The Demand for Money

 The demand for money is the quantities of money people are

willing and able to hold at alternative interest rates, ceteris
paribus.
 WHY HOLD MONEY?
 John Maynard Keynes noted that people had three reasons
for holding money
 People hold money to make transactions
 People hold money for precautionary reasons
 People hold money to speculate

demand for money

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 The Keynesian Motives for
Holding Money

 The transaction motive

 Individuals have day-to-day purchases for which they pay in
cash or by check
 Individuals take care of their rent or mortgage payment, car
payment, monthly bills and major purchases by check
 Businesses need substantial checking accounts to pay their
bills and meet their payrolls.
 The precautionary motive
 People will keep money on hand just in case some unforeseen
emergency arises
 They do not actually expect to spend this money, but they
want to be ready if the need arises

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 The Keynesian Motives for Holding Money

 The speculative motive

 When interest rates are very low you don’t stand to lose
much holding your assets in the form of money
 Alternatively, by tying up your assets in the form of
bonds, you actually stand to lose money should interest
rates rise
 You would be locked into very low rates

 This motive is based on the belief that better

opportunities for investment will come along and that,
in particular, interest rates will rise

demand for money

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 Why Hold money

 Economists have since identified four factors that influence

the three Keynesian motives for holding money
 The price level
 Income

 The interest rate

 Credit availability

demand for money

 Four Influences on the Demand for
Money

 The price level

 As the price level rises, people need to hold higher money balances to carry out
day-to-day transactions
 As the price level rises, the purchasing power of the dollar declines, so the longer
you hold money, the less that money is worth
 Even though people tend to cut down on their money balances during periods of
inflation, as the price level rises people will hold larger money balances.
 Income
 The more you make, the more you spend
 The more you spend, the more money you need to hold as cash or in your
checking account
 Therefore as income rises, so does the demand for money balances

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Four Influences on the Demand for
Money
 Interest rates
 The quantity of money demanded (held) goes down as interest rates rise
 The alternative to holding your assets in the form of money is to hold them
in some type of interest bearing paper
 As interest rates rise, these assets become more attractive than money
balances.
 Credit availability
 If you can get credit, you don’t need to hold so much money
 The last three decades have seen a veritable explosion in consumer credit in
the form of credit cards and bank loans
 Over this period, increasing credit availability has been exerting a
downward pressure on the demand for money

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Four Influences on the Demand for
Money
 Four generalizations
 As interest rates rise, people tend to hold less money
 As the rate of inflation rises, people tend to hold more money
 As the level of income rises, people tend to hold more money
 As credit availability increases, people tend to hold less money

demand for money

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Money supply

According to the standard concept of money supply, it is

composed of the following elements:
Currency with public
Demand deposit with public.(balances in bank accounts that
depositors can access on demand by writing a checque)
The money supply equals currency plus demand (checking
account) deposits:
M = C + D
Since the money supply includes demand deposits, the banking
system plays an important role
 FOUR MEASURES OF MONEY SUPPLY
There are four alternative measures of money supply, popularly known as M1 ,
M2 , M3 and M4.
1.Money supply M1 or Narrow money:
M1 – The first measure of money supply M1 consists of:
 Currency with the public which includes notes and coins of all
denominations in circulation excluding cash in hand with banks;
 Demand deposits with commercial and co-operative banks, excluding inter-
bank deposits; and
‘Other deposits’ with RBI which include current deposits of foreign central
banks, financial institutions and quasi-financial institutions such as IDBI, IFCI,
etc. RBI characterizes M1 as narrow money.
M1 = C+DD+OD
 Concept of M1

M1 is defined in traditional sense. It is a narrow concept of money

supply. That is why it is referred as ‘narrow money” it is measured
as follows:
M1 = C + DD + OD
C = currency with the public || DD = demand deposits with banks ||
OD = other deposits held with the Reserve Bank of India which
include demand deposits of quasi government institution, foreign
central banks, government (central and state) the International
Monetary Fund, the World Bank etc.
The usefulness of this measure of money supply lies in the fact that it
can be easily controlled by the central bank.
 Concept of M2

 M2 is a broader concept of money supply in India than M1. In addition

to the above mentioned three items of M1, this concept of M2 includes
saving deposits with post office saving banks. Thus,
M2 = M1 + saving deposits with post office
 Post office saving banks is not as liquid as demand deposits with banks
(commercial or cooperative) as they are not chequeable account.
However, saving deposits with post office are more liquid than time
deposits with the bank.
 Accounts: savings- fixed – recurring
 Fixed and recurring – time deposits
 Concept of M3:
M3 is again a broad concept of money supply. It is based on Milton Freidman’s approach to
the definition of money supply which include time deposits besides demand deposits and
currency money as the components of money supply thus,
M3 = M1 + Time Deposits with Banks
This is the broadest measure of money; it is used by economists to estimate the entire
supply of money within an economy. M3 is also called as Aggregate Monetary Resources
( AMR )
Money supply = M3
M3 shows total purchasing power of the economy
Purchasing power increases- demand increase-price increase –inflation-demand pull inflation
To reduce inflation- reduce purchasing power – contractionary measures- to tackle demand
pull inflation
RESERVE MONEY – HIGH POWERED MONEY
 Concept of M4
 M4 is an expanded measure of M3.

 M4 =M3 + Total Deposits with the Post Office Saving Organization

 The Reserve Bank of India regards these four measures of money supply i.e.
M1, M2, M3 and M4 in the descending order of liquidity. It supplies data on
them in its annual Report on Currency and Finance.
 Of the four inter-related money supply for which the RBI publishes data, it is M3
which is of special significance. It is M3 which is taken into account in formulating
macroeconomic objectives of the economy every year.