Chapter-7

Theoretical Part
1. What are the motives for holding money? Briefly explain the ‘liquidity preference’ of John Maynard
Keynes.
Demand for money
As we discussed before, the role of money multiplier in determining the money supply depends on the
behavior of the borrowers and depositors. The price of money – the interest rate – also hinges on how much
money people want to hold in different forms of assets.
At first glance the issue of demand for money may appear to be a bit trivial. After all, don’t we all want
more money to buy more goods and services? And hence our demand for money should be infinite (or at
least as much we can possibly get)! But recall from our previous lessons that money is a stock variable (and
not a flow) and that income and wealth are not money. When we talk about the demand for money in
economics, we are referring to how much of the wealth of an individual would that person be willing to
hold in the form of money at any point in time.
7.9.1 Why do people hold money?
Holding wealth in the form of money earns zero or very little interest. Thus the opportunity cost of holding
money is the forgone interest payments. Additionally, money has no intrinsic value, it cannot provide us
with services that other assets can e.g. a house can keep us warm while a golden jewelry can make us happy.
But in spite of this, people still need to hold money for several reasons. The famous economist John
Maynard Keynes in his liquidity preference theory states that are three motives why people hold money:
the transaction motive, the precautionary motive and the speculative motive. We next turn to each of them
in detail.
7.9.1.1 Transaction motive
The demand for money arises from the fact that people hold money for the purpose of carrying out day to
day transactions. Keynes also followed this classical view and suggested that this component of money
demand is determined primarily by the level of transactions that people carry out. The volume of
transactions is in turn determined by the level of income of the individuals and hence this component of
money demand is also proportional to the level of income. In short, as income increases people demand
more money to finance higher amount of transactions.
7.9.1.2 Precautionary motive
Keynes suggested that in addition to holding money for performing transactions, people also hold money
as a cushion against an unforeseen or unexpected need. Thus if people hold money as a precaution against
unforeseen needs then they will be able to pay for things like emergency bills for hospitalization. Similar
to the transactions motive, this component of money demand is dependent on the level of transactions which
in turn is dependent on the level of income. Thus, the precautionary demand for money is also proportional
to income.

7.9.1.3 Speculative motive

So far the components of money demand we saw were found to be only dependent on the level

of income. But Keynes identified another component that set his theory apart from the classical

view that only income determined money demand. This is the speculative motive for holding

money, which depends on both wealth and interest of the economy.

2. What will happen to the economy if the demand for money increases? (Explain graphically)

3. What are the types of money? Explain?

7.4 Types of Money – Evolution of the Payments System

Over the course of time, several items have been used to perform the functions of money. These can be
broadly categorized under the heading of the following:
Commodity Money: Money which has intrinsic value i.e. the item used as money itself has a value: e.g.
metals such as gold, copper, silver etc. The value of the object used (e.g. gold) determined the value of the
money. This was the major form of money used during earlier periods but understandably was very
inconvenient to carry around. Hence their use waned over time.
Fiat Money: Money which has no intrinsic value. Initially paper currencies were issued to be convertible
into coins or into a quantity of precious metal. But over time the currency has evolved into fiat money –
paper currency decreed by governments as legal tender, which means that legally it must be accepted as
payment for debts, but not convertible into coins or precious metals. Paper money and coins are also called
‘currency’ e.g. notes issued by central banks of nations. Although paper currency is much lighter than coins
or precious metals but they can be easily stolen and difficult to transport in bulk. This lead to the
development of the next step of the payments system: bank checks.
Bank Money: Anything for which you can write a check. Personal checks are not legal tender, not as liquid
as currency. A bank check is an instruction from the account holder to his bank to transfer the stated amount
of funds from his account to the account of the person depositing the check. They can be used much like
money to make payments and settle debts but are not that liquid. The primary advantage of check is that
they facilitate large transactions without the need for carrying around big sums of money. Thus check have
improved the efficiency of the payments system. But the problem with check is that they require time and
costs to be settled and for the funds to be accordingly transferred.
Electronic Payment: With the advent of new and cheap technology, the banking system has benefitted
from the use of electronic payments – using the electronic banking system provided by banks to pay for
bills and expenses. This is especially helpful for the payment of utility bills and also saves costs and time
involved in the payment process. Thus it makes the clearing process faster and efficient and can act as
substitute of bank checks.
E-Money: Electronic payments mechanism can also act as substitute for cash in the form of Electronic
Money (or E-Money) – money that exists only in electronic form. The first type of e-money developed was
in the form of Debit Cards – cards that enable consumers to purchase goods and services by electronically
transferring funds from their bank accounts to the account of the business. Upon making a transaction, it
directly deducts money from the buyer’s checkable account. It provides the convenience of not carrying
around cash or physical checks.

4. Explain the statement

“The economist’s definition of money is a little different from the sense in which the term is
used in everyday language”
The economist’s definition of money is a little different from the sense in which the term is used in everyday
language. In economics ‘money’ is defined as anything that is generally accepted as payment for goods and
services and for paying back debts. Therefore, currency consisting of bank notes and coins certainly falls
under this category and hence is one form of money. When people talk about money in their everyday lives,
they are referring to currencies.
But for economists just defining currencies as money would be very restrictive as there are other things that
can perform similar functions. Take the case of bank check: you can use them to pay off bills, settle debts
or even pay for your purchases. Thus checks (drawn on checkable deposits) should also be treated as money.
But in the broader sense, saving deposits can also be seen as money if they can be easily converted into
cash currency or checkable deposits.
Another additional complication arises when the term money is used in everyday language as a synonym
wealth. Thus when people say “Mr. X is rather rich, he has tons of money” they are actually referring to his
wealth – the accumulation of his savings and the total values of the various assets that he owns, including
stocks, bonds, houses, yachts, etc. Although money is an asset for the person in its possession, what makes
it different from other assets is its inability to earn interest.
The term money is also sometimes used to refer to income. Therefore when we hear people say that “Mr.
Y has a great job, he earns a lot of money’, they are referring to his income – the flow of earnings per unit
of time. But money is a stock concept– the amount at a specific point of time and not a change over time
(please refer to Chapter 2, Box 1 for a detailed discussion on flow vs. stock variables). Thus income cannot
be treated as money and hence our definition of money is different form its sense when used to refer to
wealth and income. In short, we can only say that money is what money does. To summarize the above:

 Money is anything which is accepted as payment for goods and services and for paying back debts
 Money and income are not the same (same goes for wealth)
 Money is also an asset (interest free)

5. What are the criteria for any commodity to effectively perform the function of money?
No matter what form money may take - be it cowry shells, beads, rocks or precious metals like gold and
silver - it serves to perform these 3 primary functions in the economy:
7.2.1 Medium of Exchange
Money is the medium via which goods and services are paid for in almost all types of market transactions
in the economy. Therefore it acts as the medium of exchange through which goods and services are
exchanged for one another. As we can see from our own experience of day to day economic transactions,
money is what is used to buy goods and services from the market and it is also what we are paid in as salary
and wages for our services rendered.

For any commodity to effectively perform the function of money, they must meet the following criteria:
i. It must be easily standardized, making it easy to set its value.
ii. It must be widely accepted and easily recognized i.e. universally acceptable.
iii. It must be divisible, so that it is easy to ‘make change’.
iv. It must be easy to carry around and transport (low weight and easily accessible shape and size).
v. It must not deteriorate quickly (breakdown or decay easily)
7.2.2 Unit of Account
The second important role of money in the economy is that it provides a unit of account i.e. it provides a
measurement of value in the economy. The prices of goods and services in any modern economy is
measured and denoted in terms of money. For example, the way we measure weight in kilograms and
distance in kilometer, the same way the value of a good or service is measured (and quoted) in terms of
money. Thus it is money which enables us to measure the value of the good or service that we buy or sell
in the market.
7.2.3 Store of Value
The third role that money plays in the economy is that it functions as a store of value i.e. it acts as a store
of the purchasing power that is embedded in it. A store of value can save the purchasing power of money
from the time the money is received (as salary, earnings or compensation of any other form) until the time
it is spent to buy goods and services.

6. “Though money is printed by the central bank, the amount of money the economy is ended up
with depends on the behavior of other actors”-justify the statement.
7. Write down the short notes on-
a) Money multiplier
The money multiplier is the amount of money that banks generate with each dollar of reserves. Reserves
is the amount of deposits that the Federal Reserve requires banks to hold and not lend. Banking reserves is
the ratio of reserves to the total amount of deposits.

The money multiplier is the ratio of deposits to reserves in the banking system.

Imagine that you are president of a large bank. The Fed requires that you hold 10% of your deposits in
reserves, a reserve ratio of 1/10. This means that for every $1.00 of deposits, you can only lend out $0.90.
The total value of your bank's deposits is $100,000,000. You want to maximize your bank's profits, so you
loan out all of the $90,000,000. All of sudden, you've just increased the supply of money from $100,000,000
to $190,000,000!

Here's how you did it. Your depositors still have $100,000,000 with you, but only on paper. They can come
in any time and get their money. However, since not everyone wants, or needs, their money at the same
time, your reserves of $10,000,000 will cover the normal demand for withdrawals.

At the same time, you have distributed $90,000,000 in loan funds to your borrowers - that's real money
going out the bank's door. Your borrowers will spend that money on houses, cars, factories, and machinery,
among countless other purchases. The sellers who receive the loaned money in exchange for their goods or
services will deposit their revenue in banks. And of course, the banks will turn around and loan out another
90% of that $90,000,000, and the cycle will start over again.

b) Keynes liquidity preference theory

The Liquidity Preference Theory says that the demand for money is not to borrow money but the desire to
remain liquid. In other words, the interest rate is the ‘price’ for money.

John Maynard Keynes created the Liquidity Preference Theory in to explain the role of the interest rate by
the supply and demand for money. According to Keynes, the demand for money is split up into three types
– Transactionary, Precautionary and Speculative.
He also said that money is the most liquid asset and the more quickly an asset can be converted into cash,
the more liquid it is.

c) Fiat Money
Money which has no intrinsic value. Initially paper currencies were issued to be convertible into coins or
into a quantity of precious metal. But over time the currency has evolved into fiat money – paper currency
decreed by governments as legal tender, which means that legally it must be accepted as payment for debts,
but not convertible into coins or precious metals. Paper money and coins are also called ‘currency’ e.g.
notes issued by central banks of nations. Although paper currency is much lighter than coins or precious
metals but they can be easily stolen and difficult to transport in bulk. This lead to the development of the
next step of the payments system: bank checks.

8. What is the difference between M1 & M2? Why credit card can’t be counted as money?
Narrow Money (M1): The first item of monetary aggregates is Narrow Money, also called M1, which
consists of:
i i. Currency in circulation (C) – Notes and Coins; also known as Currency Outside banks; this is
also called as M0.
ii ii. Demand Deposits (DD) in the banking system. Deposits are also money as they are short term
deposits that can be converted into currency relatively easily and quickly. They can be also be used to repay
debts. Demand Deposits include current account, savings account and traveler’s check among other short
term deposits.

Thus we have: M1 = C + DD
Broad Money (M2): First define a type of money termed as Quasi Money (QM) and which includes time
and savings deposit (TD) in the banks and any foreign currency deposit (FC) of residents. Now Broad
Money (M2) which includes all liabilities in the banking system and is defined as:
Broad Money (M2) = Narrow Money (NM) + Quasi Money (QM)
Thus M2 includes everything in M1 and additionally includes savings deposits (e.g. Post Office savings
deposits), time deposits (e.g. fixed deposits of different terms) and foreign currency deposits.

No. The answer may come as a bit of a surprise as we can use credit cards to make purchases and thus it
seems to perform the functions of money. But recall that, to be money, it has to be able to store value. When
you make a purchase using a credit card: the payment the bank makes on your behalf is money and so is
the repayment that you make to the bank. But the credit that the bank provides you is just an obligation of
repayment and it cannot be used like money to say make purchases or settle debts. Thus, credit cards are
not money.

9. Briefly discuss the Barter System. What are the limitations in the barter system?
10. Derive the equation
𝑐+1
Money multiplier 𝑚= ( )
𝑟+𝑒+𝑐

Show the relation of r,e & c with m.

The money multiplier (m) measures the change in the money supply (M) due to the change in the monetary
base (MB).
M = m × MB
m gives us what multiple of monetary base is transformed into money
Let us define,
c = C/D = currency ratio
e = ER/D = excess reserve ratio
We know, Total reserve R = Required Reserve (R) + Excess Reserve (ER)
= r × D + ER
Thus, Monetary Base (MB) = R + C = r × D + ER + C
=r×D+e×D+c×D
= D (r + e + c)

Hence, D = [1/(r + e + c)] × MB

Money supply (M) = C + D = c x D + D = D [1+c]

= [(1+c)/(r + e + c)] MB
Therefore, money multiplier m = (1+c)/(r + e + c)
The above formula for money multiplier sheds light on the fact that the extent of amplification of monetary
base (reserve) critically depends on the behavior of the central bank, commercial bank and depositors.
Central Bank (r): When the central bank raises the required reserve ratio, the impact on the money supply
creation is lessened due to lower value of the multiplier. The intuition is that less money is left for loan
when r is increased. As the deposit creation depends on bank’s lending, an increase in r slows down the
money creation process by the banks.
Depositors (c): When the depositors prefer to hold more cash than make deposits, the currency ratio
increases and thus the multiplier is reduced. This leads to the lower increase in the money supply (c
m )
Banks (e): Banks may increase their excess reserves during periods of high demand for cash withdrawals
by their depositors e.g. before Eid festivals. When they do so, it serves to increase the excess reserve ratio,
lower the amount credit disbursement and thus reduces the multiplier. Hence the impact on money supply
is lower (e m ).
 Applied Part

1. If a bank’s deposits equal $579 million and the required reserve ratio is 9.5 percent, what dollar amount
must the bank held in reserve form?

2. If the Fed creates $600 million in new reserves, what is the maximum change in checkable deposits that
can occur if the required reserve ratio is 10 percent?

3. Bank A has $1.2 million in reserves and $10 million in deposits. The required reserve ratio is 10 percent.
If bank A loses $200,000 in reserves, by what dollar amount is it reserve deficient?
4. Assume, an economy currency ratio is 30. Currency in the market takes 10 million. The excess reserve
is taken 10000 and the required reserve ratio is 0.4. What is the money multiplier?
5. In our class, we have discussed the money supply & demand curve.
(a) What about the shape of the money supply & demand curve?
(b) Discuss the different scenarios of shift of money supply & demand curve.
6. Justify the following statements
(a) Money is the oil that lubricates the wheel of the economy by reducing transaction costs and improving
efficiency by encouraging specialization and the division of labor.
(b) The effectiveness of money as a store of value depends on the price level in the economy.
(c) Though money is printed by the central bank, the amount of money the economy is ended up with
depends on the behavior of other actors.
(d) The relationship of money demand with interest rate, income & inflation is ambiguous
(e) In a developing country like Bangladesh, a large share of savers remains outside the formal financial
market.
7.
a. If M times V increases, why does P times Q have to rise?
b. What is the difference between the equation of exchange and the simple quantity theory of money?
8.

Find out the money multiplier in the above cases