MACROECONOMICS – I

SESSION 7:Money

INTEGRATED PROGRAMME IN MANAGEMENT (IPM)

BATCH:2018-23 TERM:II
AY2018-19

Session Outline

• Functions of Money
• Components of Money Stock
• Theory of Money Demand

Macroeconomics-I IPM Term–II 2

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 What is Money?

• Money: Assets that people are generally

willing to accept in exchange for g&s for
payment of debts

• Asset: Anything of value owned by a person

or a firm

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Barter Economy & Money

• Economies where g&s are traded directly

for other g&s are called barter economies
• For a barter trade between two people,
each person must want what the other one
has
• Commodity money: A good used as money that
also has value independent of its use as
money

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 What Can Serve as Money?
Criteria to make a good suitable for use as
medium of exchange:
• Acceptable-Good must be acceptable by most
people
• Standardized quality-any two units are
identical
• Durable-value is not lost by spoilage
• Valuable-relates to its weight, so it is
easily transportable
• Divisible-As a medium of exchange should be
divisible because different goods are valued
differently
• Dollar/Rupee bills meet all these criteria

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Functions of Money

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 Functions of Money

• In a barter economy with no money, every

transaction has to involve exchange of
goods (and/or services) on both sides of
the transaction
• Money, as a medium of exchange, gets rid
of “double coincidence of wants”

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Functions of Money

Four traditional functions of money:

• medium of exchange
• store of value: A store of value is an asset
that maintains value over time
• unit of account: The unit of account is the
unit in which prices are quoted and books
kept
• standard of deferred payment: As a standard
of deferred payment, money units are used in
long-term transactions, such as loans
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 Components of Money Stock

Components of Money Stock

• Two main monetary aggregates: M1 and M2

• M1:comprises claims that can be used
directly, instantly, and without
restrictions to make payments
• These claims are liquid
– An asset is liquid if it can immediately,
conveniently, and cheaply be used for making
payments
– M1 corresponds most closely to the traditional
definition of money as means of payment
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 Components of Money Stock

• M2: includes, in addition, claims that are

not instantly liquid—withdrawal of time
deposits
– Example, may require notice to depository
institution

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Theory of Money Demand

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 Demand for Money

• Demand for money is a demand for real

balances
– People hold money for its purchasing power, for
the amount of goods they can buy with it
– Agents not concerned with their nominal money
holdings, i.e., number of dollar bills they hold
– Consider a money demand function that tells us
demand
for real balances, M/P not nominal balances, M
• Such behavior is described as:
An individual is free from money illusion
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Theories of Money Demand

Review theories that correspond to Keynes’s

famous three motives for holding money:
• The transactions motive, demand for money
arising from the use of money in making
regular payments
• The precautionary motive, demand for money to
meet unforeseen contingencies
• The speculative motive, arising from
uncertainties about money value of other
assets that an individual can hold
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 Transactions Demand for Money

• Transactions demand for money arises from

lack of synchronization of receipts and
disbursements
• Examine a simple model of how much money
an individual will hold to make purchases
• Tradeoff: Exists between amount of
interest forgone by holding money and
costs and inconveniences of holding a
small amount of money
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Transactions Demand for Money: Example

Suppose agent gets paid, $1,800 each month

1.Assume spend $1,800 evenly over the course
of the month, at the rate of $60 per day
2.On the first day of the month take $60 to
spend that day and put remaining $1,740 in
a daily-interest savings
– Every morning the person could go to the bank
and withdraw that day’s $60 from the savings
account

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 Transactions Demand for Money

• By the end of month depositor would have earned

interest on the money retained each day in the
savings account
• The Benefit of keeping the money holdings
down as low as $60 at the beginning of
each day is the interest earned
• The Cost of keeping money holdings down is
the cost and inconvenience of the trips to
the bank to withdraw the daily $60

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Transactions Demand for Money

• Starting with income Y, if n trips are made, the

average cash balance is Y/2n
• If each trip costs tc, the combined cost of trips
plus forgone interest is (n*tc)+i*(Y/2n).
• Choosing n to minimize costs and computing the
implied average money holdings leads to the famous
square-root Baumol-Tobin formula for the demand
for money:
𝑀 𝑡𝑐 ∗ 𝑌
𝑃 2𝑖

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 Transactions Demand for Money

𝑀 𝑡𝑐 ∗ 𝑌
𝑃 2𝑖
• Equation shows demand for money decreases with interest rate and
increases with cost of transaction
• Equation makes two very strong predictions:
– The income elasticity of money demand is 1/2, and the interest
elasticity is -1/2
– Empirical evidence supports the signs of these predictions but
suggests that the income elasticity is somewhat closer to 1 and
that the interest elasticity is somewhat closer to zero

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Precautionary Demand for Money

Demand for money arises because people are uncertain about

payments they might want, or have to make
– Realistically, an individual does not know precisely
what payments she or he will be receiving in the next
few weeks and what payments will have to be made
• If person does not have money with which to pay, she or
he will incur a loss
• The more money an individual holds, the less likely he or
she is to incur the costs of illiquidity
• But more money the person holds, the more interest he or
she is giving up

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 Precautionary Demand for Money
• Tradeoff similar to that examined in
transactions demand
• Added consideration is that greater
uncertainty about receipts and
expenditures increases the demand for
money
• Technology and structure of the financial
system are important determinants of
precautionary demand

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Speculative Demand for Money

• An individual who has wealth has to hold

that wealth in specific assets-those
assets make up a portfolio
• An investor would want to hold an asset
that provides highest returns
• Given that return on most assets is
uncertain, it is unwise to hold entire
portfolio in a single risky asset!

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 Speculative Demand for Money

• Typical investor wants to hold some amount

of a safe asset as insurance against
capital losses on assets whose prices
change in an uncertain manner
• Money is a safe asset-nominal value is
known with certainty
• In a famous article, James Tobin argued
that money would be held as safe asset in
the portfolios of investors
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Speculative Demand for Money

• The demand for money—the safest asset—

depends on expected yields and riskiness
of yields on other assets
• Tobin showed:
– An ↑ expected return on other assets—an
increase in the opportunity cost of holding
money-↓ money demand
– An ↑ in the riskiness of returns on other
assets ↑ money demand

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