Demand for Money - Coursework Example

A) Demand for Money Demand in economics means effective demand, which can be defined as a desire backed by willingness and ability to pay for a particular product. Thus, in order for a demand to be effective, three important factors namely the desire to buy, willingness to buy and ability to buy are the important factors (ICFAI Center for Management Research (ICMR)). The law of demand says that ceteris paribus when the price of a product is high, quantity demanded is low, and vice versa. In other words, other factors remaining the same, the demand for a product is inversely related to the price. When the relationship between demand and price is illustrated in a graphical form it is called the demand curve. The demand curve slopes downward from left to right, because the price of a product goes up the quantity demanded decreases. The demand curve is drawn with the assumption that only the price changes while other factors remain same. Besides such a demand for money in order to carry out various transactions, some people demand it for hoarding or holding wealth in liquid form. It can conveniently be used according to variations in the market conditions (Pinkmonkey.com). Keynes was the first economist to admit the role of speculative activities in modern economy and that of demand for money made by speculators. Such demand is made to invest in capital market for buying shares, bonds, securities etc. when their prices are low. But speculators quickly dispose of their securities when their prices are sufficiently high. They make capital gains from such transactions. In order to carry out this activity, speculators create demand for money on a large scale. Keeping money in this idle form is known as hoarding of money. Keynes has shown that speculative demand for money is highly fluctuating. It all depends upon fluctuating prices and market conditions for securities. Demand for money means demand to hold money on hand. Money in one’s hands earns no income. If converted into goods or other financial assets one can derive either additional utility or income. There are three motives as described by Keynes that makes people hold money on hand. They are: Transaction Motive: In order to meet day-to-day transactions, households and businessmen hold some money. For instance, the working class will get their salaries only on the first of every month, while their expenditures are distributed through out the month. To cater to their day-to-day expenses, people keep aside certain part of their income. It implies that the income which the people receive is periodic while the expenditure incurred by them is continuous. Hence, the transaction motive originates from the need to bridge the gap between the receipts and expenditures. Therefore, if the frequency between the receipts and expenditure is greater, people prefer to hold more money with themselves in the form of either cash or bank deposits. Precautionary Motive: Precautionary balances arise because; it is difficult to anticipate exactly the receipts and expenditures. Therefore, in order to cater to unforeseen situations, people tend to hold the money as precautionary balances. As far as the holding of money is concerned transaction motive and precautionary motive are similar. The striking difference between these two motives is that money that is, demanded to meet day-to-day expenses is transaction motive, while money that is demanded to cater to unforeseen and unexpected transactions is precautionary motive. Speculative Motive: According to Keynes, the speculative motive is, “the desire of earning profit by knowing better than the market what the future will bring forth.” In reality people tend to hold securities or assets in anticipation of increase in the value of their assets or securities and similarly, if there is no chance of increasing the value of the assets or securities, people will fear to hold those assets or securities. Generally, if people anticipate rise in the price of securities they hold them to earn a profit at a later date. Similarly, people who have idle cash balances plan to buy the securities at a lower rate and sell them at a higher price to earn profit. In other words, it implies that people tend to hold less idle cash balances, when they anticipate rise in price of securities. On the other hand people tend to dispose off their securities if they anticipate decline in the prices of the securities at higher prices and hold cash balances so as to buy the securities when the price of securities decline. Thus, the inference of the above analysis is that there is an inverse relationship between the market price of the security and the real rate of interest. B) Supply of Money: The supply money means the amount of money held by the people in the country. In other words, the supply of money is the amount of money held by and used by the people for transactions, for making payments and for settlement of debt. It does not include the amount of money with the Government in its exchequer and the amount of money held by the financial institutions such as banks. The amount of money circulation at a given point of time consists of two components namely: Currency Component – Currency component is the money available with the people. It consists of cons and currency notes issued by the Central Bank. It is also known as common money or ordinary money. Currency money is the legal tender money and it is used by the people for all transactions and settlement of debts. It does not include cash held by the banks and such other financial institutions. Deposit component – It constitutes the money deposited by the people in the form of demand deposits with the banks. Narrow Money The concept of money supply in an economy is known as narrow money or ordinary money (M1). According to Radcliffe Committee, “Spending is not limited by the amount of money in existence but it is related to the amount of money people thing they can get hold of.” Near money assets are the liquid assets and are available for the people to spend at any given point of time. The components of near money assets are the fixed deposits or time deposits. Broad Money Broad money is the summation of fixed deposits and the narrow money. It is designed as M3. The difference between narrow money and broad money is with regard to treatment of fixed deposits of the people with the banking system as they are income earning assets. Broad money (M3) includes fixed deposits of the people as part of the total monetary resources of the people. The fixed deposits have the property of liquidity because people purchase them by converting their cash into fixed deposit to earn interest income (ICFAI Center for Management Research (ICMR)). In the recent years, the liberalization policies of the banks, partial or full convertibility of fixed deposits have become more popular in terms of liquidity. Measuring the Money Supply 1. M1: demand deposits, plus currency and coin in circulation. 2. M2= M1 + near monies i. “Near Monies” will store value but cannot themselves be in circulation for purchases. Savings deposits, small time deposits (e.g. a 3-month certificate of deposit), and money market mutual funds (funds that grows your investment in a selected group of money market funds). 3. M3= M2 + large value CDs. This type of certificate of deposit is denominated in units such as $100,000, is negotiable for resale, and cannot be withdrawn against by check writing (Foothill education). Supply Side economics supports higher taxes and less government spending to help economy. Unfortunately, the Supply Side theory was applied in excess during a period in which it was not completely necessary. The Supply Side theory, also known as Reganomics, was initiated during the Regan administration. During the 1970’s, the state and local governments increased sales and excise taxes. These taxes were passed from business to business and finally to the customer, resulting in higher prices. Along with raised taxes for the middle and lower classes, this effect was compounded because there was little incentive to work if even more was going to be taxed. People were also reluctant to put money into savings accounts or stocks because the interest dividends were highly taxed. There was also too much protection of business by the government which was inefficient and this also ran up costs, and one thing the Supply Side theory was quite good at was reinforcing inflation (Cyberessays.com). Bibliography 1. Cyberessays.com. Modern Economic Theories. 05 March 2008 . 2. Foothill education. "Money in the Modern Economy." 05 March 2008 . 3. ICFAI Center for Management Research (ICMR). Economics for Managers. Hyderabad: ICFAI Center for Management Research, 2003. 4. —. Money and Banking. Hyderabad: ICFAI Center for Management Research (ICMR), 2005. 5. Pinkmonkey.com. Demand For money. 5 March 2008 . Read More