Unit I: The Concept of Money Demand: Important Theories | Financial Management & Economics Finance: CA Intermediate (Old Scheme) PDF Download

 Page 1


 
 
 
 MONEY MARKET 
UNIT I: THE CONCEPT OF MONEY DEMAND: 
IMPORTANT THEORIES 
 
LEARNING OUTCOMES 
 
At the end of 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 
CHAPTER 
3 
Page 2


 
 
 
 MONEY MARKET 
UNIT I: THE CONCEPT OF MONEY DEMAND: 
IMPORTANT THEORIES 
 
LEARNING OUTCOMES 
 
At the end of 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 
CHAPTER 
3 
3.2 ECONOMICS FOR FINANCE 
 
 
 1.1 INTRODUCTION 
Money is at the centre of every economic transaction and plays a significant role 
in all economies. In simple terms money refers to assets which are commonly 
used and accepted as a means of payment or as a medium of exchange or for 
transferring purchasing power. For policy purposes, money may be defined as the 
set of liquid financial assets, the variation in the stock of which will have 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 (RBI, 2007). 
Money has generalized purchasing power and is generally acceptable in 
settlement of all transactions and in discharge of other kinds of business 
obligations including future payments.  Anything that would act as a medium of 
exchange is not necessarily money. For example, a bill of exchange may also be a 
medium of exchange, but it is not money since it is not generally accepted as a 
means of payment. Money is a totally liquid asset as it can be used directly, 
instantly, conveniently and without any costs or restrictions to make payments. At 
the fundamental level, money provides us with a convenient means to access 
goods and services.  
Money represents a certain value, but currency which represents money does not 
necessarily have intrinsic value. When money takes the form of a commodity with 
intrinsic value, it is called commodity money. For e.g. gold, silver or any other 
such elements may be used as money. As you know, fiat money (also known as 
token money) has no intrinsic value, that is, it has no value if it were not used as 
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
UNIT OVERVIEW
Page 3


 
 
 
 MONEY MARKET 
UNIT I: THE CONCEPT OF MONEY DEMAND: 
IMPORTANT THEORIES 
 
LEARNING OUTCOMES 
 
At the end of 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 
CHAPTER 
3 
3.2 ECONOMICS FOR FINANCE 
 
 
 1.1 INTRODUCTION 
Money is at the centre of every economic transaction and plays a significant role 
in all economies. In simple terms money refers to assets which are commonly 
used and accepted as a means of payment or as a medium of exchange or for 
transferring purchasing power. For policy purposes, money may be defined as the 
set of liquid financial assets, the variation in the stock of which will have 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 (RBI, 2007). 
Money has generalized purchasing power and is generally acceptable in 
settlement of all transactions and in discharge of other kinds of business 
obligations including future payments.  Anything that would act as a medium of 
exchange is not necessarily money. For example, a bill of exchange may also be a 
medium of exchange, but it is not money since it is not generally accepted as a 
means of payment. Money is a totally liquid asset as it can be used directly, 
instantly, conveniently and without any costs or restrictions to make payments. At 
the fundamental level, money provides us with a convenient means to access 
goods and services.  
Money represents a certain value, but currency which represents money does not 
necessarily have intrinsic value. When money takes the form of a commodity with 
intrinsic value, it is called commodity money. For e.g. gold, silver or any other 
such elements may be used as money. As you know, fiat money (also known as 
token money) has no intrinsic value, that is, it has no value if it were not used as 
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
UNIT OVERVIEW
3.3 
 
CONCEPT OF MONEY DEMAND 
money. Fiat money is used as a medium of exchange because the government 
has, by law, made them “legal tender,” which means, they serve, by law, as means 
of payment. In modern days, money is not necessarily a physical item; it may also 
constitute electronic records. Money is, in fact, only one among many kinds of 
financial assets which households, firms, governments and other economic units 
hold in their asset portfolios. Unlike other financial assets, money is an essential 
element in conducting most of the economic transactions in an economy.   
‘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) 
1.2 FUNCTIONS OF MONEY  
Money performs many important functions in an economy which not only remove 
the difficulties of barter but also support trade and industry. These functions are 
as follows- 
(i)  Money is a convenient medium of exchange or it is an instrument that 
facilitates easy exchange of goods and services.  Money, though not having 
any inherent power to directly satisfy human wants, by acting as a medium 
of exchange, it commands purchasing power and its possession enables us 
to purchase goods and services to satisfy our wants.  By acting as an 
intermediary, money increases the ease of trade and reduces the 
inefficiency and transaction costs involved in a barter exchange. In a barter 
economy every transaction has to involve an exchange of goods (and /or 
services) on both sides of the transaction. By decomposing the single barter 
transaction into two separate transactions of sale and purchase, money 
eliminates the need for double coincidence of wants. Money also facilitates 
separation of transactions both in time and place and this in turn enables us 
to economize on time and efforts involved in transactions.  
(ii) Money is an explicitly defined unit of value or unit of account. A unit of 
account is the yardstick people use to post prices and record debts. All 
economic values are measured and recorded in terms of money. As a 
measure of value, money works as a common denominator, as a unit of 
Page 4


 
 
 
 MONEY MARKET 
UNIT I: THE CONCEPT OF MONEY DEMAND: 
IMPORTANT THEORIES 
 
LEARNING OUTCOMES 
 
At the end of 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 
CHAPTER 
3 
3.2 ECONOMICS FOR FINANCE 
 
 
 1.1 INTRODUCTION 
Money is at the centre of every economic transaction and plays a significant role 
in all economies. In simple terms money refers to assets which are commonly 
used and accepted as a means of payment or as a medium of exchange or for 
transferring purchasing power. For policy purposes, money may be defined as the 
set of liquid financial assets, the variation in the stock of which will have 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 (RBI, 2007). 
Money has generalized purchasing power and is generally acceptable in 
settlement of all transactions and in discharge of other kinds of business 
obligations including future payments.  Anything that would act as a medium of 
exchange is not necessarily money. For example, a bill of exchange may also be a 
medium of exchange, but it is not money since it is not generally accepted as a 
means of payment. Money is a totally liquid asset as it can be used directly, 
instantly, conveniently and without any costs or restrictions to make payments. At 
the fundamental level, money provides us with a convenient means to access 
goods and services.  
Money represents a certain value, but currency which represents money does not 
necessarily have intrinsic value. When money takes the form of a commodity with 
intrinsic value, it is called commodity money. For e.g. gold, silver or any other 
such elements may be used as money. As you know, fiat money (also known as 
token money) has no intrinsic value, that is, it has no value if it were not used as 
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
UNIT OVERVIEW
3.3 
 
CONCEPT OF MONEY DEMAND 
money. Fiat money is used as a medium of exchange because the government 
has, by law, made them “legal tender,” which means, they serve, by law, as means 
of payment. In modern days, money is not necessarily a physical item; it may also 
constitute electronic records. Money is, in fact, only one among many kinds of 
financial assets which households, firms, governments and other economic units 
hold in their asset portfolios. Unlike other financial assets, money is an essential 
element in conducting most of the economic transactions in an economy.   
‘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) 
1.2 FUNCTIONS OF MONEY  
Money performs many important functions in an economy which not only remove 
the difficulties of barter but also support trade and industry. These functions are 
as follows- 
(i)  Money is a convenient medium of exchange or it is an instrument that 
facilitates easy exchange of goods and services.  Money, though not having 
any inherent power to directly satisfy human wants, by acting as a medium 
of exchange, it commands purchasing power and its possession enables us 
to purchase goods and services to satisfy our wants.  By acting as an 
intermediary, money increases the ease of trade and reduces the 
inefficiency and transaction costs involved in a barter exchange. In a barter 
economy every transaction has to involve an exchange of goods (and /or 
services) on both sides of the transaction. By decomposing the single barter 
transaction into two separate transactions of sale and purchase, money 
eliminates the need for double coincidence of wants. Money also facilitates 
separation of transactions both in time and place and this in turn enables us 
to economize on time and efforts involved in transactions.  
(ii) Money is an explicitly defined unit of value or unit of account. A unit of 
account is the yardstick people use to post prices and record debts. All 
economic values are measured and recorded in terms of money. As a 
measure of value, money works as a common denominator, as a unit of 
  
 
3.4 ECONOMICS FOR FINANCE 
account. We know, Rupee is the unit of account in India in which the entire 
money is denominated.  
 The monetary unit measures and express the value of all goods and 
services. In fact, money helps in expressing the value of each good or 
service in terms of price, which is nothing but the number of monetary units 
for which the good or service can be exchanged. It is convenient to trade all 
commodities in exchange for a single commodity.  So also, it is convenient 
to measure the prices of all commodities in terms of a single unit, rather 
than record the relative price of every good in terms of every other good. 
Thus, an obvious advantage of having a single unit of account is that it 
greatly reduces the number of exchange ratios between goods and services. 
Use of money as a unit of account can encourage trade by making it easier 
for individuals to know how much one good is worth in terms of another. 
 A common unit of account facilitates a system of orderly pricing which is 
crucial for rational economic choices. Goods and services which are 
otherwise not comparable are made comparable through expressing the 
worth of each in terms of money. 
  Money is a useful measuring rod of value only if the value of money 
remains constant. The value of money is linked to its purchasing power, i.e 
the quantity of goods and services that can be bought with a unit of money.  
Purchasing power of money is the inverse of the average or general level of 
prices as measured by the consumer price index. As such the value of 
money decreases when prices rise and increase when prices fall.  
(iii) Money serves as a unit or standard of deferred payment i.e money 
facilitates recording of deferred promises to pay. Money is the unit in terms 
of which future payments are contracted or stated. It simplifies credit 
transactions. By acting as a standard of deferred payments, money helps in 
capital formation both by the government and business enterprises. This 
function of money enables the growth of financial and capital markets and 
helps in the growth of the economy. However, variations in the purchasing 
power of money due to inflation or deflation reduce the efficacy of money 
in this function. 
(iv) Like nearly all assets such as stocks, bonds and other forms of wealth, 
money is a store of value. A store of value is an item that people can use to 
transfer purchasing power from the preset to the future.  People   prefer to 
hold it as an asset, that is, as part of their stock of wealth. The splitting of 
Page 5


 
 
 
 MONEY MARKET 
UNIT I: THE CONCEPT OF MONEY DEMAND: 
IMPORTANT THEORIES 
 
LEARNING OUTCOMES 
 
At the end of 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 
CHAPTER 
3 
3.2 ECONOMICS FOR FINANCE 
 
 
 1.1 INTRODUCTION 
Money is at the centre of every economic transaction and plays a significant role 
in all economies. In simple terms money refers to assets which are commonly 
used and accepted as a means of payment or as a medium of exchange or for 
transferring purchasing power. For policy purposes, money may be defined as the 
set of liquid financial assets, the variation in the stock of which will have 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 (RBI, 2007). 
Money has generalized purchasing power and is generally acceptable in 
settlement of all transactions and in discharge of other kinds of business 
obligations including future payments.  Anything that would act as a medium of 
exchange is not necessarily money. For example, a bill of exchange may also be a 
medium of exchange, but it is not money since it is not generally accepted as a 
means of payment. Money is a totally liquid asset as it can be used directly, 
instantly, conveniently and without any costs or restrictions to make payments. At 
the fundamental level, money provides us with a convenient means to access 
goods and services.  
Money represents a certain value, but currency which represents money does not 
necessarily have intrinsic value. When money takes the form of a commodity with 
intrinsic value, it is called commodity money. For e.g. gold, silver or any other 
such elements may be used as money. As you know, fiat money (also known as 
token money) has no intrinsic value, that is, it has no value if it were not used as 
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
UNIT OVERVIEW
3.3 
 
CONCEPT OF MONEY DEMAND 
money. Fiat money is used as a medium of exchange because the government 
has, by law, made them “legal tender,” which means, they serve, by law, as means 
of payment. In modern days, money is not necessarily a physical item; it may also 
constitute electronic records. Money is, in fact, only one among many kinds of 
financial assets which households, firms, governments and other economic units 
hold in their asset portfolios. Unlike other financial assets, money is an essential 
element in conducting most of the economic transactions in an economy.   
‘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) 
1.2 FUNCTIONS OF MONEY  
Money performs many important functions in an economy which not only remove 
the difficulties of barter but also support trade and industry. These functions are 
as follows- 
(i)  Money is a convenient medium of exchange or it is an instrument that 
facilitates easy exchange of goods and services.  Money, though not having 
any inherent power to directly satisfy human wants, by acting as a medium 
of exchange, it commands purchasing power and its possession enables us 
to purchase goods and services to satisfy our wants.  By acting as an 
intermediary, money increases the ease of trade and reduces the 
inefficiency and transaction costs involved in a barter exchange. In a barter 
economy every transaction has to involve an exchange of goods (and /or 
services) on both sides of the transaction. By decomposing the single barter 
transaction into two separate transactions of sale and purchase, money 
eliminates the need for double coincidence of wants. Money also facilitates 
separation of transactions both in time and place and this in turn enables us 
to economize on time and efforts involved in transactions.  
(ii) Money is an explicitly defined unit of value or unit of account. A unit of 
account is the yardstick people use to post prices and record debts. All 
economic values are measured and recorded in terms of money. As a 
measure of value, money works as a common denominator, as a unit of 
  
 
3.4 ECONOMICS FOR FINANCE 
account. We know, Rupee is the unit of account in India in which the entire 
money is denominated.  
 The monetary unit measures and express the value of all goods and 
services. In fact, money helps in expressing the value of each good or 
service in terms of price, which is nothing but the number of monetary units 
for which the good or service can be exchanged. It is convenient to trade all 
commodities in exchange for a single commodity.  So also, it is convenient 
to measure the prices of all commodities in terms of a single unit, rather 
than record the relative price of every good in terms of every other good. 
Thus, an obvious advantage of having a single unit of account is that it 
greatly reduces the number of exchange ratios between goods and services. 
Use of money as a unit of account can encourage trade by making it easier 
for individuals to know how much one good is worth in terms of another. 
 A common unit of account facilitates a system of orderly pricing which is 
crucial for rational economic choices. Goods and services which are 
otherwise not comparable are made comparable through expressing the 
worth of each in terms of money. 
  Money is a useful measuring rod of value only if the value of money 
remains constant. The value of money is linked to its purchasing power, i.e 
the quantity of goods and services that can be bought with a unit of money.  
Purchasing power of money is the inverse of the average or general level of 
prices as measured by the consumer price index. As such the value of 
money decreases when prices rise and increase when prices fall.  
(iii) Money serves as a unit or standard of deferred payment i.e money 
facilitates recording of deferred promises to pay. Money is the unit in terms 
of which future payments are contracted or stated. It simplifies credit 
transactions. By acting as a standard of deferred payments, money helps in 
capital formation both by the government and business enterprises. This 
function of money enables the growth of financial and capital markets and 
helps in the growth of the economy. However, variations in the purchasing 
power of money due to inflation or deflation reduce the efficacy of money 
in this function. 
(iv) Like nearly all assets such as stocks, bonds and other forms of wealth, 
money is a store of value. A store of value is an item that people can use to 
transfer purchasing power from the preset to the future.  People   prefer to 
hold it as an asset, that is, as part of their stock of wealth. The splitting of 
 
 
3.5 
 
CONCEPT OF MONEY DEMAND 
purchases and sale into two transactions involves a separation in both time 
and space. This separation is possible because money can be used as a store 
of value or store of means of payment during the intervening time.  Again, 
rather than   spending one’s money at present, one can store it for use at 
some future time. Thus, money functions as a temporary abode of 
purchasing power in order to efficiently perform its medium of exchange 
function. 
 Money also functions as a permanent store of value. There are many other 
assets such as government bonds, deposits and other securities, land, 
houses etc. which also store value.  Despite having the advantages of 
potential income yield and appreciation in value over time, these other 
assets   are subject to limitations such as storage costs, lack of liquidity and 
possibility of depreciation in value.  Money is the only asset which has 
perfect liquidity. Additionally, money also commands reversibility as its 
value in payment equals its value in receipt. All assets other than money 
lack perfect reversibility in the sense that their value in payment is not equal 
to their value in receipt.  Even financial assets like the riskless government 
bonds do not command perfect reversibility as their purchase and sale are 
subject to certain brokerage costs although this may be quite small. 
 The effectiveness of an asset as a store of value depends on the degree and 
certainty with which the asset maintains its value over time.  Hence, in order 
to serve as a permanent store of value in the economy, the purchasing 
power or the value of money should either remain stable or should 
monotonically rise over time. 
 There are some general characteristics that money should possess in order 
to make it serve its functions as money. Money should be: 
• generally acceptable 
• 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