DEMAND OF MONEY

The demand for money is affected by several factors,– The level of income– Interest rates– Inflation–
Uncertainty about the future.The way in which these factors affect money demand is usually explained
in terms of the three motives for demanding money:

I. The transactions

II. The precautionary

III. The speculative motives

TRANSACTION OF MONEY
 The transactions motive for demanding money arises from the fact that most transactions
involve an exchange of money. Because it is necessary to have money available for transactions,
money will be demanded.• The total number of transactions made in an economy tends to
increase over time. Hence, as income or GDP rises, the transactions demand for money also
rises.

2. PRECAUTIONARY MOTIVE
People often demand money as a precaution against an uncertain future. Unexpected expenses,
such as medical or car repair bills, often require immediate payment. The need to have money
available in such situations is referred to as the precautionary motive for demanding money.

3. SPECULATIVE MOTIVE

Money, like other stores of value, is an asset. The demand for an asset depends on both its rate of
return and its opportunity cost.

Typically, money holdings provide no rate of return and often depreciate in value due to inflation.
The opportunity cost of holding money is the interest rate that can be earned by lending or investing
ones money holdings.

The speculative motive for demanding money arises in situations where holding money is perceived
to be less risky than the alternative of lending the money or investing it in some other asset.

EXAMPLE

For example, if a stock market crash seemed imminent, the speculative motive for demanding
money would come into play; those expecting the market to crash would sell their stocks and hold
the proceeds as money. The presence of a speculative motive for demanding money is also affected
by expectations of future interest rates and inflation. If interest rates are expected to rise, the
opportunity cost of holding money will become greater, which in turn diminishes the speculative
motive for demanding money. Similarly, expectations of higher inflation presage a greater
depreciation in the purchasing power of money and therefore lessen the speculative motive for
demanding money.
What is the difference between transaction and speculative demand for money?
 According to Keynse, money (liquidity) is demanded for three reasons; transaction (day to day,
routine expenses), precautionary (emergency, unforeseen expenses) and speculative reasons
(expecting that price of illiquid assets such as bonds will decrease in future and it's better to
keep liquid money in hand).

EXAMPLE

 Let's take the example of a bank which arranger a certain amount of cash every morning to be
able to pay customers who come to withdraw money prior to any deposits received by the bank.
This is a routine requirement of the business and the amount kept for this purpose is
determined by the size of the bank and total deposits it holds. A more prudent bank, however,
would keep some surplus amount in excess of its routine requirements to be able to meet any
sudden, unexpected, unforeseen cash requirements of the customers. This is precautionary
motive for demanding money and its amount also depends on the size of the bank. Another
reason for which the bank can keep more cash is low interest rate, as banks will prefer to keep
the cash instead of lending it to another bank /customer for a shorter duration of time
(overnight lending) as interest rates are too low to overcome the inconvenience of converting
cash into an illiquid asset (a loan or a government issued interest bearing security) and then
converting them back into cash. This is speculative motive of demanding money and unlike
transaction and precautionary motives, which depend on income of the bank (these motives
also depend on price level as higher prices force people to hold more cash for routine and
emergency payments) depend on interest rates. At higher interest rates less money is
demanded for speculative motives, however money demanded for transaction and
precautionary motives remain unaffected due to changes in interest rates.

SUPPLY OF MONEY
 The money supply of a country consists of currency (banknotes and coins) and bank
money (the balance held in checking accounts and savings accounts).
 Bank money, which consists only of records(mostly computerized in modern banking),
forms by far the largest part of the money supply in developed nations
 M1, M2, M3
 M1, M2, M3 are all measures of money supply, the amount of money in circulation at a
given time.

 M1, also called narrow money, normally include coins and notes in circulation and other
money equivalents that are easily convertible into cash.
 M2 is somewhat broader measure of the supply of money, which includes all of M1plus
savings and time deposits held at banks.
 M3 is an even broader measure of the money supply, which includes all of M2 plus large
denomination, long-term time
 M1 being the narrowest measure and M3 being the broadest.
 Narrow money refers to forms of money that are available immediately for use in
transactions,
 Broad those that are not immediately available.

Measures of Money Supply : M0, M1, M2, M3 and M4

 The total stock of money in circulation among the public at a particular
point of time is called money supply. The measures of money supply
classified into four categories M1, M2, M3 and M4 along with M0. Let’s
discuss these one by one:
 Reserve Money (M0): It is also known as High-Powered Money, monetary
base, base money etc.
M0 = Currency in Circulation + Bankers’ Deposits + Other deposits
It is the monetary base of economy.
 Narrow Money (M1):
M1 = Currency with public + Demand deposits with the Banking system
(current account, saving account) + Other deposits
 M2 = M1 + Savings deposits of post office savings banks
 Broad Money (M3)
M3 = M1 + Time deposits with the banking system
 M4 = M3 + All deposits with post office savings banks
Liquidity of these Measures of Money Supply
 The liquidity means how fast an instrument can be converted into cash. The
liquidity of these measures are in order M1>M2>M3>M4 i.e. M1 is most
liquid and M4 is least liquid.

Money Multiplier
 It is the relationship between monetary base and money supply in
economy. The amount money that banks generates with each unit
of money. It is the ratio of deposits to the reserves in the banking
system.
 Money multiplier= 1/ reserve ratio
 For example let’s say total deposit in banking system is $100 and
reserve ratio requirement is 10%.
The banks can lend 90% of deposit i.e. $90. This $90 that banks
will lend to its customers will ultimately be deposited in another
bank which can further lend 90% of that i.e. $81 and cycle
continues. Have you ever tried to read a financial article and
ended up barley understanding the terms and abbreviations.
Well, that should not keep you away from further reading these
very interesting financial anecdotes. Here are some to tell.
 Money is the focus of the whole scene in financial markets.
Money supply is measured in many forms.
 M0 (M-zero) and M1 are two abbreviations used to refer to coins
and notes in circulation in addition to other money equivalents
that can easily be converted into cash in an economy. They are
the “most liquid” part of funds flowing in that economy.
 M2 sometimes called “near money” and “quasi money” includes
M1 and short-term time deposits in banks (demand deposits,
check accounts, etc.) and 24-hour money market funds.
 M3 includes M2 plus “less liquid” funds such as longer-term time
deposits and money market funds with more than 24-hour
maturity.
 M4 includes M3 plus all other types of deposits (including post
office savings).
 Definitions and uses may differ according to the practices of each
country’s central bank. For example, M0 in England is referred to
as the “narrow money”, while in USA the latter is M1 (M0 +
 demand deposits). The term “broad money” can be used to refer
to M2, M3 and M4 depending on the local practice.
 Finally, it is not an easy task to measure “how much money” there
is in an economy. However, this is one of the "very interesting"
tasks that are carried out by the central bank of a country or of a
monetary union.
 M1, M2, M3, M4 they are four alternative measures of money
supply.
 I would like to answer this in India context.
 M1 measurement
 M1= C+DD+OD
 (C refers to currency which includes coins and paper notes held by
public,
 DD refers to demand deposits of public with commercial banks,
 OD refers to other deposits like demand deposits with RBI of
financial institutions like IDBI, foreign central banks or foreign
govts, international financial institutions like IMF world bank)
 It's the most liquid and narrow concept.
 M2 measurement
 Broader concept of money supply compared to M1, it includes M1
and short term deposits.
 THUS, it is M3 measurement
 M3 is broader concept of money supply compare to M1. Besides
all components of M1 it includes
 M3 = M1+ Net time deposits with commercial banks
 (It contains long term deposits and money market funds with
more than 24 hour maturity period).
 M2 = M1+Savings of people with post offices
 M4 measurement
 It is the most broader concept than any other aspect, it is low in
liquidity.
 It includes
 M4 = M3+Savings with post offices (other than national saving
certificates)
 Exact meanings of this four concepts can vary or say depends
upon different countries.