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8
MONEY MARKET

UNIT 1 – THE CONCEPT OF MONEY DEMAND

INTRODUCTION
Money may make the world go around, it plays an essential role in causing the things in
life to work as they should; to underlie the fulfilment of the needs of human existence.
And most people in the world probably have handled money, many of them on a daily
basis. But despite its familiarity, probably few people could tell you exactly what money
is, or how it works.
In short, money can be anything that can serve as a
(1) store of value, which means people can save it and use it later—smoothing their
purchases over time;
(2) unit of account, that is, provide a common base for prices; or
(3) medium of exchange, something that people can use to buy and sell from one
another.

FIAT MONEY
Until relatively recently, gold and silver were the main currency people used. Gold and
silver are heavy, though, and over time, instead of carrying the actual metal around and
exchanging it for goods, people found it more convenient to deposit precious metals at
banks and buy and sell using a note that claimed ownership of the gold or silver deposits.
Anyone who wanted to could go to the bank and get the precious metal that backs the
note. Eventually, the paper claim on the precious metal was delinked from the metal.
When that link was broken, fiat money was born. Fiat money is materially worthless, but
has value simply because a nation collectively agrees to ascribe a value to it. In short,
money works because people believe that it will.

DEFINE MONEY AND DESCRIBE ITS NATURE AND CHARACTERISTICS

Money is all the center of every economic transaction and plays a significant role in all
economies. In simple terms money refers to assets which are commonly used and accepted

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as a means of payment or as a medium of exchange or of transferring purchasing power.

For policy purposes, money may be defined as the set of liquid financial assets, the
variation in the stock of which will impact on aggregate economic activity.
Money has generalized purchasing power and is generally acceptable in settlement of
all transactions and in discharge of other kind of business obligations including future
payments.
Anything that would act as a medium of exchange is not necessarily money. For example,
a bill of exchange may also be a medium, but it is not money since it is not generally
accepted as a means of payment. Money is a totally liquid asset as it can be used directly,
instantly, conveniently and without any cost or restriction to make payment.
At the fundamental level, money provides us with a convenient means to access goods
and services. There are some general characteristics that money should possess in order to
make it serve its function as money. Money should be:
 Generally acceptable
 Durable or long lasting
 Effortlessly recognizable
 Difficult to counterfeit i.e. easily reproducible by people
 Relatively scarce, but has elasticity of supply
 Portable or easily transported
 Possessing uniformity, and
 Divisible into smaller parts in usable quantities or fractions without losing value.

EXPLAIN THE FUNCTION PERFORMED BY MONEY:

The following points highlight some of the important functions of money:
1. Medium of Exchange: Money is a convenient medium of exchange or it is an instrument
that facilitates easy exchange of goods and services. Money, though not having any
inherent power to directly satisfy human wants, by acting as a medium of exchange,
it commands purchasing power and its possession enables us to purchase goods
and services to satisfy our wants.
By acting as an intermediary, money increases the ease of trade and reduces the
inefficiency and transaction costs involved in a barter exchange. By decomposing
the single barter transaction of sales and purchase, money eliminates the need for
double coincidence of wants. Money also facilities separation of transaction both in
time and place and this in turn enables us to economize on time and efforts involved
in transactions.

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2. Unit of Account: Money is an explicitly defined unit of value or unit of account. Put
differently, money is a common measure of value’ or ‘common denominator of value’
or money function as a numeracies. We know, Rupee is the unit in India in which the
entire money is denominated.
The monetary unit is the unit of measurement in terms of which the value of all
goods and services is measured and expressed. The value of each good or service is
expressed as price, which is nothing but the number of monetary units for which the
good or service can be exchanged.
It is convenient to trade all commodities in exchange for a single commodity. So
also, it is convenient to measure the price of all commodities in terms of a single
unit, rather than record the relative price of every good in terms of every other good.

3. Standard of deferred payment: Money serves as a unit or standard of deferred payment

i.e. money facilitates recording of deferred promises to pay. Money is the unit in terms
which future payment are contracted or stated. However, variation in the purchasing
power of money due to inflation or deflation, reduce the efficacy of money in this
function.

4. Store Value: Like nearly all other assets, money is a store of value. People prefer
to hold it as an asset, that is, as part of their stock of wealth. This splitting of
purchases and sales in to two transaction involves a separation in the both time and
space. This separation is possible because money can be used as a store of value or
store of means of payment during the intervening time. Again, rather than spending
one’s money at present, one can store it for use at some future time.

‘THE QUANTITY THEORY OF MONEY IS NOT THEORY ABOUT MONEY AT ALL, RATHER IT IS
THEORY OF THE PRICE LEVEL’ ELUCIDATE.
The quantity theory of money, one of the oldest theories in Economics, was first propounded
by Irving Fisher of Yale University in his book ‘The Purchasing Power of Money’ published
in 1911 and later by the neoclassical economist. Both versions of the QTM demonstrate
that there is strong relationship between money and price level and the quantity of
money is the main determinant of the price level or the value of money. In other words,
changes in the general level of commodity prices or changes in the value or purchasing
power of money are determined first and foremost by changes in the quantity of money
in circulation.

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Fisher’s version, also termed as ‘equation of exchanges’ or ‘transaction approach’ is

formally stated as follows:
MV = PT

Where, M= the total amount of money in circulation (on an average) in an economy

V = transaction velocity of circulation i.e. the average number of times across all transaction
a unit of money (say Rupee) is spent in purchasing goods and services
P = average price level (P=MV/T)
T = the total number of transactions.

Later, Fisher extended the equation of exchange to include demand (bank) deposite (M’)
and their velocity (V’) in the total supply of money. Thus, the expanded form of the
equation of exchange becomes:
MV + M’V’ = PT

Where M’ = the total quantity of credit money

V’ = velocity of circulation of credit money.
The total supply of money in the community consists of the quantity of actual money (M)
and its velocity of circulation (V). Velocity of money in circulation (V) and the velocity of
credit money (V’) remain constant. T is a function of national income. Since full employment
prevails, the volume of transaction T is fixed in the short run. Briefly out, the total volume
of transaction (T) multiplied by the price level (P) represents the demand for money. The
demand for money (PT) is equal to the supply of money (MV + M’V’)’. In any given period,
the total value of transaction made is equal to PT and the value of money flow is equal
to MV+M’V’.
Thus from the above discussion it can be clearly concluded that the Quantity Theory of
Money (QTM) states that there is a direct relationship between the quantity of money in
an economy and the level of price of goods and services sold.

EXPLAIN NEO CLASSICAL THEORY OF DEMAND OF MONEY.

The Cambridge approach: In the early 1900s, Cambridge Economists Alfred Marshall, A.C.
Pigou, D.H. Robertson and John Maynard Keynes (then associated with Cambridge) put
forward a fundamentally different approach to quantity theory, known as neoclassical
theory or cash balance approach. The Cambridge version holds that money increases
utility in the following two ways:

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(a) enabling the possibility of split-up of sale and purchase to two different points of
time rather than being simultaneous, and (Transaction Motive)
(b) being a hedge against uncertainty. (Precautionary Motive)
While the fist above represents transaction motive, just as Fisher envisaged, the second
points to money’s role as a temporary store of wealth. Since sale and purchase of
commodities by individuals do not take place simultaneously, they need a ‘temporary
adobe’ of purchasing power as a hedge against uncertainty. As such, demand for money
also involves a precautionary motive in Cambridge approach. Since money gives utility in
its store of wealth and precautionary modes, one can say that money is demanded for
itself.
The Cambridge equation is stated as: Md=kPY
Where
Md = is the demand for money
Y = real national income
P = averages price level of currently produced goods and services
PY = nominal income
K = proportion of nominal income (PY) that people want to hold as cash balances
The term ‘k’ in the above equation is called ‘Cambridge k’. The equation above explains
that the demand for money (M) equals k proportion of the total money income.

EXPLAIN KEYNESIAN APPROACH OF DEMAND OF MONEY OR LIQUIDITY THEORY BY KEYNES

Keynesian Approach
↓
Liquidity preference Approach
↓
J.M.Keynes (1936)
↓
General theory of employment Interest money.
[Demand for money both as a medium of exchange & store of value]
Transaction motive
People require money to carry out transaction at all types but most of them receive income
once is a month sometimes once in a week or even daily in case of daily wage earners.
There is a time gap between two successive Income receipts but not between the expenses
incurred on various transaction. Transaction motive is divided in to two parts,
(1) Income motive
(2) Business motive

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Income motive:
It refers to transaction demand for money by wages and salary earners. They receive their
Income once in a month, in few cases weekly or daily. Money is required for these people
to carry out transaction at all kind they may incur regular payment like Rent, electricity,
grossary bill & other payments. Suppose the time interval between Income receipts is a
month. People required to hold money with them to meet the daily payments. Money
held for this purpose gradually decline over the period.

Business motive:
Business firms required to hold money to meet their day to day transaction. The time
interval of a firm may be a month or two or even longer as there is always a time gap
between production and realization of its value. Meanwhile they are required to keep
money for payment of various bills such as electricity, rent, raw material, wages etc. The
amount of money held for transaction motive depends on three factors.
1. Level of income 2. Time interval 3. Price level

Precautionary motive:
It is necessary to be cautious about future which is uncertain. Uncertainity is an important
element in Keynesian precautionary motive and additional amount of money over and
above for a known -requirement is held for contingencies, sudden expenditure, illness,
accident or to grab opportunity of advantageous purchase money may also be required
at a time of temporary unemployment.
Business people hold cash with them to meet any unforeseen expenditure or to take
advantage of favourable market condition when price declines. A firm’s precautionary
demand for money is influenced by political uncertainty. When political conditions are
unstable business firms tend to be more cautious and hold larger amount of cash. The
demand for money for transaction & precautionary motive is directly related to income.
Income Elastic

Demand for money for transaction & precautionary motive

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The combined demand for transaction & precautionary motive is expressed as L1 = F(Y)
The demand for money for these motives is not influenced by rate of interest.
Interest inelastic

Demand for money for transaction & precautionary motive

Demand for money for speculative motive

 Demand for money for speculative motive is related to store of value function of
money.
 Speculative demand is also known as Asset demand for money
 People have the alternative to hold the either cash or financial asset like government
bonds & equities
 Speculative demand also relates to uncertainty
 The cash held under this motive is used to make speculative gain by dealing on
bond whose price fluctuates.

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 If bond prices are expected to rise, businessman will buy bonds on other hand is
bond price are expected to fall, businessman will sell bonds to avoid capital losses.
 However Market interest rate is expected to fall, businessman will buy bonds, if
interest rate is expected to rise they will sell bonds. This implies that bond price and
MRI are inversely related to each other
Market rate interest vs BONDS
BONDS MRI ------- FD
↓ 1000/- x 5% 10%
= 50/- 8% ( ROI rises )
7.5%
5.5%
500x10%
=50/-

 Equal amount of return (i.e.) Rs. 50 will be earned by making a financial investment
of just Rs. 500 hence a Rs.1,000 bond value has declined to Rs. 500
 Keynes assumes that at very high rate interest (low bond price) all other asset
holder will be bulls
 On other hand, at low rate of interest (high bond price) all other asset holder will
be bears
 Speculative demand for money increases as market interest rate fall and vice versa.
Demand for money held under speculative motive is as demand for idle cash balance
L2 = F(r) → Rate of interest

List out the factor that determine the demand for money in the Baumol-Tobin analysis of
transactions demand for money? How does a change in each affect the quantity of money
demanded?
Baumol (1952) and Tobin (1956) developed a deterministic theory of transaction demand
for money, known as Inventory Theoretic Approach, in which money or ‘real cash balance’
was essentially viewed as an inventory held for transaction purposes. Inventory models
assume that there are two media for storing value:
(1) Money and
(2) An interest-bearing alternative financial asset.
There is a fixed cost of making transfers between money and the alternative assets
e.g. broker charges. While relatively liquid financial assets other than money (such
as, bank deposits) offer a positive return, the above said transaction cost of going
between money and these assets justifies holding money.

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Baumol used business inventory approach to analyze the behaviour of individual. Just
as businesses keep money to facilitate their business transactions, people also hold
cash balance which involves an opportunity cost in terms of lost interest. Therefore,
they hold an optimum combination of bonds and cash balance, i.e., an amount that
minimizes the opportunity cost.
Excess cash over and above what is required for transaction during the period under
consideration will be invested in bonds or put in an interest-bearing account. Money
holding on an average will be lower if people hold bonds or other interest yielding
assets.
The higher the income, the higher is the average level or inventory of money holdings.
The level of inventory holding also depends also upon the carrying cost, which is the
interest forgone by holding money and not bonds, net of the cost to the individual
of making a transfer between money and bonds, say for example brokerage fee.
The inventory-theoretic approach also suggests that the demand for money and
bonds depend on the cost of making a transfer between money and bonds e.g. the
brokerage fee. An increase the brokerage fee raises the marginal cost of bond market
transactions demand for money and lowers the average bond holding over the period.

To what extent does Friedman’s Restatement of the Quantity Theory explain the demand for money?
Milton Friedman (1956) extended Keynes’ speculative money demand within the
framework of assets price theory. Friedman treat the demand for money as nothing more
than the application of a more general theory of demand for capital assets.
Demand for money is affected by the same factors as demand for any other assets, namely
1. Permanent income.
2. Relative return on assets. (Which incorporate risk).
Friedman maintains that it is permanent income and not current income that determines
the demand for money. Permanent income which is Friedman’s measure of wealth is the
present expected value of all future income. To Friedman, money is a good as any other
durable consumption good and its demand is a function of a great number of factors.

Fried identifies the following four determinates of the demand for money.
The nominal demand for money:
 Is a function of total wealth, which is represented by permanent income divided by the
discount rate, defined as the average return on the five asset classes in the monetarist
theory world, namely money, bond, equity, physical capital and human capital.
 Is positively related to the price level, P. If the price level rises the demand for

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money increases and vice versa.

 Raises if the opportunity costs of money holding (i.e. returns on bonds and stock)
decline and vice versa.
 Is influenced by inflation, a positive inflation rate reduces the real value of money
balances, thereby increasing the opportunity coast of money holdings.

‘Risk-avoiding behaviour of individual provided the foundation for the liquidity preference and for a
negative relationship between the demand for money and the interest rate’ Elucidate with examples.
‘Liquidity Preference as Behaviour towards Risk’ (1958). Tobin established that the
theory of risk-avoiding behaviour of individuals provided the foundation for the liquidity
preference and for a negative relationship between the demand for money and the
interest rate. The optimal portfolio structure is determined by
1. the risk/reward characteristics of different assets
2. the taste of the individual in maximizing his utility consistent with the existing
opportunities
In his theory which analyzes the individual’s portfolio allocation between money and bond
holdings, the demand for money is considered as a store of wealth. Tobin hypothesized
that an individual would hold a portion of his wealth in the form of money in the portfolio
because the rate of return on holding money was more certain than the rate of return on
holding interest earning assets and entails no capital gains or losses. It is riskier to hold
alternative assets vis-a vis holding interest just money alone because government bonds
and equities are subject to market price volatility, while money is not.
According to Tobin, rational behaviour of a risk-averse individual induces him to hold an
optimally structured wealth portfolio which is comprised of both bond and money. The
overall expected return on the portfolio would be higher if the portfolio were all bonds,
but an investor who is ‘risk-averse’ will be willing to exercise a trade-off and sacrifice
to some extent the higher return for a reduction in risk. Tobin’s theory implies that the
amount of money held as an asset depends on the level of interest rate. An increase in the
interest rate will improve the terms on which the expected return on the portfolio can be
increased by accepting greater risk. In response to the increase in the interest, the individual
will increase the proportion of wealth held in the interest-bearing asset, say bonds, and
will decrease the holding of money. Tobin’s analysis also indicates that uncertainty about
future changes in bond prices, and hence the risk involved in buying bonds, may be a
determinant of money demand. Just as Keynes’ theory, Tobin’s theory implies that the
demand for money as store of wealth depends negatively on the interest rate.
SHORT NOTE ON LIQUIDITY TRAP: (Diagram same as speculative motive)

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Definition:
Liquidity trap is defined as set of points on liquidity preference schedule when the
percentage change in demand for money in response to % change in rate of interest is
infinite.
The inverse relationship between rate of interest and speculative demand for money
transforms in to a different form of relationship, at a very low rate of interest speculative
demand for money becomes perfectly elastic. Keynes considered 2% rate of interest as
the lowest below which market rate of interest would not decline at such low rate of
interest people prefer cash and not securities or any other assets as the risk is far greater
than interest offered. At point C the L2 curve become horizontal straight line, and that
horizontal part of L2 curve shows liquidity trap.

‘There is no unique definition of ‘money’, either as a concept in economic theory or as

measured in practice. Money can be defined for policy purposes as the set of liquid
financial assets, the variation in the stock of which could impact on aggregate economic
activity. As a statistical concept, money could include certain liquid liabilities of a
particular set of financial intermediaries or other issuers’. (Reserve Bank of India Manual
on Financial and Banking Statistics, 2007)

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1.3.3 The Keynesian Theory of Demand for Money

Keynes’ theory of demand for money is known as ‘Liquidity Preference Theory’. ‘Liquidity
preference’, a term that was coined by John Maynard Keynes in his masterpiece ‘The General
Theory of Employment, Interest and Money’ (1936), denotes people’s desire to hold money
rather than securities or long-term interest-bearing investments.

According to Keynes, people hold money (M) in cash for three motives:
(i) Transactions motive,

(ii) Precautionary motive, and

(iii) Speculative motive.
(a) The Transactions Motive
The transactions motive for holding cash relates to ‘the need for cash for current transactions
for personal and business exchange.’ The need for holding money arises because there is lack
of synchronization between receipts and expenditures. The transaction motive is further
classified into income motive and business (trade) motive, both of which stressed on the
requirement of individuals and businesses respectively to bridge the time gap between receipt
of income and planned expenditures.

Keynes did not consider the transaction balances as being affected by interest rates. The
transaction demand for money is directly related to the level of income. The transactions
demand for money is a direct proportional and positive function of the level of income and is
stated as follows:

Lr = kY

Where

Lr, is the transactions demand for money,

k is the ratio of earnings which is kept for transactions purposes

Y is the earnings.

Keynes considered the aggregate demand for money for transaction purposes as the sum of
individual demand and therefore, the aggregate transaction demand for money is a function
of national income.

(b) The Precautionary Motive

Many unforeseen and unpredictable contingencies involving money payments occur in our
day to day life. Individuals as well as businesses keep a portion of their income to finance
such unanticipated expenditures. The amount of money demanded under the precautionary

© The Institute of Chartered Accountants of India

 MONEY MARKET 8.9

motive depends on the size of income, prevailing economic as well as political conditions and
personal characteristics of the individual such as optimism/ pessimism, farsightedness etc.
Keynes regarded the precautionary balances just as balances under transactions motive as
income elastic and by itself not very sensitive to rate of interest.
(c) The Speculative Demand for Money

The speculative motive reflects people’s desire to hold cash in order to be equipped to exploit
any attractive investment opportunity requiring cash expenditure. According to Keynes,
people demand to hold money balances to take advantage of the future changes in the rate
of interest, which is the same as future changes in bond prices. It is implicit in Keynes theory,
that the ‘rate of interest’, i, is really the return on bonds. Keynes assumed that that the
expected return on money is zero, while the expected returns on bonds are of two types,
namely:

(i) the interest payment

(ii) the expected rate of capital gain.
The market value of bonds and the market rate of interest are inversely related. A rise in the
market rate of interest leads to a decrease in the market value of the bond, and vice versa.
Investors have a relatively fixed conception of the ’normal’ or ‘critical’ interest rate and
compare the current rate of interest with such ‘normal’ or ‘critical’ rate of interest.
If wealth-holders consider that the current rate of interest is high compared to the ‘normal or
critical rate of interest’, they expect a fall in the interest rate (rise in bond prices). At the high
current rate of interest, they will convert their cash balances into bonds because:
(i) they can earn high rate of return on bonds
(ii) they expect capital gains resulting from a rise in bond prices consequent upon an
expected fall in the market rate of interest in future.
Conversely, if the wealth-holders consider the current interest rate as low, compared to the
‘normal or critical rate of interest’, i.e., if they expect the rate of interest to rise in future (fall
in bond prices), they would have an incentive to hold their wealth in the form of liquid cash
rather than bonds because:
(i) the loss suffered by way of interest income forgone is small,

(ii) they can avoid the capital losses that would result from the anticipated increase in
interest rates, and
(iii) the return on money balances will be greater than the return on alternative assets

© The Institute of Chartered Accountants of India

. 8.10 BUSINESS ECONOMICS

(iv) If the interest rate does increase in future, the bond prices will fall and the idle cash
balances held can be used to buy bonds at lower price and can thereby make a capital-
gain.
Summing up, so long as the current rate of interest is higher than the critical rate of interest,
a typical wealth-holder would hold in his asset portfolio only government bonds, and if the
current rate of interest is lower than the critical rate of interest, his asset portfolio would
consist wholly of cash. When the current rate of interest is equal to the critical rate of interest,
a wealth-holder is indifferent to holding either cash or bonds. The inference from the above
is that the speculative demand for money and interest are inversely related.

The speculative demand for money of individuals can be diagrammatically presented as

follows:

Figure: 2.1.1
Individual’s Speculative Demand for Money

The discontinuous portfolio decision of a typical individual investor is shown in the figure
above. When the current rate of interest rn is higher than the critical rate of interest rc, the
entire wealth is held by the individual wealth-holder in the form of government bonds. If the
rate of interest falls below the critical rate of interest rc, the individual will hold his entire
wealth in the form of speculative cash balances.

When we go from the individual speculative demand for money to the aggregate speculative
demand for money, the discontinuity of the individual wealth-holder's demand curve for the
speculative cash balances disappears and we obtain a continuous downward sloping demand
function showing the inverse relationship between the current rate of interest and the
speculative demand for money as shown in figure below:

© The Institute of Chartered Accountants of India

 MONEY MARKET 8.11

Figure: 2.1.2
Aggregate Speculative Demand for Money

According to Keynes, higher the rates of interest, lower the speculative demand for money,
and lower the rate of interest, higher the speculative demand for money.
The concept of Liquidity Trap
Liquidity trap is a situation when expansionary monetary policy (increase in money supply)
does not increase the interest rate, income and hence does not stimulate economic growth.
Liquidity trap is the extreme effect of monetary policy. It is a situation in which the general
public is prepared to hold on to whatever amount of money is supplied, at a given rate of
interest. They do so because of the fear of adverse events like deflation, war. In that case, a
monetary policy carried out through open market operations has no effect on either the
interest rate, or the level of income. In a liquidity trap, the monetary policy is powerless to
affect the interest rate.

There is a liquidity trap at short term zero percent interest rate. When interest rate is zero,
public would not want to hold any bond, since money, which also pays zero percent interest,
has the advantage of being usable in transactions.
In other words, investors would maintain cash savings rather than hold bonds. The speculative
demand becomes perfectly elastic with respect to interest rate and the speculative money
demand curve becomes parallel to the X axis. This situation is called a ‘Liquidity trap’.
In such a situation, the monetary authority is unable to stimulate the economy with monetary
policy. Since the opportunity cost of holding money is zero, even if the monetary authority
increases money supply to stimulate the economy, people would prefer to hoard money.
Consequently, excess funds may not be converted into new investment. The liquidity trap is
synonymous with ineffective monetary policy.

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