Money Management

❑ What is Money?
Money is “anything which is widely accepted in payment for goods or in discharge of
other kinds of obligations”.

The Functions of Money:

Money is any object that is generally accepted as payment for goods and services
and repayment of debts in a given country or socio-economic context.
Anything used as money – whether a beaver pelt, a cowrie seashell, cigarettes, or a
dollar bill – should fulfill the following four functions:

1) Medium of Exchange: Money serves as a medium of exchange when sellers are

willing to accept it in exchange for goods and services. When the local
supermarket accepts your $5 bill in exchange for bread and milk, the 5 dollar bill
is serving as a medium of exchange.

With a medium of exchange, people can sell goods and services for money and use
the money to buy what they want. An economy is more efficient when a single
goods is recognized as a medium of exchange.
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2) Unit of Account:
In a barter system, each good has many prices. A cow may be worth two ploughs, 20
bushels of wheat, or six axes.

Once a single good is used a money, each good has a single price rather than many
prices.

This function of money gives buyers and sellers a unit of account, a way of measuring
value in the economy in terms of money.

Because the Canadian economy uses dollars as money, each good has a price in terms
of dollars.

3) Store of Value:
Money allows value to be stored easily. If you do not use all of your dollars to buy
goods and services today, you can hold the rest to use in the future.

Money is not the only store of value, however. Any asset – shares of Coca-Cola stock,
Canada bonds, real estate, or Renoir paintings, for example – represents a store of
value.
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Financial assets, such as stocks and bonds, offer an important benefit relative to
holding money because they pay a higher rate of interest or may increase in value in
the future.

Why do people hold any money? The answer has to do with liquidity or the ease with
which an asset can be converted into medium of exchange. Because money is the
medium of exchange , it is the most liquid asset.

4) Standard of Deffered Payment: Money is useful because it can serve as a

standard of differed payment in borrowing and lending. Money can facilitate exchange
at a given point in time by providing a medium of exchange and unit of account.

Money can facilitate exchange over time by providing a store of value and standard of
deffered of payment. For example, a computer manufacturer may buy hard drives
from another firm in exchange for the promise of making payment in 60 days.
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How important is it that money be a reliable store of value and standard of deferred
payment? People care about how much food , clothing, and other goods and services
their dollar will buy.

The value of money depends on its purchasing power, which refers to its ability to buy
goods and services. Inflation causes a decline in purchasing power because with rising
prices, a given amount of money can purchase fewer goods and services.

When inflation reaches the levels seen in Zimbabwe, money is no longer a reliable
store of value or standard of deferred payment.
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Types of Money: Generally we have two types of money such as: Narrow Money and
Broad Money.

Narrow Money (M1): Narrow money is a way of measuring and categorizing the
money supply within an economy. It includes specific kinds of money that are
highly liquid.

Due to its liquidity, it is easily accessible and can be used for immediate
spending.

Some examples include cash or checkable deposits.

It is important to note that foreign currency, however, is not included in narrow

money. Narrow money can also be known as M1.
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Board Money: Broad money is the secondary component of measuring the money
supply.

Although it does include all forms of narrow money, it includes additional forms that
are less liquid.

Typically, broad money is known as M2, M3, or M4.

M1 Examples: Notes and coins

M2 Examples: Notes, coins, traveler’s checks, and demand deposits
M3 Examples: Notes, coins, traveler’s checks, demand deposits, savings
deposits, and money market deposits
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M1 Money: The narrowest measure of money that the FED reports is M1, which
includes currency, checking accounts deposits, and traveler’s check.

These assets are clearly money because they can be used directly as a medium of
exchange.

Until the mid-1970s, only commercial banks were permitted to establish checking
accounts, and they were not allowed to pay interest on them.

With the financial innovation, regulations have changed, so that other types of banks,
such as savings and loan associations, mutual savings banks, and credit unions can
also offer checking accounts.
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M2 Money: The M2 monetary aggregate adds to M1 other assets that have

check-writing features (money market deposit accounts and money market mutual
fund shares) and other assets (small-denominator time deposits, saving deposits
overnight purchase agreements and overnight Eurodollars) that are extremely liquid
because they can be turned into cash quickly at very little cost.

M3 Money: The M3 monetary aggregate adds to M2 somewhat less liquid assets such
as large-denomination time deposits, term repurchase agreements, term Eurodollars,
and institutional money market mutual fund shares.
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❖Demand for Money and Supply of Money:

Demand for Money: The old idea about the demand for money was that money was
demanded for completing the business transactions.

In other words, the demand for money depended on the volume of trade or
transactions.

As such, the demand for money increased during boom period or when the trade was
brisk and it decreased during depression or slackening of trade.

The modern idea about the demand for money was put forward by the Lord John
Maynard Keynes, the famous English economist, who gave birth to what has been
called the Keynesian economics.

There are three main motives on account of which money is wanted by the people.
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1) Transaction demand
2) Precautionary demand
3) Speculative demand

4) Transaction demand: This motive can be looked at a) from the point of

consumers who want income to meet the household expenditure which may be
termed the income motive and b) from the point of view of the businessmen, who
require money and want to hold it in order to carry on their business i.e., the
business motive.

Income Motive: The transactions motive relates to the demand for money or the
need for cash for the current transactions of individual and business exchanges.
Individuals hold cash in order to bridge the interval between the receipt of income
and its expenditure. This is called the income motive.
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Most of the people receive their incomes by the week or the month, while the
expenditure goes on day by day. 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 current in the locality.

Business Motive: The businessmen and the entrepreneurs also have to keep a
proportion of their resources in ready cash in order to meet current needs of various
kinds.

They need money all the time in order to pay for raw materials and transport, to pay
wages and salaries and to meet all other current expenses incurred by any business
exchange. Keynes calls it the Business Motive for keeping money.
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The amount of money held under this business motive will depend to a very extent on
the turnover. The larger the turnover the larger in general will be the amount of money
needed to cover current expenses.

2) Precautionary Motive: 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 risk of unemployment,
sickness, accidents and other more uncertain perils (serious or immediate danger). The
amount of money held under this motive will depend on the nature of the individual
and on the conditions in which he lives.

3) Speculative Motive:
The speculative motive relates to the desire to hold one’s resources in liquid forms in
order to take advantage of market movements regarding the future changes in the rate
of interest.
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The notion of holding money for speculative motive is a new typically Keynesian
idea. Money held under the speculative motive serve as a store of value as money held
under the precautionary motive does. The cash held under this motive is used to make
speculative gains by dealing in bonds whose prices fluctuates. If bond prices are
expected to rise, means that the rate of interest is expected to fall, businessmen will
buy bonds to sell when the price actually rises.

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.

Supply of Money:
The supply of money means the supply of money to hold. Money must always be
held by someone, otherwise it cannot exist. Hence, the supply of money means the
sum of all the forms of money which are held by a community at any given moment.
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The stock of money, which constitutes the supply of it, consists of a) metallic money
or coin, b) currency notes issued by the currency authority of the country whether the
central bank or the government, c) chequable bank deposits.

In old times, the coins formed the bulk of money supply of the country.

Later the currency notes eclipsed the metallic currency and now the bank deposits in
current account withdrawn by cheques have overwhelmed all other forms of money.
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The modern economists includes in money stock not only currency or cash balances
and demand deposits in banks together called M1.

They also include time deposits in the bank called near money and call it M2 (=M1+
time deposits and deposits in post offices).

The total money stock is this sense is called M3. Further, term deposits in the form of
postal bonds/cash certificates are also included.

Thus money stock in this comprehensive sense includes currency, demand deposits in
banks, time deposits with banks plus total post office deposits, savings bank and term
deposits. It has been designed as M4.
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What is the Quantity Theory of Money?

The Quantity Theory of Money refers to the idea that the quantity of money
available (money supply) grows at the same rate as price levels do in the long
run.

When interest rates fall or taxes decrease and the access to money becomes less
restricted, consumers become less sensitive to price changes and, thus, will have
a higher propensity to consume. As a result, the aggregate demand curve will
shift right, thus shifting up the equilibrium price level.

Exchange Equation
To better understand the Quantity Theory of Money, we can use the Exchange
Equation. The equation enables economists to model the relationship between
money supply and price levels. The exchange equation is:
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M*V=P*Q

Where:
M – refers to the money supply
V – refers to the velocity of money, which measures how much a single dollar of
money supply spend contributes to GDP
P – refers to the prevailing price level
Q – refers to the quantity of goods and services produced in the economy

Holding Q and V constant, we can see that increases in the money supply will
cause price levels to increase, thus causing inflation.

The assumption that Q and V are constant holds in the long run as these factors
cannot be influenced by changes in the economy’s money supply.
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The theory provides a quick overview of monetarist theory, which states that
changes in the current money supply cause fluctuations in overall economic
output; excessive growth in money supply causes hikes in inflation.

Demand for Money

The Exchange Equation can also be remodeled into the Demand for Money
equation as follows:
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Md= P*Q/V

Where:
Md – Refers to the demand for money
P – refers to the price level in the economy
Q – refers to the quantity of goods and services offered in the economy
V – refers to the Velocity of Money

In the formula, the numerator term (P x Q ) refers to the nominal GDP of a

country. Moreover, the equation provides another take on the monetarist theory
as it relates GDP to the demand for money (contrary to Keynesian economists,
who believe that interest rates drive inflation).
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The velocity of Money refers to the frequency with which a unit of the currency
can be exchanged for purchasing the goods and the services that are
manufactured domestically during the specified time period i.e., it is a number
of times the money movement is there from one of the entities to another entity.

Velocity of money V= Nominal gross domestic product/Average amount of money

that circulates in the country