Money | Money Demand, Money Supply, Quantity Theory, Factors

Money Demand Demand for money represents the total amount of money an individual wishes to hold for various reasons. It reflects the inclination to keep resources in a liquid form rather than spending them and is termed Liquidity Preference in economics.   Motives For Holding Money Lord Menard Keynes proposed three main motives for holding […]

Money Demand

Demand for money represents the total amount of money an individual wishes to hold for various reasons. It reflects the inclination to keep resources in a liquid form rather than spending them and is termed Liquidity Preference in economics.

 

Motives For Holding Money

Lord Menard Keynes proposed three main motives for holding money:

  1. Transactional Motives: Individuals hold money for day-to-day transactions and to cover the gap between income receipt and expenditures.
  2. Precautionary Motives: Holding money in liquid form to address unforeseen contingencies or unexpected expenditures, such as sickness, unexpected visitors, or accidents.
  3. Speculative Motives: Holding money specifically for business transactions to engage in speculative dealings in the bond (security) market.

 

Money Supply

Money supply refers to the total amount of money available for use in the economy at a given time. It encompasses currency in the form of banknotes and coins circulating outside the banking system, as well as bank deposits in current accounts that can be withdrawn by cheque (i.e., bank money).

 

Factors Affecting Money Supply

Several factors influence the supply of money:

  1. Bank Rate: The interest rate charged by the Central Bank to commercial banks for lending or borrowing money, affecting the money supply.
  2. Cash Reserve Ratio: The percentage of deposits that commercial banks are expected to keep, where a higher ratio leads to lower money supply and vice versa.
  3. Economic Situation: The Central Bank adjusts the money supply based on inflation and deflationary periods.
  4. Demand for Excess Reserves: Increased demand for excess reserves by commercial banks results in an augmented money supply.
  5. Total Reserves of Central Bank: The money supply is influenced by the total reserves supplied by the Central Bank, with higher reserves leading to a higher money supply and vice versa.

 

Quantity Theory Of Money

Sir Irving Fisher’s quantity theory of money posits that the value of money depends on its circulation quantity. The theory, expressed as MV=PT (where M is the stock of money, V is the velocity of money, P is the average price level, and T is the total volume of transactions), establishes a connection between money, output, and prices.

EXAMPLE:

Using MV=PT with P=20, M=200,000, and T=20,000, the velocity of money (V) is calculated as V=20 x 20,000/200,000, resulting in V=2.

 

Criticisms Of The Quantity Theory Of Money

Critics argue that the quantity theory of money:

  1. Appears more as truism than a theory.
  2. Rests on the assumption of constant variables.
  3. Fails to consider factors outside the theory that may lead to changes in prices.
  4. Neglects the discussion of the effect of the interest rate.
  5. Emphasizes changes in the value of money while overlooking the determinants of its original value.
  6. Lacks acknowledgment of the demand for money, focusing solely on the supply side.

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