The execution of monetary policy as
an instrument to direct the economy to the needed trajectory is essentially
dependent on people’s willingness to use those instruments. As observed in the
previous posts, the monetary policy is an indirect attempt to induce an increase
or decrease in consumption or investment to the required rate using the cost of
money, the interest rates as the guiding principle. By increasing or decreasing
the interest rates, the objective would be to keep money supply stable while
encouraging or discouraging economic agents to indulge in consumption or
investment. Therefore, the context provides the backdrop for understanding
money supply and the demand for money thus the foundation of monetary framework.
The current note will delve deeper into these aspects.
The understanding would begin with
the functions of money. Money has three key functions viz, the unit of account,
the store of value and medium of exchange. The inability to perform the first
two roles is what deters the cryptocurrencies from being accepted as currencies
equivalent to the current fiat currency. The issue of currency is the monopoly of
the Central Bank of the country. Thus the currency is backed by fiat. The digital
currencies while being media of exchange are too volatile to be a store of
value. The functions of money would lead one to decoding the underlying
dynamics of demand for money and supply of money.
The supply of money is
fundamentally, the total amount of money in the economy. It is measured through
decreasing order of liquidity. The most liquid is the currency in hand. Therefore
the currency in hand becomes the first measure of money supply and usually
denoted by M0. Yet, this is not the only money in the economy. There are demand
deposits in banks which are near liquid. There are banks which have parked
their deposits with the RBI either for regulatory purposes or otherwise. The sum
of currency in hand, banks deposits with RBI and demand deposits in banks
constitute a form of money supply, which in India is denoted as M1. To this M1,
there gets added time deposit in banks which too have certain degree of
liquidity. The resultant sum gives us M3 which is the measure for money supply
in India. Over recent years, other measures have been constructed around these measures.
Yet for broader purposes. M3 would be the default money supply in India. When RBI
seeks to target inflation within a given range through changes in interest rates,
it is essentially targeting a certain level of M3. The equation of money in the
Indian context would be fundamentally a direct linkage between M3 and inflation
measured by CPI or WPI for a given level of GDP assuming a constant velocity of
money.
If money supply is a function of RBI
and thus a vertical curve if plotted geometrically between real interest rates
and GDP growth rate, the demand for money is a function willingness and ability
to use money. Understanding demand for money would entail understanding its
definition and furthermore the purposes of using money. The demand for money is
the willingness and ability of economic agents to hold money given the levels
of interest rates, economic activity and price level. In other words, the
demand for money is the tradeoff between holding money in non-interest bearing
financial assets and holdings in interest bearing bonds. The demand for money
is essentially an opportunity cost of holding money, a cost that is determined
by the interest rates. This naturally leads to the question what are the
determinants of money. The determinants of money demand lie in three different
uses.
The first purpose of demand for
money is the transaction motive. Money is medium of exchange and thus essential
for undertaking transactions. Therefore economic agents use money to undertake
day to day transactions and thus demand for money becomes a function of the
level of transactions economic agents undertake in any given economy. While
there is a demand for money for transactions, people prefer to hold money for
precautionary motive too. There might exist an emergency, a rainy day, for
which money might be required. Therefore it would be prudent to hold money for
such exigencies. The precautionary motive often overrides the other motives
during times of slump. In recent times, when economy is on a downturn following
a pandemic induced lockdown, the people would prefer to postpone consumption to
some future date. The uncertainty in income would deter people from engaging in
what they would feel would be unnecessary consumption. During times of boom,
the precautionary motive gives way to other motives. Money left to itself is
idle and hence economic agents desire to earn a return on their excess
holdings. Therein arises the speculative motive of holding money. The speculative
motive is the amount of money holdings in interest bearing instruments. Higher the
interest rates, the shift towards a speculative motive overriding the
consumption and transaction motive. People would prefer to earn returns at a
higher level and thus high deposit rates attract people’s attention which
emerges in the form of tradeoff with transaction motive.
All these three motives are dynamic
in nature. They are determined by the level of financial sophistication. Higher
levels of financial sophistication generally leads to lower demand for money.
People tend to hold less money when it is available in financially
sophisticated forms from ATMs to digital wallets to online banking among
others. The higher levels of economic activity would encourage a greater demand
for money as transaction motive overrides the rest. Therefore, there is a positive
relationship between economic activity and demand for money. Demand for money
however is inversely proportional to interest rates. Higher interest rates
shift the use of money from transactions to speculative and vice versa. People prefer
to park their money in interest bearing instruments during times of higher interest
rates and vice versa. During high inflation, there naturally exists a higher demand
for money, thus a direct relation between demand for money and price level in
the economy. Increasing the money supply during inflation given the already
high demand for money would lead to spiraling of inflation given the inability of
Aggregate Supply to match with Aggregate Demand.
The current post highlights the
basic note for money demand and supply and thus is a primer to understanding
the broader dimensions of the monetary policy and its inter-linkages with
economic growth. The current discussion however is preliminary in nature and
targets the basic understanding above which the detailed analysis which might
follow in the posts to succeed.
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