Macroeconomics

Session 6
Demand for Money
 What is Money?

What is money? Why does anyone want it?

• In economics, money = medium of exchange or means of payment

• What ever is accepted in exchange

• Demand for money refers to the stock of assets held as cash, checking
accounts, and closely related assets, specifically not generic wealth or
income
• Why consumers and firms hold money as opposed to an asset with a higher
rate of return?
Classical Quantity Theory of Money (Theory of inflation)
• The quantity theory of money provides a very simple way to organize thinking about
the relation between money, prices, and output:
M * V = P * Y (1)
where M = Money stock, V = transaction velocity of circulation, P=
average price level, Y = output of goods and services

• Equation (1) is the famous quantity equation, linking the price level and the level of output to
the money stock

• Classicals argued that both V and Y were fixed

 If both V and Y are fixed, it follows that the price level is proportional to the money stock
 Classical Quantity Theory of Money
• Money market is in equilibrium where money supply = money demand. Thus,
Ms = Md
i.e. Md = 1/V *P*Y (2)

• With velocity assumed constant, and in classical case (vertical) supply

function, Y is also fixed
• Money demand is proportional to nominal value of the goods and services produced
in an economy.

• Thus, higher the price level, higher the demand for money
 The Demand for Money: Theory by Keynes

• The demand for money is the demand for real money balances →
people hold money for its purchasing power

• Real money demand is unchanged when the price level increases, and all real variables,
such as the interest rate, real income, and real wealth, remain unchanged
• An individual is free from money illusion if a change in the level of prices, holding all real
variables constant, leaves the person’s real behavior, including real money demand,
unchanged

An individual is free from money illusion if a change in the level of prices,

holding all real variables constant, leaves the person’s real behavior,
including real money demand, unchanged.
 The Demand for Money: Theory by Keynesians

• The theories covered here correspond to Keynes’s famous three

motives for holding money:

• The transactions motive, which is the demand for money arising from the use
of money in making regular payments

• The precautionary motive, which is the demand for money to meet

unforeseen contingencies

• The speculative motive, which arises from uncertainties about the money
value of other assets that an individual can hold
 Transaction Demand
• The transaction demand for money arises from the lack of
synchronization of receipts and disbursements
• You are not likely to get paid at the exact moment you need to make a
payment → keep money on hand to make purchases between pay periods

• There is a tradeoff between the amount of interest an individual

forgoes by holding money and the costs of holding a small amount of
money
• Benefits of keeping small amounts of money on hand is interest earned on
money left in the bank
• Cost of keeping small amounts of money is the cost and inconvenience of
making trips to the bank to withdraw more
 The Precautionary Motive
• People are uncertain about the payments they might want or have to
make → there is demand for money for these uncertain events

• The more money a person holds, the less likely he or she is to incur the
costs of illiquidity
• The more money a person holds, the more interest he/she will give up →
similar tradeoff encountered with transactions demand for money
• Added consideration is that greater uncertainty about receipts and expenditures increases
the demand for money

• Technology and the structure of the financial system are important

determinants of precautionary demand
 Speculative Demand for Money
• Speculative demand for money focuses on the store-of-value function
of money → concentrates on role of money in the investment
portfolio of an individual

• Money is a safe asset

• Demand for money depends upon the expected yields and riskiness of the
yields on other assets
 Increase in the opportunity cost of holding money lowers money demand
 Increase in the riskiness of the returns on other assets increases money demand
 Aggregate Demand for Money

Mt = f1(Y) + f2(r)
Mp = f1(Y) + f2(r)
Msd = f1 (r)

• Thus, aggregate money demand, Md = f1(Y) + f2(r)

• Revised by Tobin and Baumol:
Md = f(Y, r)
 Components of the Money Stock
• M0: = Currency in Circulation + Bankers’ Deposits with RBI + ‘Other’ Deposits with RBI

• M1 = Currency with the Public + Demand Deposits with the Banking System + ‘Other’ Deposits
with RBI

• M2 = M1+ Time Liabilities Portion of Savings Deposits with the Banking System + Certificates of
Deposit issued by Banks + Term Deposits of residents with a contractual maturity of up to and
including one year with the Banking System+ Post Office Savings Deposits 

• M3 = M2+ Term Deposits of residents with a contractual maturity of over one year with the
Banking System + Call/Term borrowings from ‘Non-depository’ financial corporations by the
Banking System
• As liquidity of an asset decreases, the interest yield increases
• A typical economic tradeoff: in order to get more liquidity, asset holders have to sacrifice
yield