ICAI Notes- Unit 1: The Concept of Money Demand: Important Theories | Business Economics for CA Foundation PDF Download

 Page 1


LEARNING OUTCOMES 
 
  
  
UNIT - 1: THE CONCEPT OF  
MONEY DEMAND: IMPORTANT  
THEORIES 
 
 
 
 
After studying this Unit, you will be able to – 
? Define money and describe its nature and characteristics 
? Explain the functions performed by money  
? Describe the various theories related to demand for money 
?
Identify the factors that affect the demand for money.
 
?
Distinguish between the different variables considered by each of 
the theories of demand for money 
  
MONEY MARKET 
 
    
 
 
CHAPTER 
8 
© The Institute of Chartered Accountants of India
Page 2


LEARNING OUTCOMES 
 
  
  
UNIT - 1: THE CONCEPT OF  
MONEY DEMAND: IMPORTANT  
THEORIES 
 
 
 
 
After studying this Unit, you will be able to – 
? Define money and describe its nature and characteristics 
? Explain the functions performed by money  
? Describe the various theories related to demand for money 
?
Identify the factors that affect the demand for money.
 
?
Distinguish between the different variables considered by each of 
the theories of demand for money 
  
MONEY MARKET 
 
    
 
 
CHAPTER 
8 
© The Institute of Chartered Accountants of India
1.2  
 
BUSINESS ECONOMICS 
 
 8.2 
 
 
1.1 INTRODUCTION 
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. 
Money Market 
The Concept of Money 
Demand  
Functions 
of Money 
The 
Demand 
for Money 
Theories of 
Demand for 
Money 
Post-Keynesian 
Developments 
in the Theory of 
Demand for 
Money 
CHAPTER OVERVIEW 
 
© The Institute of Chartered Accountants of India
Page 3


LEARNING OUTCOMES 
 
  
  
UNIT - 1: THE CONCEPT OF  
MONEY DEMAND: IMPORTANT  
THEORIES 
 
 
 
 
After studying this Unit, you will be able to – 
? Define money and describe its nature and characteristics 
? Explain the functions performed by money  
? Describe the various theories related to demand for money 
?
Identify the factors that affect the demand for money.
 
?
Distinguish between the different variables considered by each of 
the theories of demand for money 
  
MONEY MARKET 
 
    
 
 
CHAPTER 
8 
© The Institute of Chartered Accountants of India
1.2  
 
BUSINESS ECONOMICS 
 
 8.2 
 
 
1.1 INTRODUCTION 
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. 
Money Market 
The Concept of Money 
Demand  
Functions 
of Money 
The 
Demand 
for Money 
Theories of 
Demand for 
Money 
Post-Keynesian 
Developments 
in the Theory of 
Demand for 
Money 
CHAPTER OVERVIEW 
 
© The Institute of Chartered Accountants of India
 1.3 
 
 
 
8.3 
MONEY MARKET 
For example, a person who specialises in fixing cars and needed to trade for food would have 
to find a farmer with a broken car. But what if the farmer did not have anything that needed 
to be fixed? Or what if a farmer could only give the mechanic more eggs than the mechanic 
could reasonably use? Having to find specific people to trade with makes it very difficult to 
specialise. People might starve before they were able to find the right person with whom to 
barter. 
But with money, you don’t need to find a particular person. You just need a market in which 
to sell your goods or services. In that market, you don’t barter for individual goods. Instead 
you exchange your goods or services for a common medium of exchange—that is, money. 
You can then use that money to buy what you need from others who also accept the same 
medium of exchange. As people become more specialised, it is easier to produce more, which 
leads to more demand for transactions and, hence, more demand for money. 
To put it a different way, money is something that holds its value over time, can be easily 
translated into prices, and is widely accepted. Many different things have been used as money 
over the years—among them, cowry shells, barley, peppercorns, gold, and silver. 
Fiat Money  
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 is no unique definition of ‘money’, either as a concept in economic theory or as 
measured in practice. Money can be defined for policy purposes as the set of liquid financial 
assets, the variation in the stock of which could impact on aggregate economic activity. As a 
statistical concept, money could include certain liquid liabilities of a particular set of financial 
intermediaries or other issuers’. (Reserve Bank of India Manual on Financial and Banking 
Statistics, 2007) 
There are some general characteristics that money should possess in order to make it serve 
its functions as money. Money should be: 
• generally acceptable 
© The Institute of Chartered Accountants of India
Page 4


LEARNING OUTCOMES 
 
  
  
UNIT - 1: THE CONCEPT OF  
MONEY DEMAND: IMPORTANT  
THEORIES 
 
 
 
 
After studying this Unit, you will be able to – 
? Define money and describe its nature and characteristics 
? Explain the functions performed by money  
? Describe the various theories related to demand for money 
?
Identify the factors that affect the demand for money.
 
?
Distinguish between the different variables considered by each of 
the theories of demand for money 
  
MONEY MARKET 
 
    
 
 
CHAPTER 
8 
© The Institute of Chartered Accountants of India
1.2  
 
BUSINESS ECONOMICS 
 
 8.2 
 
 
1.1 INTRODUCTION 
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. 
Money Market 
The Concept of Money 
Demand  
Functions 
of Money 
The 
Demand 
for Money 
Theories of 
Demand for 
Money 
Post-Keynesian 
Developments 
in the Theory of 
Demand for 
Money 
CHAPTER OVERVIEW 
 
© The Institute of Chartered Accountants of India
 1.3 
 
 
 
8.3 
MONEY MARKET 
For example, a person who specialises in fixing cars and needed to trade for food would have 
to find a farmer with a broken car. But what if the farmer did not have anything that needed 
to be fixed? Or what if a farmer could only give the mechanic more eggs than the mechanic 
could reasonably use? Having to find specific people to trade with makes it very difficult to 
specialise. People might starve before they were able to find the right person with whom to 
barter. 
But with money, you don’t need to find a particular person. You just need a market in which 
to sell your goods or services. In that market, you don’t barter for individual goods. Instead 
you exchange your goods or services for a common medium of exchange—that is, money. 
You can then use that money to buy what you need from others who also accept the same 
medium of exchange. As people become more specialised, it is easier to produce more, which 
leads to more demand for transactions and, hence, more demand for money. 
To put it a different way, money is something that holds its value over time, can be easily 
translated into prices, and is widely accepted. Many different things have been used as money 
over the years—among them, cowry shells, barley, peppercorns, gold, and silver. 
Fiat Money  
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 is no unique definition of ‘money’, either as a concept in economic theory or as 
measured in practice. Money can be defined for policy purposes as the set of liquid financial 
assets, the variation in the stock of which could impact on aggregate economic activity. As a 
statistical concept, money could include certain liquid liabilities of a particular set of financial 
intermediaries or other issuers’. (Reserve Bank of India Manual on Financial and Banking 
Statistics, 2007) 
There are some general characteristics that money should possess in order to make it serve 
its functions as money. Money should be: 
• generally acceptable 
© The Institute of Chartered Accountants of India
1.4  
 
BUSINESS ECONOMICS 
 
 8.4 
• 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  
How money is measured 
In official statistics, the amount of money in an economy is generally measured through what 
is called broad money, which encompasses everything that providers a store of value and 
liquidity.  Liquidity refers to the extent to which financial assets can be sold at close to full 
market value at short notice.  That is, they can easily be converted into another form of money, 
such as cash.  Although currency and transferable deposits (narrow money) are included by 
all countries in broad money, there are other components that may also provide sufficient 
store of value and liquidity to count as broad money.  Among the things the IMF (2000) says 
can be counted as broad money are the following: 
National currencies (generally issued by the central government). 
Transferable deposits, which include demand deposits (transferable by check or money order), 
bank checks (if used as a medium of exchange), travelers checks (if used for transactions with 
residents), and deposits otherwise commonly used to make payments (such as some Foreign-
Currency deposits).  
Other deposits, such as nontransferable savings deposits., term deposits (funds left on deposit 
for a fixed period of time), or repurchase agreements (in which one party sells a security and 
agrees to buy it back at a fixed price). 
Securities other than shares of stock. Such as tradable certificates of deposit and commercial 
paper (which is essentially a corporate IOU). 
Source : IMF  
1.2 THE DEMAND FOR MONEY  
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 
© The Institute of Chartered Accountants of India
Page 5


LEARNING OUTCOMES 
 
  
  
UNIT - 1: THE CONCEPT OF  
MONEY DEMAND: IMPORTANT  
THEORIES 
 
 
 
 
After studying this Unit, you will be able to – 
? Define money and describe its nature and characteristics 
? Explain the functions performed by money  
? Describe the various theories related to demand for money 
?
Identify the factors that affect the demand for money.
 
?
Distinguish between the different variables considered by each of 
the theories of demand for money 
  
MONEY MARKET 
 
    
 
 
CHAPTER 
8 
© The Institute of Chartered Accountants of India
1.2  
 
BUSINESS ECONOMICS 
 
 8.2 
 
 
1.1 INTRODUCTION 
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. 
Money Market 
The Concept of Money 
Demand  
Functions 
of Money 
The 
Demand 
for Money 
Theories of 
Demand for 
Money 
Post-Keynesian 
Developments 
in the Theory of 
Demand for 
Money 
CHAPTER OVERVIEW 
 
© The Institute of Chartered Accountants of India
 1.3 
 
 
 
8.3 
MONEY MARKET 
For example, a person who specialises in fixing cars and needed to trade for food would have 
to find a farmer with a broken car. But what if the farmer did not have anything that needed 
to be fixed? Or what if a farmer could only give the mechanic more eggs than the mechanic 
could reasonably use? Having to find specific people to trade with makes it very difficult to 
specialise. People might starve before they were able to find the right person with whom to 
barter. 
But with money, you don’t need to find a particular person. You just need a market in which 
to sell your goods or services. In that market, you don’t barter for individual goods. Instead 
you exchange your goods or services for a common medium of exchange—that is, money. 
You can then use that money to buy what you need from others who also accept the same 
medium of exchange. As people become more specialised, it is easier to produce more, which 
leads to more demand for transactions and, hence, more demand for money. 
To put it a different way, money is something that holds its value over time, can be easily 
translated into prices, and is widely accepted. Many different things have been used as money 
over the years—among them, cowry shells, barley, peppercorns, gold, and silver. 
Fiat Money  
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 is no unique definition of ‘money’, either as a concept in economic theory or as 
measured in practice. Money can be defined for policy purposes as the set of liquid financial 
assets, the variation in the stock of which could impact on aggregate economic activity. As a 
statistical concept, money could include certain liquid liabilities of a particular set of financial 
intermediaries or other issuers’. (Reserve Bank of India Manual on Financial and Banking 
Statistics, 2007) 
There are some general characteristics that money should possess in order to make it serve 
its functions as money. Money should be: 
• generally acceptable 
© The Institute of Chartered Accountants of India
1.4  
 
BUSINESS ECONOMICS 
 
 8.4 
• 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  
How money is measured 
In official statistics, the amount of money in an economy is generally measured through what 
is called broad money, which encompasses everything that providers a store of value and 
liquidity.  Liquidity refers to the extent to which financial assets can be sold at close to full 
market value at short notice.  That is, they can easily be converted into another form of money, 
such as cash.  Although currency and transferable deposits (narrow money) are included by 
all countries in broad money, there are other components that may also provide sufficient 
store of value and liquidity to count as broad money.  Among the things the IMF (2000) says 
can be counted as broad money are the following: 
National currencies (generally issued by the central government). 
Transferable deposits, which include demand deposits (transferable by check or money order), 
bank checks (if used as a medium of exchange), travelers checks (if used for transactions with 
residents), and deposits otherwise commonly used to make payments (such as some Foreign-
Currency deposits).  
Other deposits, such as nontransferable savings deposits., term deposits (funds left on deposit 
for a fixed period of time), or repurchase agreements (in which one party sells a security and 
agrees to buy it back at a fixed price). 
Securities other than shares of stock. Such as tradable certificates of deposit and commercial 
paper (which is essentially a corporate IOU). 
Source : IMF  
1.2 THE DEMAND FOR MONEY  
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 
© The Institute of Chartered Accountants of India
 1.5 
 
 
 
8.5 
MONEY MARKET 
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. 
1.3 THEORIES OF DEMAND FOR MONEY  
1.3.1 Classical Approach: The Quantity Theory of Money (QTM) 
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.  
© The Institute of Chartered Accountants of India