WEEK SEVEN LESSON NOTE

Money: Demand and Supply of Money

Demand for money
The demand for money is the total amount of money which all individuals in the economy wish,
for various reasons, to hold. In other words, the demand for refers the desire to hold money; that
is keep one’s resources in liquid form rather than spending it. The demand for money for money
in economics is known as liquidity preference.
Reasons or motive for holding money
(1) Transactionary motive: People desire to keep or hold money for day to day transactions or
current expenditures. Household needs to hold money in order to cater for the interval
between the receipt of incomes and their expenditures
(2) Precautionary motive: This is when people demand for money in order to meet up with
unforeseen circumstances or unexpected expenditures. These may include sicknesses,
unexpected visitors, etc. due to uncertainties in life. People keep money against future
emergencies that may require monetary expenditures.
(3) Speculative motive: This motive is specifically a business motive and refers to the desire
to hold cash balance in order to embark on speculative dealings in the bond market. The
demand to hold money for a specific purpose is elastic.
Supply of money
The supply of money refers to the total amount of money available for use in the economy at a
given period of time. The supply of money involves the currency in the bank notes and coins
circulating outside the banking system as well as the bank deposits in current accounts, which can
be withdrawn by cheque.
Factors affecting the supply of money
(1) Open Market Operation (OMO): This is the purchase or sale of government securities in
the open market to expand restrict the volume of money in circulation. The central bank
applies this policy with the aim of regulating the volume of money in circulation. When
there is too much money in circulation, the central bank will sell securities. But in order to
expand the volume, it buys securities.
(2) Liquidity ratio or cash ratio or cash reserve: The commercial banks are mandated by the
government to keep a special proportion, e.g. 25%, of their total deposit with the central
bank in order to control the volume of credit. The size can be expanded or contracted
depending on the condition of the nation.
(3) Bank rate: This is the minimum rate of interest charged by the central bank for discounting
bill of exchange. By lowering or raising the rate, the central bank can control activities of
the commercial banks. When the rate increases, loan to the public (customers) reduces,
while a fall in the rate will encourage more loans.
(4) Economic situation: During the period of inflation in an economy, the central bank will
reduce the supply of money and increase it during the period of deflation.
(5) Demand for excess reserves: When the commercial banks demand for excess reserves, the
supply of money will increase.
(6) Total reserves of the central bank: The supply of money is affected by the total reserves
the central bank. If the total money supplied by the central bank is high, money supply will
also be high, vice versa.
The value of money
The value of defined as the quantity of goods and services which a given amount of money
can buy. In other words, the value of money refers to the purchasing power of money.
When a certain amount of money can buy fewer goods and services, this will mean that the
value of money has fallen and this can only happen when there is rise in prices. But if a given
amount has risen, and this can only happen when there is a fall in prices such as when a N50
note can purchase 20 cups of beans instead of 10, this means there is an increase in the value
of money.
Factors that determine the value of money
(1) The price level: The value of money varies with the price level. If the price level increases,
this would mean that a given sum of money will fewer goods and services. The value of
money therefore falls with an increase with the price level. Note that a fall in the price leads
to an increase in the value of money.
(2) The supply of money: When a given quantity of money in circulation increases while there
is little or no corresponding increase in the available quantity of goods and services, this
would mean that a larger quantity of money would purchase fewer commodities. The value
of money would therefore be low.
(3) The speed or velocity of circulation of money: The velocity of circulation of money refers
to the speed at which money circulates within the economy by changing from one to
another. When there is an increase in the velocity of circulation of money, prices increase,
leading to a reduction in the value of money.
(4) Inflation and deflation: It is generally known that the value of money reduces during the
period of inflation while its value increases during deflation.
(5) Volume of goods and services: The level of production determines the volume of goods
and services in an economy when more goods and services are available while the supply
of money remains constant, the value of money will increase. This is due to the fact more
commodity can be purchased with a given sum money.
Measurement of value of money
The value of money as well as the nation’s cost of living is measured by the use of price index,
which is also called index of retail prices. A price index is a weighted average of prices and is
expressed as a percentage of prices existing in a base year. The value of money is inversely
related to price level.
Mathematically, price index is expressed as:
𝑝𝑟𝑖𝑐𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟
Price index = 𝑝𝑟𝑖𝑐𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑦𝑒𝑎𝑟 X 100%

Example
Assuming that the price of a packet of sugar was N20 in 2012 but rose to N30 in 2013.
Calculate the index number
𝑝𝑟𝑖𝑐𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟
Price index = 𝑝𝑟𝑖𝑐𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑦𝑒𝑎𝑟 X 100%

𝑝𝑟𝑖𝑐𝑒 𝑖𝑛 2013
Price index = 𝑝𝑟𝑖𝑐𝑒 𝑖𝑛 2012 X 100%
30
Price index = 20 X 100% = 150

Form the calculation, assuming the index of the base year is taken to be 100, it then means that
the index rose from 100 to 150. It equally means that the price of a packet of sugar rose by 5%
between 2012 and 2013. It can also be concluded that the value of money fell by 5% between
2012 and 2013. Thus the cost of living rose in that period. The significance of price index is
that it is used to compare the rise in the cost of living between any chosen period of time.
The quantity theory of money is defined as the relationship between the quantity of money in
circulation in an economy and the price level. The theory explains the imbalance that exists
between the demand for money (by households and firms) and supply of money (to households
and firms). The theory explains that if people hold more money than they require (i.e. if there
is an excess supply of money over demand), they will spend the surplus on currently produced
goods and services. This will increase the price level.
The quantity theory of money also stated that an increase in the quantity of money in circulation
will bring about services. Professor Irving Fisher remodified the quantity theory of money into
what is known as velocity of circulation of money.
Velocity of circulation of money according to Professor Irving Fisher, refers to the speed at
which money circulates within the economy by changing from one hand to another. When
there is an increase in the velocity of circulation of money, prices will increase, leading to a
lower value of money. The quantity theory of money modified by Fisher is expressed in what
is known as the quantity equation of exchange and is presented by this equation:
MV = PT
Where
M = Supply of money
V = Velocity of circulation of money
P = Price level
T = Quantity of goods