Demand and Supply for Money

DEMAND AND SUPPLY FOR MONEY – MACROECONOMICS REPORT DEMAND FOR MONEY * What is Demand for Money? The demand for money represents the desire of households and businesses to hold assets in a form that can be easily exchanged for goods and services. Spendability, or liquidity, is the key aspect of money that distinguishes it from other types of assets. For this reason, the demand for money is sometimes called the demand for liquidity. * Many factors influence our total demand for money balances. The four main factors are 1. the level of prices 2. the level of interest rates . the level of real national output (real GDP) 4. the pace of financial innovation * Three Reasons or Motives for a Large Demand of Money Economists have identified three primary motives for holding money: †¢ To settle transactions, since money is the medium of exchange. †¢ As a precautionary store of liquidity, in the event of unexpected need. †¢ To reduce the riskiness of a portfolio of assets by including some money in the portfolio, since the value of money is very stable compared with that of stocks, bonds, or real estate. * Transaction Motives Money is an essential element in order to have a purchasing power. * This is money used for the purchase of goods and services. The transactions demand for money is positively related to real incomes and inflation. As an individual's income rises or as prices in the shops increase, he will have to hold more cash to carry out his everyday transactions. The quantity of nominal money demand is therefore proportional to the price level in the economy. * The  transactions motive  for demanding money arises from the fact that most transactions involve an exchange of money.Because it is necessary to have money available for transactions, money will be demanded. The total number of transactions made in an economy tends to increase over time as income rises. Hence, as income or GDP rises, the  transactions demand  for money also rises. * The transactions motive for money demand results from the need for liquidity for day-to-day transactions in the near future. This need arises when income is received only occasionally (say once per month) in discrete amounts but expenditures occur continuously. Example: Households and firms hold money or demand money in order to conduct regular payments of goods and services they purchase from the market. * The households and firms hold money to pay for daily expenses such as food, clothing, transportation, and rentals. * In other words, people hold money for transactions purposes – hence the motive is for transaction. * Precautionary Motive * This is money held to cover unexpected  items of expenditure. As with the transactions demand for money, it is positively correlated with real incomes and inflation. People often demand money as a  precaution  against an uncertain future. Unexpected expenses, such as medical or car repair bills, often require  immediat e payment. The need to have money available in such situations is referred to as the  precautionary motive  for demanding money * People need to be financially secure in the future, especially in financing or paying for unforeseen events. * Example: Money is used for emergency expenses such as hospitalization, accidents, contingency funds for unidentified household or business expenses. * Speculative Motives This is money not held for transaction purposes but in place of other financial assets, usually because they are expected to fall in price. * People want to earn the highest possible income from their different investments. Hence, they hold money to invest into assets or business prospects that have a promising steady flow of returns or income. * It depends on the decisions of households and firms to hold other assets that are liquid and free risks of depreciation in terms of money. * People hold money to make profits or avoid possible losses when the opportunity in the fina ncial market comes. Example: If the bank interest rate is low, the amount of money held for speculative purposes is higher while it is lower if the interest rate is high since the interest rate is the ‘opportunity cost’ of holding cash. QUANTITY THEORY OF MONEY (QTM) It states that the level of prices in the economy is dependent on the amount or level of money circulating in the economy. * The level of prices in the economy is basically the inflation rate. It is the rate at which prices are increasing. * Inflation – refers to the increase in the general level of prices and therefore is the result of too much money circulating in the economy.What would happen if there is an increase in the supply of or too much money circulating in the economy? * There is a possibility that every actor in the economy has so much money and it is natural for them to purchase goods or even services in the economy. An increase in the demand of goods and services without accompanying i ncrease in the available supply will cause the equilibrium price in the economy increase. This premise can be clearly explained if we discuss the quantity theory of money. The Quantity Theory of Money can be expressed by the equation: MV=PYWhere: M= quantity of money or money supply V= velocity of money P= price level Y= aggregate output * PY can be interpreted as the market value of output of the economy or the national income or the GNP. * PY refers to the total income or expenditure for the economy’s final goods. Since it is the value of all final goods and services produced in the economy. It is simply regarded as the nation’s GDP. * From the given equation, velocity of money or V can be expressed as the ration of GNP and money supply. Let us take a look at this equation: V=PYM= GNPM For instance, GNP is equal to P300 B while the amount of money supply in the economy is P50 B then the velocity of money is equal to 6. V= GNPM= 30050=6 * This means that a peso was us ed six times that year to purchase goods and services. * It also being interpreted as the speed of money per year in the circulation. * The QTM assumes that the velocity of money (V) and aggregate output (Y) are fixed, or at least for simplicity purposes, we assume that these factors do not change (or do not change much) MV=PY As a result of the assumptions we made, changes in prices level (or the inflation level in the economy) is directly proportional to changes in money supply * It means that a percentage increase in the money supply will cause an equal percentage increase in the price level or will lead to inflation. THE COMPONENTS OF THE MONETARY STOCK There is a wide range of financial assets in any economy. * Money in the economy is not confined to be circulating paper, bills and coins and the reserved money in the vaults of banks. * Money has many forms which comprises the monetary stock or the money supply in the economy.However, the question is, which part of these is call ed as or being considered as money? * The following table shows the classification of the monetary stock or the money supply. Definition of Money| Components| M1| Currency + Checking Deposits + traveler’s Check + other checkable deposits such as NOW and ATS| M2| M1 + Savings and Small Denomination Time Deposits + Money – Market Mutual Funds| M3| M2 + Large Denomination time Deposits + Repurchase Agreements| L| M3 + liquid assets such as securities (i. e. Treasury Bills), Bankers? Acceptances, Commercial Paper| M1 comprises claims that are liquid. This refers to claims that can be used directly, instantly, and without restrictions to make payments. It consists of items used as medium of exchange. * M2 includes in addition, claims that are not instantly liquid, those that may require notice to depository institution or banks. * M3 includes items that are held primarily by large corporations and wealthy individuals. * L consists of several liquid assets that are close sub stitutes for money. MAIN FEATURES OF THE COMPONENTS OF THE MONETARY STOCK Liquid Low interest earnings Less Liquid High interest earnings It should be noted that from M1 to L, the monetary stock is becoming liquid. M1 is directly used for transactions and L is less liquid and cannot be directly used for transactions purposes. * However, the trade-off is that if the individual hold more M1 than L, the individual is forgoing potential interest earnings from L. the L is being offered at a higher interest rate as compared to the M1. * In general, if you hold more M1, you are very liquid yet you earn little. On the other hand, if you hold more L, you find it very difficult to conduct day-to-day transactions yet you are earning much.Basic Concepts in Definitions * Currency * It refers to coins and bills (paper money) in circulation. * Checking Deposits * Accounts that grant a depositor the right to write checks to individuals, firms, or the government. This component is used in order to a void carrying large amount of money. * This particular component can be considered as money because checks are accepted as for of payments or exchange. * Traveler? s Check * It includes checks issued by non-banks such as American Express 8checks issued by banks are not checking deposits).It is usually used by travelers and tourists, since personal checks are not acceptable in other territories. Therefore, traveler? s check is generally accepted as payment in different territories. Negotiable Order of Withdrawals * A check is invented by thrift institutions as a way getting around the prohibitions of having checking accounts. It is almost same function as travelers check. * Automatic Transfers from Savings Accounts (ATS) * When deposit holders keep money in savings account, the bank automatically transfers from the savings account to the checking account when payment has to be made.This method is usually for bank to bank or institutional transactions. All commercial banks offer this service where savings account can be transferred to other forms of financial assets such as checks or current account (e. g. Land Bank ATS and Metro Bank ATS) * Savings Deposits * Deposits at banks that are not transferable by checks and are often recorded in a separate passbook or ATM (Automated Teller Machine) card kept by the depositor. * Time Deposits * These are the accounts in a bank which require certain maturity date. * Money Market Mutual Funds Interest-earning checkable deposits in financial intermediaries that raise funds by selling shares to individual savers and invest in short-term assets. In addition, these are built-in in all commercial banks such as the BPI Mutual Funds and PNB Mutual Funds * Repurchase Agreements * These are transactions in which bank borrows from a non-bank customer * The bank sells a security today and promise to buy it back at a fixed price tomorrow (that is why it is repurchase) * In that way, the bank gets to use the amount borrowed for a day * Liquid Assets These are assets that can be easily converted into cash such as stocks, cash on hand, cash in banks and accounts receivable- * Treasury Bills * Securities that are issued by the government that have certain maturity date. For instance, the Philippine Government treasury bills (such as the Centennial Treasury Bills). * Banker? s Acceptance * These are orders to pay specific amount at a specific time. This concept usually arises from future date and guaranteed by a bank that stamps it as accepted. * Commercial Paper * It refers to a liquid short term debt instrument issued by private corporations.