The Demand And Supply Of Money

What Is Money?Money is any asset that serves as a unit of account and can be used as a medium of exchange for economic transactions.

It is all assets that have a high degree of liquidity.

Money also serves as a store of value, but it is not unique in this role.

Contd.Unit of account

Medium of exchange

Store of value

Why Do We Need Money?The Demand For Money: The demand for money represents the desire of households and businesses to hold assets in a form that can be easily exchanged for goods and services.

Spendability, or liquidity, is the key aspect of money that distinguishes it from other types of assets. For this reason, the demand for money is sometimes called the demand for liquidity

Types Of DemandDemand For MoneyTransactions Demand

Speculative Demand

Precautionary DemandTransactions DemandPeople hold money because they hope to make transactions for goods and services in the futureHow much money we hold depends upon the value of transactions we expect in the future.Similarly the total value of all transactions in the economy during a period of time would influence the aggregate transactions demand for money.GDP, the value of all goods and services produced during the year, will influence the aggregate value of all transactions since all GDP produced will be purchased by someone during the year.

GDP risesMore transactions needed to buy extra GDPMore Demand for moneyGDP referred to here is Nominal GDP(GDP at exisiting prices). Nominal GDP=Real GDP x P(Real GDP-GDP after eliminating the effect of price changes that have occurred since the base year)Therefore because Transactions demand for money increases with increase in nominal GDP , it also changes with change in prices and/or change in real GDP

GDP will rise Transactions demand for money will rise ,If:(a) the amount of goods and services produced in the economy rises while the prices of all products remain the same.

(b) if the average prices of goods and services produced in the economy rises, then even if the economy produces no additional products, people will still demand more money to purchase the higher valued GDP, hence the demand for money to make transactions will rise.Speculative DemandSpeculative demandis thedemandfor financial assets,such assecurities,moneyor foreign currencythat is not dictated by real transactions such astrade, orfinancing.Refers to real balances held for the purpose of avoiding capital loss from holding bonds.Assets demand for money is the money held by people to avoid the risk of capital loss due to holding other financial assets, e.g., bonds, equities, long-term bonds, etc., because these assets have variable market valuesThe assets demand for money is proportional to the risk involved in selling the asset.People would rather hold their money in liquid form than investing it in an asset whose future value is unpredictable.It depends on investors aversion to risk, the relative demand for and the supply of other financial assets and real assets and the change in expectations of the economic climate.Precautionary DemandPrecautionarymoney is held for unexpected transactions such as car repairs or medical bills, although does not need to be limited to serious expenses or needs.

Supply Of MoneyMoney has value because of the relative availability. If money were as plentiful as grains of sand on all the worlds beaches, it would have no value. Just like shares of stock, money is similar in that it symbolizes a claim on assets. If you have a ten-dollar bill, it represents your claim to ten dollars worth of goods or services. However, if that ten-dollar bill represents such a small fraction of all bills in existence, it is virtually worthless.

Supply Of MoneyDifferent measures

M1is the base measurement: cash in the hands of the public(coins and currency)M2is equal to M1 plus savings deposits, money market accounts, overnight repurchase agreements M3equals M2 plus institutionally held money market funds, term repurchase agreementsL,the fourth measure, is equal to M3 plus Treasury bills,commercial papers, banker's acceptances, and very liquid assets such as savings bonds.

Why Can't the Government Print Money and Make Everybody Wealthy?The reason is because there would be a large supply of money relative to the goods produced and the value of the rupee will fall.We really don't desire money for the sake of holding additional pieces of paper. We desire it to purchase more things. Themore thingswe are able to purchase, the wealthier we are.On a relative scale, when there is more money than products(lets say bank accounts of people get doubled overnight!) things appear a little cheap and people act accordingly and get in line to buy. The retailers cannot handle the excess demand so they raise the prices to a point where they are in equilibrium and supply equals demand to a point where prices are exactly doubled.Contd.This phenomenon is often called thequantity theory of money. It states that a given money supply is spent over and over (called thevelocityof money) on goods and services throughout the year. Money Supply*Velocity=Prices*QuantityVelocity is the rate at which people spend and Q is the quantity of goods and services produced.These remain fairly constant over a given timeThus If money supply increases, the prices will rise in equal proportion to balance the equationContd.So while the government does have the right and the ability to print more money, the economic forces of supply and demand prevent us from using printing presses to create true wealth. We can create more pieces of paper but youd find that you are no better off than before. The reason is that prices will be proportionately inflated by the amount of cash in the system.Thank You