIONAL
RESERVE SYSTEM).

1
In this example it is assumed that the reserve with bank itself for the purpose of day to day operations is zero or
constant and all the advances granted to the public are deposited bank in the banking sector.
2
CRR is the % amount of total net deposits, that has to be kept as a reserve with RBI. It safeguards the interest of
the depositors and it is a weapon of the monetary policy of the central bank to control the money supply and
liquidity in the economic system.
 Macro Economics, B.K. Patel, NSVK MBA College, Visnagar

All the figures are in Rs. Cr.

STEP-1: PERSON-X DEPOSITS 1000 RUPEES IN A BANK
LIABILITIES ASSETS
DEPOSITS 1000 RESERVES (crr) 200
LOAN (ADVANCES) 800
STEP-2:
BANK GRANTS ADVANCES OF RS 800 TO
THE PUBLIC WHICH IS AGAIN DEPOSITED IN THE
BANKING SYSTEM
DEPOSITS 1800 RESERVES (crr)
(1000+ (200+20%OF 800) 360
800) LOAN (ADVANCES)
(800+80% OF 800) 1440
STEP-3: BANK GRANTS ADVANCES OF RS 640 TO THE PUBLIC
WHICH IS AGAIN DEPOSITED IN THE BANKING SYSTEM
 SO IN THE ABOVE MENTIONED WAY BANKS CREATE MONEY
 THE FINAL VALUE OF Rs. 1000 WILL BECOME Rs. 5000 IF THE
CRR IS 20% AND IT BECOMES 10000 Rs. IF CRR IS 10%.
 IN GENERAL THE RUPEE ONE OF THE FIRST DEPOSIT WOULD
CREAT THE TOTAL DEPOSITS OF RUPEES 1 / r, WHERE r= THE
FRACTION OF DEPOSITS HELD AS RESERVE BY THE BANKS.
 SECONDARY DEPOSIT CREATED BY THE BANK IS EQUAL TO
TOTAL DEPOSITS CREATED BY THE BANK- PRIMARY
DEPOSIT DEPOSITED IN THE BANK.
 IN THE ABOVE EXAMPLE PRIMARY DEPOSIT OF Rs. 1000 HAS
CREATED A SECONDARY DEPOSIT OF Rs. 4000.
 THE CREATION OF MONEY INCREASES SUPPLY OF MONEY OR
LIQUIDITY IN THE SYSTEM, BUT DOESN’T EFFECT THE WEALTH
OF THE NATION.
 Macro Economics, B.K. Patel, NSVK MBA College, Visnagar
MONEY SUPPLY FUNCTION:SSS