What is Money?

refers specifically to assets that are widely used and

accepted as payment. Most forms of money is checkable deposits or
bank accounts. Money is the economist’s term for assets
A person’s decision about how much money to hold is a part of a
broader decision about how to allocate wealth among various assets
that are available.
The Functions of Money
Medium of Exchange : money permits people to trade at less
cost in time and effort
Unit of Account : basic unit for measuring economic values.
Store of Value : is a way of holding wealth.

How much money you chose to hold

Portfolio Allocation Decision: - Expected Return, Risk and Liquidity
Trade off among the three characteristics that make an asset
desirable: a high expected return, safety and liquidity.
Liquidity of an asset is the ease and quickness with which it can be
exchanged for goods, services and other assets. Money is a highly
 Emphasis on money due to
Most dynamic element in modern economy, A link between present and
future, Durable asset capable of performing store of value function,
Recovery in employment and income can be effected through
monetary adjustment,Public outlays and private outlays find unit of
value in money,High levels of output and employment are found in the
flow of income rather than in accumulation of wealth., Monetary
adjustments are publicly controllable,To the extent that the monetary-
fiscal authorities exercise an appreciable influence over the flow of
income economic activities are freed from erratic fluctuations

In-adequacy of Monetary Economy

Monetary-fiscal policy should be supplemented by non-monetary policy.
Monetary theory is essentially a short run analysis.
Theory is inadequate in explaining the long run behaviour of economy
based largely on such “real” factors as technological, institutional or
structural changes
 Internal Value of a Currency
The internal value of currency refers to purchasing power of that
currency in terms of domestic goods and services.

External Value of a Currency

The external value of currency refers to (purchasing power of that
currency in terms of foreign goods and services), that is, its foreign
exchange rate or the domestic price of a foreign currency.

The value of money

A change in value of money affects our general ability to command
goods and services in exchange.High prices of other things are reflected
in the low exchange value of money. The value of money is therefore
reciprocal of general price level
 Functions and Significance of Money
Classical economists had a common tendency to regard monetary
phenomena as a misleading reflection of real phenomena. Money might
disturb smooth operation of natural laws of supply and demand. They
tacitly assume the stability of the value of money. Money could never be
a disequilibrating factor.
By contrast the starting point of modern monetary theory is that
money is inherently unstable. In Keynes general theory of monetary
equilibrium monetary variables as income, consumption, savings and
investment play major roles. The stabilization of the value of money is
brought into direct relation with stabilization of income and
employment. In-adequacy of Monetary Economy
Monetary-fiscal policy should be supplemented by non-monetary policy.
Monetary theory is essentially a short run analysis.
Monetary theory is inadequate in explaining the long run behaviour of
economy based largely on such “real” factors as technological,
institutional or structural changes.
 The Demand for Money
The macro-economic variables that have greatest effect on money
demand are the Price level, Real Income, Interest Rate, Wealth (small
impact), Risk (money does not always carry a low risk, in erratic
inflation, money demand may fall as people switch to inflation hedges
such as gold, real estate), Liquidity of Alternative assets (innovation in
financial markets and how quick and easily alternative assets can be
converted to cash), payment technologies for making and receiving
payments (credit card, debit card, ATMs).
 The Demand for Money
•Everything else being equal, the nominal Md is proportional price
level.
•The more transactions that individuals/ businesses conduct, the more
liquidity they need and the greater is their demand for money.
•Unlike the response of Md to changes in the price level, the increase
in Md need not be proportional to an increase in real income.
•With risk and liquidity held constant , the Md depends on the
expected returns of both money and alternative monetary assets.
•The many interests in the economy generally tend to move up or
down together.
•Expected real interest rates is relevant to saving and investment
dcsns
•An increase in the roi on money makes people hold on to money.
•An increase in wealth on money demand is likely to be small
•Money doesnot always carry a low risk
•Increased riskiness in the economy may increase money demand
•As alternative assets become more liquid demand for money
 The Demand for Money
•Md = P x L (Y, i), Y-real Income or output, i- nominal roi earned
by non-monetary assets. Md- aggregate dd for money in nominal terms
•Md = P x L (Y, r +einf), Y-real Income or output, i= r +einf.
•For any expected rate of inflation an increase in real interest rate
increases the nominal interest rate and reduces demand for money
•Md/P = L (Y, r +einf),=> demand for real balances is the amounts of
money in terms of goods it can buy.
•Interest and Interest elasticity of money demand and its usefulness

Money Supply
The money supply is the amount of money available in the economy. It
is mostly determined by the Central Bank. Central Bank can use newly
minted currency to buy financial assets directly from the govt. or public.
Open market operations to change money supply or efforts to curb
demand for money.Money supply is a stock item.
 Monetary Aggregates
Monetary aggregates differ in how narrowly they define the concept of
money. Accordingly different weight-ages are given.
M1- Currency, Travelers’cheque, demand deposits, chequable deposits
M2- M1 plus (less money-like) Savings deposits including MMDAs,
small-denominations time deposits, MMMFs (non-institutional)
M3- M2 plus other assets such as large-denomination time deposits,
MMMFs held by institutions, repurchase agreements and other
currencies (denominated to our currency value) held by home residents
in foreign branches of host country’s banks. Many of the assets included
in M3 are not money in strict sense of being directly acceptable in
payment.
The distinction between monetary assets and non-monetary assets isn’t
so clear. Assets differ in their moneyness. The various monetary
aggregates differ in how narrowly they define the concept of money.
Broader measures of money includes assets that can be quickly and
cheaply converted into currency and checkable deposits
 The velocity of money is determined by ;-Individual spending
habits, expectations and whims,development of banking and financial
institutions, method of income payment,People’s habit as to
consumption and saving, ability to invest savings, expectation as to
changes in future prices and income,during depression people tend to
spend less, sell securities, and hold on to cash, expecting prices and
incomes to fall further, thereby decreasing velocity.

Velocity is nominal GDP divided by money stock, i.e. V=PY/M

MV=PT or MV=PY=nominal GDP
•Velocity of M1, M2 and M3 are different
• Financial innovation plays a crucial role in velocity.
•Lower interest rate on non-monetary assets may increase the
willingness to hold low interest or zero-interst money
•When demand to hold money is high, velocity is reduced.
•Numerous explanations for surprising instability in money demand
=> pace of innovation and change in financial system.
 •Sweep programmes have distorted dd for M1 substantially.
•As a way to avoid reserve requirements on transaction accounts

Asset Market Equilibrium

•The asset market is in equilibrium when the quantity of each asset
that holders of wealth demand equals the fixed available supply of that
asset.
•Aggregation assumption---all assets may be grouped into two
categories, money and non-monetary assets.
•This assumption ignores many interesting differences among assets
•And asset market equilibrium reduces to the condition that the
quantity of money supplied equals the quantity of money demanded.
Asset Market Equilibrium Condition
•Real demand for money = real supply of money
•Md/P= L (Y, r +einf) = real dd for money = M/P = real money ss
•P= economy’s price level = M/{ L (Y, r +einf)} equals ratio of money
supply to real demand for money
 Asset Market Equilibrium Condition
•Real demand for money = real supply of money
•Md/P= L (Y, r +einf) = real dd for money = M/P = real money ss
•P= economy’s price level = M/{ L (Y, r +einf)} equals ratio of money
supply to real demand for money
•dP/P= dM/M-{ dL (Y, r +einf) / L (Y, r +einf)}