Demand for and Supply of Money

Concept of Money Supply

Money supply refers to the stock of money held by the people in disposable form.

In other words, currency (notes) and coins issued by the central bank and also by treasury and
demand deposits created by the commercial banks in circulation are called supply of money.

So, stock of money held by the commercial banks in their tills as cash reserve and with the
central bank and the money stock held by the central bank in non-disposable form are obviously
not regarded as money supply in the economy.

According to above definition, money supply can be expressed as follows:

M s=DD +Cu

Where, M s = money supply, DD = demand deposit and Cu = currency with the people

According to Milton Friedman, money supply can be expressed as follows:

M s=DD +Cu+TD

Where, TD = Term deposit

According to J. G. Gurley and E. S. Shaw, the money supply can be shown as:

M s=DD +Cu+TD+ma

Where, ma = another financial assets which can be used as alternative of DD, Cu and TD

Components of Money Supply

The three main components of money supply are as follows:

a) Currency with the people

b) Demand deposit

c) Term deposit

These components are discussed below.

a) Currency with the people

It refers to the difference between total money supply and the sum of currency with the central bank and
currency in the tills of commercial banks. In another way,

Cu=M s −(currency reseved wit h central bank +currency reseved ∈commercialbank)

Whereas the last two components do not reach to the public for use, so they are excluded from
total money supply.

b) Demand deposit

It indicates the deposits which are payable by bank on demand. The demand depositors can
convert their deposits into cash or can withdraw cash by issuing cheques at any time. Demand
deposit includes all current accounts excepting interbank transactions, payment order, demand
draft, bills payable, margin from certificate etc. Briefly, it can be expressed as:

DD=M s−Cu – TD

Where, TD = Term deposit

c) Term deposit

It refers to the difference between total money supply and the sum of currency with public and demand
deposit, i.e.,

TD=M s−(Cu+ DD)

The components of the term deposit are fixed accounts, deposits withdrawn in special notice,
provident fund, insurance premium etc.

Causative Factors of Changes in Money Supply

The causative factors of changes in money supply are divided into two classes:

1. Internal/domestic factors

2. External/foreign factors

Among the domestic factors, there are net change in credit, net change in term deposit and net
change in government revenue while net change in foreign reserve as external factor. These are
functionally expressed as,

M s=g (C , T , G , F ) (i)

Where, C, T, G and F stand for credit, term deposit, government revenue and foreign reserve.
The factors are briefly discussed below.

1. Net change in credit (C)

The first domestic factor to bring change in money supply is net change in credit both in public
and private sectors. Money supply will be increased or decreased, if the credit in public and
private sectors increases or decreases respectively. This direct relationship can be expressed from
equation (i) as,

d Ms
>0
dC

2. Net change in term deposit (T)

Remaining other things constant, money supply will decrease or increase with the increase or
decrease in term deposit respectively. From equation (i) we can show this opposite relationship
as,

d Ms
<0
dT

3. Net change in government revenue (G)

If government revenue is increased or revenue activities expanded, money supply will be

increased. In the same way, money supply will be reduced with the reduction in government
revenue or revenue activities of the state. Using equation (i) this proportional relationship can be
showed as,

d Ms
>0
dG

4. Net change in foreign reserve (F)

Remaining other things constant, money supply will be increased, if foreign reserve increases
while it will be decreased with the decrease in foreign reserve. This direct relationship can be
expressed from equation (i) as,

d Ms
>0
dF
Difference between Narrow Money and Broad Money

Narrow Money Broad Money

1 Sum of currency with the people and 1. Sum of currency with the people and
. demand deposit in commercial banks is demand and term deposit in commercial
termed as narrow money. banks is termed as broad money.

2 Equation of narrow money is: 2. Equation of broad money is:

. n
M =C + D M b=C + D+T
Where, M n, C and D stand for supply of That means, M b=M n +T
narrow money, currency with people and Where, M b and T imply broad money and
demand deposit respectively. term deposit respectively.

3 Narrow money can be used as a medium of 3. Term deposit of broad money cannot be
. exchange in any time. used as a medium of exchange.

4 Conversion of narrow money into cash 4. Term deposit needs time to be converted
. flow does not face any problem. into cash and there occurs money spent.

5 Narrow Money is highly liquid. So it is 5. It is less liquid than narrow money

. more popular than broad money in
institutional and functional purposes.

6 It is less related with national income. 6. It is more related with national income
. and for this it is preferable in making
financial policies and planning.
High Power Money

The sum of currency with people (currency outside the banks) and other banks’ reserves in
central bank is called high power money or financial base of the economy. It can be expressed
as,

H=C+R

Where, H = high power money, C = currency with people and R = reserve with central bank

High power money indicates the quantity of money issued by the central bank. Its quantity
depends on the monetary policy of the country. Central bank can increase or decrease the
quantity of high power money by using monetary policy.

High power money is the main base of the economy. Without it banks cannot create credit for
indefinite period. High power money is essential to obtain financial assets for the government.

Money Multiplier

Money multiplier is the ratio between total money supply and high power money. Total money
supply includes the currency with people and deposits in the banks. On the other hand, high
power money includes the currency with people and reserves in central bank. It can be shown as,

M=M/H

Where, m = money multiplier, M = total money supply and H = high power money

Meaning and Types of Demand for Money

Demand for money indicates the tendency to hoard money by the people. This demand is related
to the income and the rate of interest. With respect to income and rate of interest, the amount of
money hoarded by the people in a specific period is termed as demand for money. Money I
demanded mainly for storing value and transaction motives.

According to Keynes, there are three types of demand for money. These are discussed below:

(i) Transaction demand

People want to hoard some money in hand to perform day to day transactions. This type of
demand depends on the amount of transactions, spending habit, time lag between income earned
and expenditure incurred financial income of the individual, etc. Transaction demand for money
directly depends on the income.

(ii) Precautionary demand

The amount of money demanded by the people to meet the sudden needs of unwanted situations
in future like future security, expected expenditure, accident, sickness, etc is defined as
precautionary demand for money. It also directly depends on the income of the individual.

(iii) Speculative demand

The amount of money demanded by the speculators for earning expected profit in speculative
market is called speculative demand for money. It inversely depends on the rate of interest.

Liquidity Trap

Liquidity trap may be defined as perfectly elastic demand for money at a particular low rate of
interest. It is set up of points on the liquidity preference curve where the percentage changes in
∆M ∆i
the demand for money ( ¿ in response to a percentage change in the rate of interest ( ¿
M i
approaches to infinity. This concept is related to the speculative demand for money.
In the figure above, L2 curve depicts the liquidity preference under the speculative motive at
varying rates of interest.

It is obvious from the diagram that a high rate (20%), there is very little demand for money under
the speculative motive. As the interest rate moves lower and lower, the demand for speculative
balances larger and larger until at 2% it becomes infinitely elastic, i.e., any increase in money
supply will be held as idle cash balances by the people. The situation is called liquidity trap. The
trap is depicted in the liquidity preference curve, where the slope of the tangent to the curve
becomes horizontal.

The existence of the trap, in real world would be characterized by a situation, at a moment in
time, when large increase in money stock would simply be absorbed as speculative idle balances
in anticipation of a future rise in the rate of interest.

Money Illusion

Money illusion refers to the valuing money for its face value without any regard for what it will
buy, i.e., purchasing power. It was invented by American economist Irving Fisher. Money
illusion is the emotional attachment of people towards money. Workers usually have a strong
money illusion. When their pay scales are revised or additional dearness allowances are paid in
view of rising prices, they feel happier even though their real wage has remained unchanged.

People have such illusion about money that they disregard its purchasing power- its real value
and tend to feel satisfied more its quantity only. It is very common that laborers always demand
more money wages and will show great resentment if money wage is cut even in a situation of
falling prices and enhanced value of money (i.e., appreciation of real wage).