This unit introduces the students to the theory of demand for and supply of
money, both Keynesian liquidity preference and quantity theory of money were
explicitly discussed.
At the end of this unit student should be able to;
i) Differentiate between money supply and demand for money.
ii) Explain the motives why people hold money.
iii) Understand the quantity theory of money.
SUPPLY OF MONEY
The concept of money supply or money stock refers to the total amount of
money in the economy, for purposes of policy various definitions or variants of
money supply (e.g. M1, M2, etc.) are adopted in every economy and these vary
from one country to the other.
Generally, the narrow money definitions refers mainly to the money used as
medium of exchange (i.e. M1= C + DD), where M1imply narrow money, C =
money in circulation outside banking system, it is otherwise refer to as based
money, while the broad money or broad definitions include money being used as
both medium of exchange and store of value (i.e. M2 = M1 + SD + TD). Here SD
and TD mean savings deposit and time deposit.
In every country, the Central Bank always state which definitions of money it is
adopting at any particular time and for which purpose. The quantity of money in an economy has direct effect on the price level and therefore on the value of money. Hence, to promote price stability and economic growth, the total money supply is subject to government control through the Central Bank in every modern economy.
DETERMINANTS OF SUPPLY OF MONEY
The determinants of money supply are both exogenous and endogenous which
can be described broadly as the minimum cash ratio, the level of bank reserves
and the desire of the people to hold currency relative to deposits.
1. The Required Reserve Ratio:
The required reserve ratio (or minimum cash reserve ratio or the reserve deposit ratio) is the ratio of cash to current and time deposit liabilities which is determined by law, every commercial bank is required to keep a certain percentage of these liabilities in the form of deposits with the central bank of the country. This is an important determinant of money supply, an increase in the required reserve ratio
reduces the supply of money with commercial banks increases the money
supply with commercial bank lending purposes.
2. The Level of Bank Reserves:
The level of bank reserves is another determinant of the money supply. Commercial bank reserves consist of reserves on deposits with the Central bank of the country influences the reserves of commercial banks in order to determine the supply of money.
The commercial banks are required to hold reserves equal to a fixed percentage of both time and demand deposits. These are legal minimum or required reserves. Required reserves are determined by the required reserves ratio and the level of deposits of a commercial bank, the higher the reserve ratio, the higher the required reserves to be kept by a bank, and vice versa.
But it is the excess reserve that is important to the determination of money
supply and excess reserves are the difference between total reserves and
required reserves. A commercial bank advances loans equal to its excess
reserves which are important component of the money supply. To determine the supply of money with a commercial bank, the central bank influences its
reserves by adopting open market operations and discount rate policy
Open market operation refers to the purchase and sale of government
securities and other types of assets like bills, securities, bonds etc. , both
government and private in the open market. When the central bank buys or
sells securities in the open market, the level of bank reserves expands or contracts.
The discount rate policy affects the money supply by influencing the cost and supply of bank credit to commercial banks. It is also the interest rate at which commercial banks borrow from the central bank. A high discount rate means that commercial banks get less amount by selling securities to the central bank. The commercial banks in turn raise their lending rates to the public thereby making advances dearer to them. Thus, there will be contraction of credit and the level of commercial bank reserves. When the bank rate is lowered it tends to expand credit and consequently bank reserves It should be noted that commercial bank reserves are affected significantly
only when open market operations and discount rate policy supplement each
other. Otherwise, their effectiveness as determinants of bank reserves and
consequently of money supply is limited.
3. Public desire to hold Currency and Deposits:
People‘s desire to hold currency (or cash) relative to deposits in commercial banks also determines the money supply. If people are in the habit of keeping less in cash and more in deposits with the banks, the money supply will be large. This is because banks can create more with larger deposits. On the contrary, if people do not have baking habits and prefer to keep their money holding in cash, credit
creation of banks will be less and the money supply will be at a low level.
4. High-Powered Money:
High-powered money is the sum of commercial bank reserves and currency (notes and coins) held by the public. High powered money is the base for the expansion of bank deposits and creation of money supply varies directly with changes in the monetary base and inversely with the currency and reserves ratios.
5. Other Factors:
Money supply is a function not only of the high powered money determined by the monetary authorities, but of interest rates, income and other factors. These factors change the proportion of money balances
that the public holds as cash. Changes in business activity can change the behaviour of banks and the public and thus affect the money supply. Hence the money supply is not only exogenous controllable item but also an endogenously determined item.
6. The velocity of circulation of money also affects the money supply.
If the velocity of money in circulation increases, the bank credit may fall even
after a decrease in the money supply. The central bank has little control over
the velocity of money which may adversely affect bank credit.
Self Assessment Exercise
i. Differentiate between M1 and M2 supply of money.
ii. What are the component of each of (M1) and (M2)
iii. What factors determine supply of money?
DEMAND FOR MONEY (The Liquidity Preference)
Demand for money is sometimes referred to as liquidity preference in Keynesian context, and it mean the desire of people to hold their resources or wealth in the form of cash i.e. currency notes and coins, instead of interest – yielding assets. The British economist John Maynard Keynes (1883 – 1946) identified three reasons for cash balances or why people hold money.
i) The Transactions Motives:
This represents cash balances held in order to carry out ordinary, everyday transactions. For example, individual persons need to hold money to buy food, cloth, pay bus fares, and so on. Similarly, business organizations need money to pay wages and electricity bills, buy raw materials, vehicles and equipments, etc. the transactions demand for money is directly related to income, and inversely related to the rate of interest that could be earned from holding interest – yielding assets in the alternative.
ii) The Precautionary Motive:
This refers mostly to the desire to hold cash balances as a precaution against unexpected events. For instance, people hold money to provide them with some degree of security against sudden illness,
accidents, fire and flood disasters, etc. while firms hold money against unpredictable occurrences such as sudden breakdown of vehicles, equipment, and so on. The main factor influencing this motive is the level of income.
iii) The Speculative motive:
This refers mostly to the desire to hold cash balances in order to make speculative dealing in the bond or securities (interest – yielding assets) markets. The demand for money for speculative purposes is interest –elastic. The higher the rate of interest, the lower the demand for the speculative cash balances. Thus, there is an inverse relationship between the price of bond and interest rate. This motive otherwise referred to as asset motive for holding money, is a decreasing function of the rate of interest and it is also influenced by incomes.
Lord Keynes refers to the money held for transaction and precautionary motive
as active balances, and that which is held for speculative motive as idle balances. The total demand for money is found by the summation of transactions, precautionary, and speculative demands.
Self Assessment Exercise:
i. Briefly explain the reasons why people desire to hold money.
The quantity theory of money.
The theory suggests the existence of a direct relationship between money
supply and the average price level in the macro economy. Specifically the
quantity theory of money states that the price level is strictly proportional to the money supply.
The quantity of money which was pioneered by the 18th century economists
including Adam Smith and David Hume, was modified and popularized in
1911 by the American Economist, Irvin Fisher (1867 – 1947) in what is known
as equation of exchange:
MV = PQ………………………………………….(1)
Where M = Total money supply
V = velocity of circulation of each unit of money
P = average price level
Q = real national output
The assumptions of the theory are that:
i. The velocity of money in circulation (V) is fixed.
ii. The real GNP denoted (PQ) is fixed in the short – run.
iii. The money stock (M) is determined from time to time by the country‘s
monetary authorities.
iv. The economy is at full employment level.
Given the above assumptions, the equilibrium price level (P) is determined
by the money stock (M) as expressed in equation (1)
P= …………………………….(2)
…. ………………………..(3)
Equation (2) which represents the quantity theory of money is obtained by making P the subject of the relation in equation (1). It follows, for example.
That 5 per cent increase in money stock will cause average price level in the
economy to rise by 5 per cent. Since both Q and v are fixed, in the case of Q
full employment is assumed. Thus, inflation is conceived as a monetary
phenomenon.
Also eqn. (3) represent the money velocity which imply number of time
money changes hand, it measure how enterprising a nation is.
The major policy implication of the theory is that monetary policy, of the restrictive type, is most relevant for effective control of inflation. In other words, to curb the problem of inflation effectively requires the reduction of money stock through the use of monetary policy instruments such as open market operations (OMO), reserve requirements, and bank rate.
The weakness of the quantity theory of money lies in the underlying assumptions, especially the assumption of fixed output and fixed velocity of money circulations which are unrealistic.
However, the theory provides a guide to the government to regulate money supply along the rate of changes in national output so as to avoid the problems of inflation.
DETERMINANTS OF DEMAND FOR MONEY
There are various factors that can determine the reason why people hold money at any particular time in an economy and among them we have the following:
i) Level of Income:
the higher the level of income, the higher the willingness to hold money and vice versa. It should be noted that to a great extend, income level influences the liquidity preference of individual.
ii) Interest Rate:
Interest rate payable on savings is another factor that influence or determine liquidity preference the higher the rate of interest, the lower the willingness to hold money in its liquid form. This means that
interest rate is a stimulus to savings; people forgo current consumption for
higher interest rate given that price level is stable overtime.
iii) Price level:
the price level which is the measure of inflation rate level in the economy is another determinant of liquidity preference, the higher the price
level, the higher the willingness to hold money in its liquid form and vice
versa. Note that a higher inflation is a disincentive to savings and this affects
investment level since savings imply investment at equilibrium.
iv) Return on Financial assets:
The return on financial assets such as bonds, treasury bills and certificates, stocks, etc. can also influence the demand for money. For example, if return on these assets is high people would be willing to invest in them in order to reap the hike in returns.
v) Government Policy:
There are number of government policies that have direct impact on income which also has implication on the amount of money people are willing to hold in liquid form. For instance a higher tax will
reduce disposable income and the amount to be held in liquid form, while subsidy will have opposing effect.
vi) The time lag between income is received and expenditure takes place also determine the transaction balance or cash balance.
Income and expenditure
are not done simultaneously, therefore the level of individual transaction influence the amount cash balance held at any point in time.
Self Assessment Exercise
i. Explain the equation of exchange by Irvin Fisher.
Conclusion
This unit examined the demand for money and supply for money and conclude thus that demand for money is endogenously determine while the supply of money is exogenously determine.
Summary
This unit looked at the determining factors of both demand for money and supply of money, what determine demand could be found in the system, that is endogenous, while what determine supply of money is only known to the monetary authority that is exogenous.
Marked Assignment
i) Differentiate between demand for money and supply of money.
ii) List and explained all motives for holding money according to J. M. Keynes
iii) Evaluate the quantity theory assertions
iv) Differentiate between transactional and precautionary motives.
v) Differentiate between demand for and supply of money.
References/Further Readings
Attah B.O, Bakare, T.A. & Daisi, O.R., (2011); Anatomy of Economics
Principles, Q&A (Macroeconomics), Raamson Printing Press, Oke-Afa, Isolo,
Lagos, Nigeria
Amacher, R and Ulbrich, H, (1986); Principles of Economics, South Western
Publications Co. Cincinnafi, Oliso
Bakare –Aremu T.A, (2013); Fundamental of Economics Principles
(Macroeconomics), Raamson Printing Press, Oke-Afa, Isolo, Lagos, Nigeria
Bakare I.A.O, Daisi, O.R., Jenrola, O.A., & Okunnu, M.A., (1999): Principles
and Practice of Economics (Macro Approach), Raamson Printing Press,
Mushin, Lagos, NigeriaDennis R. A. et-al; International Economics, Mcgraw
Hill Irwin, 8th edition.
Fashina E.O, (2000); Foundations of Economics Analysis (Macro Theories),
F.E.F International Company, Ikeja, Lagos, Nigeria
Jhingan M.L, (2010); Macroeconomics Theory, 12th edition, Vrinda
Publications (P) Ltd. Delhi, India
Jhingan M.L, (2010); International Economics, Vrinda Publications (P) Ltd.
Delhi, India
Lipsey R.G, (1979); An Introduction to Positive Economics, Hayper & Raw, London
Umo J.U, (1986); Economics; An African Perspectives , Johnwest, Lagos
Nigeria.
Gordon Robert J. (2009). Macroeconomics (Eleventh ed.). Boston: Pearson
Addison Wesley. ISBN 9780321552075
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