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6.3.2.1 Demand for Money and Stock of Money
The monetarist theory of demand for money can be illustrated with the Cambridge cash
balance approach to the equation of exchange: M = kPY. The Cambridge equation can be
interpreted as the demand for money. We then write the equation as
Md = kPY
6.18
Where, Md is demand for money. The demand for money is the willingness of people to hold
money; k represents the fraction of income people wish to hold in the form of money; P is the
price level, and Y is output.
According to monetarists people demand for money for variety of reasons including
store of value, transaction motive, and precautionary motive. The money stock (Ms) is set by
monetary authority like The Reserve Bank of India. The equilibrium occurs in all markets,
where the quantity demanded equals the quantity supplied, or
Md = Ms
6.19
There are five major factors that affect the demand for money is:
1.
Wealth: The relationship between wealth and demand for money is directly related.
Rich people hold more assets than poor people. Money is just one type of asset.
Greater the transactions, greater the demand for money. Thus, more the wealth, more
the demand for money.
2.
Rate of interest: Money held in the form of currency and coins earns no interest. If
rate of interest is low, demand for money (in cash) will be high and vice versa. The
cost of holding money is the interest rate foregone by not holding other assets. As the
rate of return on bonds, equities, and bank deposits rises; the demand for money
decreases because the cost of holding money increases. This shows that demand for
money is inversely related to the interest rate.
3.
The price level: The price level refers to prices of commodities. If price level goes up,
people will need to hold more money balances to carry out the same amount of
transactions. Consequently, demand for money balances rises when the price level
rises and declines when the price level declines. In essence, people adjust their
nominal money balances, M, in order to achieve their desired level of real money
balances. Real money balances means quantity of money in terms of the quantity of
goods and services it can buy. This amount, M/P, is called real money balances. Real
money balances measures the purchasing power of the stock of money. For example,
if price of a loaf of bread is Rs.5 and the quantity of money is Rs. 200, then real
money balances are 40 loaves of bread. That is at current prices, the stock of money in
the economy is able to buy 40 loaves of bread.
4.
The expected rate of inflation: Inflation reduces the value of money balances. If rate
of inflation exceeds the nominal rate of interest on money, it will reduce the
purchasing power of their current money holdings. People will therefore reduce their
holdings of money if the expected rate of inflation goes up. This indicates that
demand for money is inversely related to the expected rate of inflation.
5.
Institutional factors: The expected future stability of the economy will influence the
demand for money. Besides, prevailing pattern of bill payments and wage payments
affects the demand for cash balances. Demand for money will rise when economic
condition is unstable and vice versa.
A money demand function is an equation that shows what determines the quantity of
real money balances people wish to hold. A simple money demand function is,
(M/P)
d
= kY
6.20
Where, (M/P)
d
is demand for real money balances and k tells us how much money people
want to hold for every Rs. of income (Y). This equation states that the quantity of real money
balances demanded is proportional to real income.
The money demand function is just like the demand function for a particular good.
Here, the “good” is the convenience of holding real money balances
4
. Just as owning a
owning a automobile makes it easier for a person to travel, holding money makes it easier to
make transactions (see Fisher, approach). Therefore, high income leads to a greater demand
for automobiles, higher income also leads to a greater demand for real money balances
((M/P)
d
.
This money demand function offers another way to view the quantity equation. To see
this, add to the money demand function the condition that the demand for real money
balances (M/P)
d
must equal the supply of money. Therefore,
M/P = kY
6.21
M/P = 1/V(Y) (since k = 1/V)
MV = PY
6.22
The equation 6.22 is derived from equation 6.21. The V and K are inversely related to each
other because when people want to hold more money (K) for each Rs. of income (Y), there
will be less transaction means less velocity of circulation of money (V). Holding more money
of income (k is large), money changes hands infrequently (V is small) and holding less
money of income (k is small), money changes hands frequently (V is large).
Now, come to the equation 6.19
Md = Ms
If The Reserve Bank of India increases the money stock to Ms1, then desired money balances
will be less than the actual money balances. This may be shown as,
Md < Ms1
Because of increase in stock of money, people spend more, prices level will go up in the
short-run (because classical economists assumed full employment in the short-run). Increase
in price level (P) will reduce real money balances (M/P). The rising price level
5
increase the
demand for money balances until people become willing to hold the new, higher stock of
4.
Mankiw, Gregory, N, 2003, Macroeconomics, Worth Publishers: 84
5.
Kamerschen, et al, op. cit,: 37
Money. In terms of Cambridge equation, P is pushed up until Md = kPY is once again equal
to the stock of money (Ms1),
Md = kPY = Ms1
6.23
In actual economy, the transmission from money to prices is somewhat more complex. When
supply of money increases, people and businesses try to reduce their money balances in more
ways than simply increasing purchases of goods and services. They will also purchase other
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