Money Market (Part -1)
Table of Content:
Money may make the world go around, it plays an essential role in causing the things in life to work as they should; to underlie the fulfilment of the needs of human existence. And most people in the world probably have handled money, many of them on a daily basis. But despite its familiarity, probably few people could tell you exactly what money is, or how it works.
In short, money can be anything that can serve as a
(1) store of value, which means people can save it and use it later—smoothing their purchases over time;
(2) unit of account, that is, provide a common base for prices; or
(3) medium of exchange, something that people can use to buy and sell from one another.
Perhaps the easiest way to think about the role of money is to consider what would change if we did not have it.
If there were no money, we would be reduced to a barter economy. Every item someone wanted to purchase would have to be exchanged for something that person could provide.
Until relatively recently, gold and silver were the main currency people used. Gold and silver are heavy, though, and over time, instead of carrying the actual metal around and exchanging it for goods, people found it more convenient to deposit precious metals at banks and buy and sell using a note that claimed ownership of the gold or silver deposits. Anyone who wanted to could go to the bank and get the precious metal that backs the note. Eventually, the paper claim on the precious metal was delinked from the metal. When that link was broken, fiat money was born. Fiat money is materially worthless, but has value simply because a nation collectively agrees to ascribe a value to it. In short, money works because people believe that it will. As the means of exchange evolved, so did its source—from individuals in barter, to some sort of collective acceptance when money was barley or shells, to governments in more recent times.
There are some general characteristics that money should possess in order to make it serve its functions as money. Money should be:
• durable or long-lasting
• effortlessly recognizable.
• difficult to counterfeit i.e. not easily reproducible by people
• relatively scarce, but has elasticity of supply
• portable or easily transported
• possessing uniformity; and
• divisible into smaller parts in usable quantities or fractions without losing value
Having understood the role of money in an economy, we shall now examine the concept of demand for money. If people desire to hold money, we say there is demand for money. As we are aware, the demand for money is in the nature of derived demand; it is demanded for its purchasing power. The demand for money is a demand for real balances. In other words, people demand money because they wish to have command over real goods and services with the use of money. Demand for money is actually demand for liquidity and demand to store value. The demand for money is a decision about how much of one’s given stock of wealth should be held in the form of money rather than as other assets such as bonds. Although it gives little or no return, individuals, households as well as firms hold money because it is liquid and offers the most convenient way to accomplish their day to day transactions.
Demand for money has an important role in the determination of interest, prices and income in an economy. Understanding money demand and how various factors affect that demand is the basic requirement in setting a target for the monetary authority.
Before we go into the theories of demand for money, we shall have a quick look at some important variables on which demand for money depends on. The quantity of nominal money or how much money people would like to hold in liquid form depends on many factors, such as income, general level of prices, rate of interest, real GDP, and the degree of financial innovation etc. Higher the income of individuals, higher the expenditure; richer people hold more money to finance their expenditure. The quantity which people desire to hold is directly proportional to the prevailing price level; higher the prices, higher should be the holding of money. As mentioned above, one may hold his wealth in any form other than money, say as an interest yielding asset. It follows that the opportunity cost of holding money is the interest rate a person could earn on other assets. Therefore, higher the interest rate, higher would be opportunity cost of holding cash and lower the demand for money. Innovations such as internet banking, application based transfers and automated teller machines reduce the need for holding liquid money. Just as households do, firms also hold money essentially for the same basic reasons.
The quantity theory of money, one of the oldest theories in Economics, was first propounded by Irving Fisher of Yale University in his book ‘The Purchasing Power of Money’ published in 1911 and later by the neoclassical economists. Both versions of the QTM demonstrate that there is a strong relationship between money and price level and the quantity of money is the main determinant of the price level or the value of money. In other words, changes in the general level of commodity prices or changes in the value or purchasing power of money are determined first and foremost by changes in the quantity of money in circulation. Fisher’s version, also termed as ‘equation of exchange’ or ‘transaction approach’ is formally stated as follows:
In the early 1900s, Cambridge Economists Alfred Marshall, A.C. Pigou, D.H. Robertson and John Maynard Keynes (then associated with Cambridge) put forward a fundamentally different approach to quantity theory, known as cash balance approach. The Cambridge version holds that money increases utility in the following two ways:
1. enabling the possibility of split-up of sale and purchase to two different points of time rather than being simultaneous, and
2. being a hedge against uncertainty
In the early 1900s, Cambridge Economists Alfred Marshall, A.C. Pigou, D.H. Robertson and John Maynard Keynes (then associated with Cambridge) put forward a fundamentally different approach to quantity theory, known as cash balance approach. The Cambridge version holds that money increases utility in the following two ways:
1. enabling the possibility of split-up of sale and purchase to two different points of time rather than being simultaneous, and
2. being a hedge against uncertainty.
Keynes’ theory of demand for money is known as ‘Liquidity Preference Theory’. ‘Liquidity preference’, a term that was coined by John Maynard Keynes in his masterpiece ‘The General Theory of Employment, Interest and Money’ (1936), denotes people’s desire to hold money rather than securities or long-term interest-bearing investments.
According to Keynes, people hold money (M) in cash for three motives:
The transactions motive for holding cash relates to ‘the need for cash for current transactions for personal and business exchange.’ The need for holding money arises because there is lack of synchronization between receipts and expenditures. The transaction motive is further classified into income motive and business (trade) motive, both of which stressed on the requirement of individuals and businesses respectively to bridge the time gap between receipt of income and planned expenditures.
Many unforeseen and unpredictable contingencies involving money payments occur in our day to day life. Individuals as well as businesses keep a portion of their income to finance such unanticipated expenditures. The amount of money demanded under the precautionary motive depends on the size of income, prevailing economic as well as political conditions and personal characteristics of the individual such as optimism/ pessimism, farsightedness etc. Keynes regarded the precautionary balances just as balances under transactions motive as income elastic and by itself not very sensitive to rate of interest.
The speculative motive reflects people’s desire to hold cash in order to be equipped to exploit any attractive investment opportunity requiring cash expenditure. According to Keynes, people demand to hold money balances to take advantage of the future changes in the rate of interest, which is the same as future changes in bond prices. It is implicit in Keynes theory, that the ‘rate of interest’, i, is really the return on bonds. Keynes assumed that that the expected return on money is zero, while the expected returns on bonds are of two types, namely:
(i) the interest payment
(ii) the expected rate of capital gain.
Baumol (1952) and Tobin (1956) developed a deterministic theory of transaction demand for money, known as Inventory Theoretic Approach, in which money or ‘real cash balance’ was essentially viewed as an inventory held for transaction purposes.
Inventory models assume that there are two media for storing value:
(a) money and
(b) an interest-bearing alternative financial asset.
Milton Friedman (1956) extended Keynes’ speculative money demand within the framework of asset price theory. Friedman treats the demand for money as nothing more than the application of a more general theory of demand for capital assets. Demand for money is affected by the same factors as demand for any other asset, namely
1. Permanent income.
2. Relative returns on assets. (which incorporate risk)
James Tobin, an American economist, in his analysis makes a valid assumption that people prefer more wealth to less. According to him, an investor is faced with a problem of what proportion of his portfolio of financial assets he should keep in the form of ready money (which earns no interest) and in the form of investment (which earns interest) such as bonds. An individual’s portfolio may also consist of more risky assets such as shares.
According to Tobin, when individuals are faced with various safe and risky assets, they diversify their portfolio by holding a balanced combination of safe and risky assets.
According to Tobin, an individual's behaviour shows risk aversion, which means they prefer less risk to more risk at a given rate of return.
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