Comprehensive Dynamics of Demand for Money

Since money is globally accepted and hence easily exchangeable for other goods, it is the most liquid of all assets. However, there is an opportunity cost involved. You can earn interest on money by putting it in a fixed deposit at a bank rather than keeping it in a specific cash balance. 

One must weigh the benefits of liquidity against the drawbacks of missing out on interest when determining how much money to hold at any given time. As a result, demand for cash balance is frequently referred to as liquidity preference. People desire to hold money balance for transactions and precautionary motives, showcasing the dual facets of the demand for money.

Transaction Motive: Why do we always demand for Money for daily expenses ?

• The main reason for holding money is to carry out transactions. 
• If you receive income weekly and pay bills on the first day, you don’t need to maintain a cash balance throughout the week. 
• However, the misalignment of expenditure patterns with receipts highlights the ongoing demand for money, as individuals navigate their financial transactions.

• Transaction Demand (M^d_T): In general, therefore, the transaction demand for money in an economy, M^d_T , can be written in the following form

M^d_T = k.T

Where T is the total value of (nominal) transactions in the economy over a unit period and  k is a positive fraction.

• The Two-Person Economy: It uses a money balance of Rs 100 for transactions worth Rs 200 per month.
  • Each rupee changes hands twice a month, with the velocity of circulation being the ratio of money balance to transaction value. 
  • The economy operates on a two-person system, with each rupee being transferred from the employer’s pocket to the worker’s hand and vice versa.
• Thus, in general, we may rewrite the equation in the following form

                          (1/ k).M^d_T = T, or  v.M^d_T= T

• • Where v = 1/k is the velocity of circulation.
  • T, is a flow variable: the term on the right-hand side of the above equation, whereas 
  • M^d_T (money demand): It is a stock concept, it refers to the stock of money people are willing to hold at a particular point in time.
• Time Component: But the velocity of money, v, has a time component. 
  • It relates to how frequently each unit of stock changes hands over the course of a given time period, such as a month or a year. 
• The Left-Hand Side,v.M^d_T: It calculates the total value of monetary transactions done with this stock throughout the course of the unit period of time. 
  • Since this is a flow variable, it is equal to the right side.
• Ultimately, the goal is to understand the relationship between the aggregate transaction demand for money of an economy and the (nominal) GDP in a given year.
  • However, normally, there exists a stable, positive relationship between the value of transactions and the nominal GDP.
  • An increase in nominal GDP implies an increase in the total value of transactions and hence a greater transaction demand for money.
  • Thus, in general, the equation for MdT can be modified in the following way

M^d_T =kPY

Where Y is the real GDP and P is the general price level or the GDP deflator.

• The above equation tells us that transaction demand for money is positively related to the real income of an economy and also to its average price level.

Speculative Demand: Impact on market dynamics and demand for Money

• Individuals can hold wealth in various forms, including bonds, which are papers promising a future stream of monetary returns over a certain period. 
• Bonds: These are issued by governments or firms for borrowing money from the public and are tradable in the market. 
• Example: 
  • A two-period bond with a face value of Rs 100, a maturity period of two years, and a coupon rate of 10% can be compared to a savings bank account with an interest rate of 5%. 
  • This helps in understanding the potential earnings of bonds compared to savings bank accounts.
  • The amount of money X, will generate Rs 10 after being kept in a savings account,

• • This amount, Rs X, is called the present value of Rs 10 discounted at the market rate of interest.
  • Similarly, let Y be the amount of money which if kept in the savings bank account will generate Rs 110 at the end of two years. 
  • Thus, the present value of the stream of returns from the bond should be equal to the Calculation revealing that it is Rs 109.29 (approx.)

• Competitive Asset Market: In this market the price of a bond must always equal its present value in equilibrium. 
  • If a bond is offered at a face value of Rs 100, it becomes more attractive than a savings bank account. 

• Competitive Bidding: It raises the bond price above its face value until it equals its present value (PV). 
  • If the price rises above the PV, the bond becomes less attractive and people may want to sell it.
• Increase in the Market Rate of Interest: Suppose it increases from 5% to 6%. The present value, and hence the price of the same bond, will become
• It follows that the price of a bond is inversely related to the market rate of interest.
• Capital Loss to Bond Holder: 
  • People have varying expectations about future market interest rates based on their economic information.
  • If the current rate of 5% is considered too low, people may expect interest rates to rise, leading to a fall in bond prices. 
  • This loss, known as a capital loss, can result in bondholders selling their bonds and holding money instead. 
  • This dynamic interaction highlights the intricate relationship between bonds and the ongoing demand for money in competitive markets.
• Speculative Demand for Money: Under this speculation, people try to sell their bonds and hold money instead of relying on future market rate movements.
  • High-Interest Rates: It leads to people anticipating capital gains from bond-holding, converting money into bonds, and reducing speculative demand for money.
  • Low-Interest Rates: It results in people converting bonds into money, causing a high speculative demand for money, which is inversely related to the interest rate.
  • Assuming a simple form, the speculative demand for money can be written as

• Where r is the market rate of interest and rmax and rmin are the upper and lower limits of r, both positive constants.
• It is evident from the above equation that as r decreases from rmax to rmin, the value of MdS increases from 0 to ∞.
• Interest rates are an opportunity cost or ‘price’ of holding money balance in an economy. 
  • An Increase in Money Supply: It leads to higher bond demand, higher bond prices, and a decline in interest rates. 
  • However, if the market rate of interest is low enough to cause capital losses, people will not want to hold bonds. 
  • Instead, they will hold their wealth in a money balance. 

• Liquidity Trap: If additional money is injected, it will be used to satisfy people’s craving for money balances without increasing bond demand or lowering interest rates below the floor rmin. 
  • This is known as a liquidity trap.
  • The speculative money demand function is infinitely elastic here.
  • In Figure the speculative demand for money is plotted on the horizontal axis and the rate of interest is on the vertical axis.
  • When r = rmax , speculative demand for money is zero. 
  • Everyone expects the rate of interest to decline since it is so high and believes that there will be a capital gain in the future.
  • So, everyone changed the balance of speculative money into bonds.
  • When r = rmin , the economy is in a liquidity trap.
• The Total Money Demand: In a modern economy, it consists of transaction and speculative demand, with transaction demand directly proportional to GDP and price level and speculative demand inversely related to market interest rate.
• The aggregate money demand in an modern economy can be summarized by the following equation

Conclusion 

• Loans and credit are necessary for economic activity. There are numerous sources of credit. They may be formal sources or informal sources.
• It is crucial that total formal sector credit rises in order to reduce reliance on more expensive informal credit. 
• Money facilitates exchanges by acting as a common medium. 
• In modern economies, people hold money for transactions and speculative motives. 
• In India, the Reserve Bank of India (RBI) regulates the supply of money by controlling high-powered money stock, bank rates, and reserve requirements of commercial banks. 
• The RBI also sterilises the money supply against external shocks, ensuring a stable and efficient economy.]