Understanding some conceptual issues in money demand

University Degree Business and Administrative studies

Definitional issues

What is money?

Money represents an implicit social contract by society between present and future purchasing power. It is a form of asset, which represents claims by individuals and firms against the government and financial institutions and a liability for the latter.

In an economy without money one would need to engage in barter transactions, where goods are exchanged against goods. There would be tremendous inefficiencies in a barter economy due to the problem of arriving at a “double coincidence of wants” every time one wishes to engage in a transaction. One would need to find the right exchange partners both in terms of the products and the quantities desired. The inefficiencies of such an exchange system, the high time and transactions costs, and the limits imposed on the number of transactions are evident. Therefore, money serves a very important function by removing the need for coinciding wants in the exchange process.

What is the role of money in an economy?

At any point in time, the public holds money for the services or functions that money performs. Money serves four basic functions.

(a) Medium of exchange

Money facilitates exchange of goods and services as less time and resources are spent on such transactions than would be required under a barter system. It increases the scope for exchange, increases the division of labour, leads to more efficient resource allocation, and augments production possibilities in the process.

(b) Unit of account

Money is used as a standard of value in exchange. Suppose there are 1,000 distinct commodities in an economy. This would give rise to 499,500 different relative prices

(n(n-1)/2 prices). However, with money, there are only 1,000 price tags. Money is therefore a useful common accounting denominator, which facilitates exchange. (Note that when the purchasing power of money is very unstable such as in inflationary environments, the medium of exchange need not be the unit of account).

In the absence of money one would need to save in the form of commodities, which would be very inefficient. As Milton Friedman said, money serves an important function by acting as a “temporary abode of purchasing power”. People save a part of their current income to use at a future date. In doing so, they make use of the “storing value” of money (though this is not completely costless due to changes in the price level).

(d) Standard of deferred payments

Payments are postponed to the future and made in the form of money. In doing so, the exchange, value storing, and accounting functions of money are embodied.

(e) Financial intermediation

In developing countries, the traditional functions of money as a medium of exchange and store of value are important but money also plays a very critical role in the intermediation process between savings and investment. Financial intermediation involves the channeling of funds from savers to investors through financial institutions. With development, this becomes increasingly important unlike the case in a primitive economy where investment is largely self-financed. Money then becomes an important infrastructural link between savings and investment activities and helps stimulate economic growth. The role of the monetary authorities is to establish the channels for intermediation and improve the dynamic efficiency of the economy.

Classification of money

Money can be classified into several categories ranging from the most liquid to the least liquid forms. It ranges from highly liquid assets such as currency and demand deposits to less liquid assets such as government bonds, to very illiquid assets such as real estate and other durables. (Liquidity refers to the ability to turn an asset into a medium of exchange rapidly with minimum transactions cost or loss in capital value).

The classification of monetary aggregates varies across economies, depending on the degree of financial sophistication, extent of monetization of the economy, the range of financial instruments available, etc. In the US economy there are four broad monetary aggregates, M1, M2, M3, L. In the UK, there are six aggregates. We consider below the monetary classification for the US and Indian economies

(i) US monetary aggregates

The first category of money is M1. This consists of currency holdings with the public, demand deposits, other checkable deposits, and travelers’ checks. It represents claims that can be used directly and instantly without restrictions to make payments. It refers to the liquid part of money which can be immediately, conveniently, and cheaply used to make payments.

M1 = CU +DD

Currency or CU refers to notes and coins in circulation. Checkable deposits are deposits against which checks can be written. These are held at common commercial banks and at thrift institutions.

The second category of money is M2. This category includes M1 and a range of less liquid forms of money such as savings deposits and mutual funds.

M2 = M1 + overnight repurchase agreements + overnight Eurodollars issued to residents + Money Market Mutual Funds + Money Market Deposits + savings deposits + small denomination time deposits.

The largest part of M2 is savings deposits (of less than $100,000) and time deposits at banks and thrift institutions. These include regular as well as fixed deposits in savings accounts. The second largest part of M2 is money market mutual funds (MMMFs) and deposit accounts. The MMMF consists of investment assets in short-term interest bearing securities like CDs and treasury bills which pay interest and on which checks can also be written. Larger check amounts can be written under M2 than under M1.

The third category of money is M3, which is often also called broad money.

M3 = M2 + large denomination time deposits + term repurchase agreements + some Money Market Mutual Funds

The fourth and final category of money is L.

L = M3 + long term Eurodollars + savings bonds + short term treasury securities + commercial paper + bankers’ acceptances.

As we move from M1 to L, the liquidity of money falls. This is countered by an increase in the interest yield. The typical tradeoff is between liquidity and interest yield. To have more liquidity, one must give up on the return and vice versa. Note also, that these monetary aggregates are not fixed. With financial innovation and deregulation, the classification of monetary aggregates changes in any economy.

(Definitions of the various components of the different categories above are provided in Dornbusch and Fischer in Chapter 13, Box 13-1).

(ii) Indian monetary aggregates

Developing countries reflect ...

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(Definitions of the various components of the different categories above are provided in Dornbusch and Fischer in Chapter 13, Box 13-1).

(ii) Indian monetary aggregates

Developing countries reflect less sophistication in their monetary aggregates. In India, we have four categories of monetary classification.

M1 = Currency + demand deposits (current account) + other deposits with the RBI

M2 = M1 + savings deposits with Post Office Savings bank

M3 = M1 + time deposits

M4 = M2 + all deposits with post office savings organizations

The important thing to note for the Indian monetary aggregates is that M1 and M3 are separated on the basis of time deposits with banks versus currency and demand deposits, which are more liquid forms of money. M2 and M4 are separated based on institutional differences between banks and post office savings organizations. M1 is called narrow money and M3 is called broad money. When we discuss monetary policy, for the most part we shall be looking at broad money.

Non-monetary assets

Money competes with various interest bearing and other assets in the individual’s portfolio decisions. The following discussion outlines the definitions for the most common competing assets.

Bonds are a promise by the borrower to pay the lender the principal (face value of the bond) upon maturity plus interest per year in the interim. For instance, a bond could promise payment of 10,000 plus 7 percent per year in interest. Bonds are issued by governments, municipalities, corporations, etc. The interest rate reflects the default risk. A perpetuity is a special type of bond, which pays interest forever but makes no principal payment.

Stocks or equities are claims to the share of profits of an enterprise. They promise returns in the form of regular dividends of a certain amount for each share owned and capital gains on the value of the stock. (When there is an increase in the price of the stock there are capital gains to the stock holders). The return on a stock holding is the dividend on the stock plus the capital gain. If there is an increase in the price of the stock to 16.50, then there is capital gain of 1.50/15 or 10 percent. The yield on a stock is given by the ratio of the dividend to the price of the stock. So, if there is dividend of 0.75 on a stock of value 15, then the yield is 0.75/15 or 5 percent. When the price of a stock declines, then the yield on the stock rises. There is an inverse relationship between the yield and the stock price.

Real assets are machines, land, structures owned by corporations, consumer durables of households, etc.

The assets market is where money, bonds stocks, houses, and other forms of wealth are traded. The different types of assets outlined above offer different forms of return. Equities and bonds are claims on the part of tangible wealth held by corporations. They assign part ownership to real assets.

Linking the money and assets markets

The money and assets markets are linked through the individual’s or firm’s portfolio decisions. Money competes with other assets such as bonds and equities. In the individual’s portfolio decision, each asset is assessed in terms of liquidity, its expected rate of return, riskiness, and the expected rate of return on competing assets. Portfolio diversification occurs due to uncertainty about future yields and because every asset offers some unique utility level. When there is a change in the present and future value of assets and the stock of wealth in the individual or firm’s portfolio (possibly due to a change in the interest rate), it causes an adjustment of the portfolio composition between money and other assets. For instance, when the interest rate falls, there is typically a shift away from other assets towards holdings of money in the portfolio. Thus, the money and assets markets are linked through a wealth or portfolio constraint.

Specifically, the wealth constraint is given by the fact that total financial wealth for an individual is the sum of money demand and bond demand. Individuals make decisions on the composition of their portfolios by holding some of their assets in the form of money balances and some of their assets in the form of bonds. Therefore, decisions regarding money holdings implicitly involve decisions on bond holdings through the wealth budget constraint. This means that equilibria in the money and assets markets are interlinked and disequilibrium in one spills over to the other.

[Note that money demand can be real or nominal. Nominal money demand is an individual’s demand for a given number of rupees or dollars. Real money demand or real money balances is the number of units of goods money will buy. It is given by the nominal money demand or the nominal quantity of money held divided by some index of the price level. (This is something we will keep referring to in this module). Similarly, bond demand can be real or nominal. Nominal bond demand is the demand for a certain number of Rupees or dollars worth of bonds while real bond demand is the nominal quantity of bonds held, divided by the price level.]

The wealth budget constraint which links demand for money balances and bonds is given by:

L + DB = WN/P

where L is holdings of real money balances and DB refers to real bond holdings. WN is the nominal stock of wealth and when deflated by P, the price level, gives the real stock of wealth. The above equation states that real money balances plus real bond holdings equal real financial wealth. Decisions to hold more real money balances imply a decision to hold less real wealth in the form of bonds.

The supply of money balances and bonds can be represented by the following equation:

M/P + SB = WN/P

The above accounting relationship gives how much financial wealth there is in the economy. M/P refers to real money supply, SB to the real supply of bonds, and WN/P as before to the real stock of financial wealth in the economy.

Combining the demand and supply sides of the wealth equations above, we see that given the stock of real wealth in the economy, equilibrium in the money market implies equilibrium in the assets market. In other words,

(L -M/P) + (DB-SB) = 0

So, if real money supply equals real money demand, through the wealth budget constraint, it must be that the real demand for bonds must equal the real supply of bonds. The wealth budget constraint says that when the money market is in equilibrium, the bond market must also be in equilibrium and disequilibrium in one is reflected in the other. If there is excess demand in the money market (L>M/P), there must be excess supply in the bond market, DB<SB. So, what happens in the money market affects the bond market. The wealth constraint is very important to understand in the context of a discussion on monetary policy (as seen later).

Money demand

In the Keynesian view, the liquidity preference or demand for money is the schedule of the ratio of money balances to income and assets that an individual wishes to hold. There are three parts to liquidity preference. These are:

- the transactions motive

- the precautionary motive

- the speculative motive.

The transactions demand for money is the use of money for regular payments of goods and services. The tradeoff is the interest forgone by holding money and the costs and inconveniences of holding a small amount of money. It is more applicable to the monetary aggregate M1. Transactions demand for money is prompted by the temporary gap between income receipts, which are discrete and expenditures, which are continuous.

Precautionary demand is the demand for money to meet unforeseen contingencies. One needs to hold some cash balances for the sake of liquidity in case there are unanticipated expenditure requirements. This is because there are costs and delays involved in converting illiquid assets (long term savings deposits, real estate, etc.) to meet unforeseen spending needs.

The speculative demand for money relates money demand to interest rates and makes money demand a part of the individual’s portfolio decisions. The interest rate is like the opportunity cost of holding money. Therefore, movements in the interest rate affect money demand. The precautionary and speculative motives for holding money are more suited to the monetary aggregates M2 and M3.

These three motives can be captured in the following money demand equation. L represents the demand for real money balances.

L = kY - hi where k,h>0, Y=real income

The first component of the money demand equation above, given by kY represents the transactions demand for money. It indicates that the demand for real balances is a positive function of the real income level. When the real income level Y rises, the transactions demand for money also rises as people’s spending on goods and services typically goes up with real income. The parameter k represents the real income elasticity of money demand or the sensitivity of money demand to changes in real income (percentage change in real money balances held for a percentage change in real income).

The second component of the money demand equation represents the part of money demand that is influenced by the cost of holding money, i.e., the interest forgone by holding money rather than interest bearing assets. This part of the money demand function is related to Keynes’ speculative demand for money. The idea here is that since money is a non interest-bearing asset, there is an opportunity cost to holding it, which is given by the interest rate. The higher the interest rate, the more the interest forgone by holding money. Therefore, money demand is negatively related to the interest rate. When the interest rate rises, the opportunity cost of holding money rises and one is willing to hold less cash balances. Also, the greater the probability of a decline in the interest rate (when the interest rate is high), the greater the likelihood of higher bond prices (capital gains). Thus greater the gains from holding more bonds or interest bearing assets as opposed to money. The parameter h represents the interest elasticity of money demand. It represents the sensitivity of money demand to changes in the interest rate (the percentage change in money demand for a percentage change in the interest rate).

The important thing to note about the parameters k and h is that they are subject to much debate and empirical estimation. Monetary policies are very much dependent on the income and interest elasticities of money demand. Different schools of thought make different assumptions about the income and interest sensitivities of money demand which gives rise to different implications for the effectiveness of monetary policy (to be discussed later).

Regarding the speculative demand for money, Keynes noted that it is typically large when the prevailing interest rate is very low. Keynes’ view was that people have a relatively fixed concept of the normal interest level that should hold in the economy. So, if the prevailing interest rate is very low, they would expect it to rise and expect bond prices to fall. If capital losses from holding bonds exceed the interest gains, then there would be a large amount of speculative demand for money in the economy. In such a situation, there would be unlimited money demand relative to money supply and the economy would be in a liquidity trap. (Any increases in money supply would be totally absorbed in increased money holdings and lower turnover of money without any corresponding changes in real output or prices-discussed later). Money demand would thus be horizontal at the prevailing low interest rate. The excess demand for money relative to supply at very low interest rates would imply excess supply of bonds given the wealth constraint. (This can be related to our discussion in module 2, that when business confidence is low, even if interest rates are very low and credit is available, investment demand need not pick up. This is because available credit is absorbed in the form of speculative money demand).

Quantity theory of money

The classical money demand function is based on the famous quantity theory of money, which is rooted in the Fisher equation of exchange.

MV = P*Y where

M = money stock,

V =velocity of circulation of money is the number of times the stock of money is turned over per year or the rate at which the nominal stock of money changes hands per year to finance the annual flow of income/sales in the economy.

P = general price level of the economy

Y = real output.

The Fisher equation given above embodies the classical view of money. In the classical tradition, money is like a veil, which determines only nominal values of macroeconomic aggregates like output and has no ultimate effect on economic activity. In other words, money reflects economic activity but does not regulate it. In the above equation, all variables other than prices are determined elsewhere. Output is a function of real factors, money stock is determined by policy makers, and V is dependent on institutional factors such as the degree of financial sophistication in the economy. Since output Y is always at Y*, the full employment level of output in the long run equilibrium, and velocity is inherently stable given that the institutional structure does not change very much over time, the Fisher equation of exchange above gives a direct proportional relationship between money and spending and money and prices. Higher money balances lead to higher spending and higher prices.

Using the quantity theory equation, the money demand function can be expressed as:

Md = (1/V)PY

Given that money market equilibrium requires money supply and money demand to be equal, and given fixed V and Y for the reasons outlined above, higher money holdings must translate into higher prices. Therefore, there is an important dichotomy between real and monetary factors in the economy as real variables such as output and real interest rates are determined by the stock of technology, productivity, factors of production, etc. while nominal variables such as prices are determined by money. Hence, an increase in money supply only affects prices but not real variables in the economy. The classical proposition is that the price level is proportional to the money stock.

Money demand and the quantity theory

The importance of the quantity theory equation for money demand is through the velocity parameter. Velocity is one way of capturing money demand. Suppose the demand for real balances is as given earlier, L(i,Y) where Y is real income and i is the interest rate. When the supply of money equals the demand for money, we have:

M/P = L(i,Y)

Or the nominal money supply, M can be given by:

M = P * L(i,Y)

Substituting for M into the Fisher equation gives us:

V = YN/ (P*L(i,Y)) where YN is nominal income

= Y/L(i,Y) (Y = YN/P)

Then income velocity is the ratio of the level of real income to the demand for real money balances. This is another way of understanding the demand for money. From the above equation we see that velocity of money is a function of real income and the interest rate. An increase in the interest rate lowers the demand for real money balances (as discussed earlier) and thus raises the velocity of money. The idea is that when the cost of holding money rises, individuals turn over the same money more often, making it work more than when the opportunity cost of holding money is lower. The extent to which changes in the interest rate affect the velocity of money depends on the interest elasticity of money demand.

Likewise, changes in income level affect the velocity of money through the income elasticity of money demand. If the income elasticity of money demand is one, then for a percent increase in the income level, there is a percent increase in the demand for real money balances and thus no effect on velocity. If the income elasticity of money demand is less than one, then velocity rises with an increase in income. The income elasticity of money demand and thus the effect of changes in real income on velocity differ for the different categories of money, M1 , M2, etc.

Empirical evidence on money demand

We turn to examine the empirical evidence on money demand in general, and specifically in the Indian context. Since money demand is very important in designing monetary policy and in predicting the effects of changes in monetary policy on interest rates, output, spending, etc., a lot of empirical work has been done to estimate money demand functions. In particular, much work has been done to estimate the interest and income elasticities of money demand as these elasticities affect the ability of money supply to support a certain growth rate in output and income. Empirical work has also been done to assess which monetary aggregates are the most relevant in the money demand function, to distinguish between the effects of temporary and permanent changes on money demand, to distinguish between short and long run responses, and to see which policy variables and structural parameters affect money demand.

Empirical evidence from the US and some other developed economies clearly indicates that money demand is affected by changes in the interest rate and income. Money demand is negatively related to the interest rate and positively related to real income. The short run response to changes in the interest rate and income are smaller than the long run response. Evidence also indicates that velocity does change with changes in the interest rate, refuting the classical view of the stability of velocity. This means that policies, which affect the interest rate, do affect money demand and velocity, and thus through the interest rate effect can affect output and income levels.

Evidence also sheds light on the role of prices, inflation, wealth, and financial regulations in determining money demand. For instance, data indicate that the price level does not affect real money demand. Demand for nominal balances is proportional to the price level. This means that changes in the price level do not affect real money balances and that there is no money illusion.

Expected inflation is an important determinant of money demand. When inflation is high, people prefer to hold real rather than financial assets as returns on holding the former are perceived to be higher and safer. The increased cost of holding money due to the erosion of purchasing power causes a decline in real money demand. Inflation is particularly important in regulated financial markets where interest rates are not necessarily market determined.

Financial regulation, degree of financial innovation, development of capital markets, and improvements in technology also affect money demand by affecting the transactions cost of holding money and by making available alternative financial instruments for investment purposes.

Finally, wealth affects money demand. Higher holdings of bonds and equities means lower holdings of money balances, as is also implied by the wealth constraint discussed earlier.

Empirical evidence on money demand functions in India

There have been numerous empirical studies estimating money demand functions for India. The real question is whether conventional factors such as income, the own rate of return, the return on competing assets, price expectations, etc. satisfactorily explain money demand in the Indian context. Specifically, these studies have focused on estimating the sensitivity of money demand to real income and interest rates. The differences in results mainly stem from the differences in their definition of real income, whether it is farm or nonfarm, whether it is measured real income or permanent/ expected real income, the way in which price is used to deflate nominal income as well and differences in the interest rate that is used in the money demand equation.

The main findings of these studies are that real income is an important determinant of money demand. Real income, particularly permanent as opposed to measured real income, performs better as a determinant of money demand, with all studies finding real income elasticities of money demand of well over one. (Rangarajan (1988) estimates real income elasticity of broad money at 1.9 for the 1961-62 to 1986-87 period). Thus the transactions motive appears to be important in explaining money demand in India. Most of the studies also find that short-term interest rates are significant for money demand while long-term interest rates, such as returns on government securities with maturity exceeding 20 years, are insignificant.

There are also estimated sectoral money demand functions for businesses and households separately. For households, net disposable income and the short term interest rate is found to be important, indicating the importance of both portfolio shifts and transactions purposes in determining money demand. For businesses, income, current expenses, assets, and the interest rate are found to be important determinants, indicating that business sector money demand is explained by a combination of assets and sales.

The estimated money demand function for India has been tested for narrow money (demand for currency and demand deposits) as well as for broad money (M3). In all three cases, the coefficients have the expected signs and are statistically significant. The explanatory power of the equations is also high. The broad money demand estimate indicates a short run real income elasticity of money demand of 1.31 and corresponding long run real elasticity of 1.82 for the 1970 to 1999 period. The elasticity with respect to the opportunity cost variable (the real rate of return on alternate assets) is estimated at -0.0107 in the short run and -0.0149 in the long run, for this same period. Also, there is a uniform upward shift in the elasticities in the post 1982 period reflecting the deepening of the Indian financial system through deregulation, functional diversification, and financial innovations that started in 1982-83.

Estimates of velocity in India

There are also numerous studies that estimate the velocity of money in India. The velocity of narrow money is found to be higher than that for broad money. Also, there has been a notable downward trend in the velocity of broad money. There is also quite a large divergence between the velocities of broad and narrow money.

Empirical evidence from the Indian studies lead to the following broad conclusions. Velocity appears to be affected by three sets of institutional factors. These are the degree of monetisation, which has a negative effect on velocity, the degree of financial sophistication, which tends to raise velocity through increased substitution of money with other assets, and the degree of economic stability, which raises the velocity of money by lowering precautionary demand for money. Overall, the studies indicate that the velocity of broad money in India is very predictable and in conformity with expectations. Prior information on real income, the interest rate, monetisation, financial sophistication explain most of the variation in velocity.

The speculative component of the money demand equation is Keynes’ contribution to linking the real and financial sectors of the economy and overcoming the classical dichotomy. By creating a broader money demand function, Keynes created a link between the goods and the money markets, through the interest rate. In the classical view. only the transactions demand for money was present.

The classical system uses the equation of exchange as a theory of price determination. The number of physical transactions is limited by the economy’s potential to produce. Then if the velocity and real output are stable, prices are determined by the stock of money.

The degree of financial innovation and development of the capital markets is important in determining not only transactions costs of money management but also in determining the significance of interest rates. When capital markets are well developed, interest rates reflect expectations of inflation. When financial markets are regulated, the interest rate may not pick up expectations that clearly.

These include Vasudevan (1977), Biswas (1962), Sastry (1962), Gujarati (1968), Gupta (1970), and Singh (1970) among others.