Functions of Money and Its Demand

Can you even imagine a world without money? How would we

conduct everyday transactions? How would we price items? Money

has great significance in an economy as it performs four important

functions. Let us learn more about these functions of money as well as

the demand for money.

Functions of Money

Economists define money via four of its basic functions. These

functions will help us understand the importance and need of money

as far as the economy is concerned.

Unit of Account

Say you went to a shop and started browsing around. You see the

price of the products on display. They are all expressed in terms of

money (rupees in this case). The cake is a hundred rupee, the pencil is

ten rupees, the sneakers are a thousand rupees and so on. So as you

can see, money is the basic unit of account or measurement of

everything in an economy.

It is very important to have a uniform unit of account in an economy.

The barter system does not work in all cases. So it is highly efficient

and convenient to have a uniform base for all transactions, i.e. money.

It is the foundation of every economic transaction happening

anywhere around the world.

Browse more Topics under Money And Banking

● Supply of Money

● Instruments of Monetary Policy and the Reserve Bank of India

Medium of Exchange

This is what most economists consider the most important function of

money. Money has the ability to satisfy all your unlimited needs and

wants. You want the cake, or the pencil, or the sneakers, or all of

them. The money will give you the ability to buy it all.

One can argue you can also barter for the goods. But then you would

have to have some service or product that the shop owner wants. And

it also has to be of equal value. Say the shop owner wants 5 pairs of

socks in exchange for the sneakers but you do not possess them. Then

you cannot buy the sneakers. The exchange can only take place if

there is a double coincidence of wants. This is why money is of such

essence, it makes these transactions possible with minimum effort and

maximum ease.

Store Value

Money means liquidity, i.e. it is the most liquid asset. It is the most

convenient way to store wealth since you can use to buy any goods or

products directly. It requires no conversion. This is what we call the

store value of money.

If one was to store their wealth in other commodities, like gold or

shares, there is a risk. These commodities do not have a stable value.

However, money does not fluctuate in value, it’s value/worth remains

stable. This is one of the biggest advantages of storing the value in

money or currency.

Standard for Deferred Payment

Deferred payment is any payment that is to be made in the future. Like

if you have taken a loan or buy goods on credit. The payment of these

transactions has to be made on some date in the future. So these

amounts are measured in terms of money. And they are ultimately

paid in money as well. This is because the value of money remains

stable in any economy. And so one of the most important functions of

money.

(Source: Moneycontrol)

Demand for Money

We will be seeing here the Keynesian approach for calculating the

demand for money. Money is the most liquid asset in the world. We

can exchange it for any commodity or service and so people prefer to

hold on to their cash. But then there is also the opportunity cost of

money. Instead of preferring liquidity if the money was invested it

would earn interest. And so the demand for money is the balance

between these two motives.

Transaction Motive

Money is a medium of exchange and this function of it’s gives rise to

the transactional motive for demand for money. We regularly need

money to pay for goods and services. And such financial transactions

can be of two types – income motive and business motive.

The income motive is to bridge the gap between the receipt of the

income and its eventual disbursement. And the business motive is to

bridge the gap between the time when costs are incurred and the time

when you receive the sale proceeds. If these time gaps are smaller, the

person will hold less cash for his transactions and vice versa.

There may be other factors involved for the changes in transactional

demand for money like the expectation of income, interest rate,

business turnover etc. And from the above factors, we conclude that

transactional demand for money is a directly proportional function to

the level of income. We express this as

L1 = kY

Where L1 is transactional demand for money, k is the proportion of

income kept for transactions and Y is income.

Speculative Motive

(Source: economicdiscussion)

The other important function of money is that it is a store value of

wealth, i.e. it is an asset. And the demand for any given asset depends

on its opportunity cost and its rate of return. Now money does not

have a rate of return but it has an opportunity cost. The opportunity

cost of holding money is the interest it could earn by being invested in

some bond.

The speculative motive for demand for money arises when investing

the money in some asset or bond is considered riskier than simply

holding the money. The speculative motive for demand for money is

also affected by the expected rise or fall of the future interest rates and

inflation of the economy.

If interest rates are expected to raise the opportunity cost of simply

holding the money will also rise and reduce the speculative motive.

And if inflation is expected to rise, money will lose its purchasing

power and again speculative income will drop.

Solved Question for You

Q: Transactional demand for money is ______ proportional to the

level of income

a. Directly

b. Inversely

c. Depends on the situation

d. Not proportional

Ans: The correct option is A. Transactional demand for money is a

directly proportional function to the level of income. It is expressed as

L1 = kY.

Supply of Money

Money is something which is generally accepted as a medium of

exchange, a measure of value, store of value and standard of delayed

payments. Generally, we understand money supply as the sum total of

currency with the people and demand deposits with the bank.

Supply of Money

Money supply is a stock concept. It refers to the entire stock of money

(of all types) held by the people of a country at a point of time. Money

supply includes only that stock of money which is held by people,

other than the suppliers of money themselves. In other words, money

supply refers to the stock of money held by the public or those who

demand money.

Money supply does not include stock of money held by the

government, and stock of money held by the banking system of a

country. The government and the banking system of a country are

suppliers of money or are the producers of money. Hence, money held

by them is not a part of the stock of money held by the people.

Browse more Topics under Money And Banking

● Functions of Money and its Demand

● Instruments of Monetary Policy and the Reserve Bank of India

Components of the Money Supply

Two main components of the money supply are:

1. Currency (includes coins and notes)

2. Demand deposits

Currency

i. Coins: There were two types of coins – full bodied standard

coins and token coin. Under Managed Currency System that

prevails these days, full-bodied standard coins have little

utility. Hence, these are no longer in circulation. Indian Rupee

is neither a full-bodied standard coin nor is it a perfect token

coin. Coins o the denomination of 50paisa, 25 paise, are token

coins.

ii. Currency Notes: The government and the central bank of the

country both issue the currency notes. In India, government

issues One rupee note, while the Reserve Bank of India issues

all other currency notes.

Source: istockphoto

Alternative Measures of Money Supply (Money Stock)

In India, the Reserve Bank of India uses four alternative measures of

money supply known as M1, M2, M3 and M4. M1 is the most

frequently used measure of money supply because its components are

regarded as the most liquid resources. Below is the explanation of

each measure:

(i) M1 = C + DD + OD

Here C stands for currency (paper notes and coins) detained by the

public, DD signify demand deposits in banks and OD denotes other

deposits in RBI which includes demand deposits of public financial

institutions, demand deposits of foreign central banks and

international financial institutions like IMF, World Bank, etc. Demand

deposits can be taken out at any time by the account holders. Current

account deposits are integrated with demand deposits.

However, we do not include savings account deposits in DD for the

reason that there exists certain conditions on the amount and number

of withdrawals.

Also,

(ii) M2 = M1 (detailed on top of) + saving deposits with Post Office

Saving Banks

(iii) M3= M1 + Net Time-deposits of Banks

(iv) M4 = M3 + Total deposits with Post Office Saving Institute

(excluding National Saving Certificate)

In fact, a great deal of discussion is still going on as to what

constitutes money supply. Savings deposits of post offices are not a

part of money supply for the reason that they do not provide a medium

of exchange due to lack of cheque facility. In the same way, we do not

count fixed deposits in commercial banks as money. As a result, M1

and M2 may be treated as measures of narrow money whereas M3 and

M4 as measures of broad money.

M1 is used as the measure of money supply which is also called

aggregate monetary resources of the general public. All the above four

measures represent different degrees of liquidity, with M1 being the

most liquid andM4 is being the least liquid. It is noteworthy here that

liquidity means the ability to change an asset into money quickly and

without loss of value.

Important Facts about Measures of Money Supply

● The four measures of money supply represent different degrees

of liquidity, with M1 being the most liquid and M4 being the

least liquid.

● M1 is widely used as a measure of money supply and it is also

known as ‘aggregate monetary resources of the general public’.

● M1 and M2 are generally known as narrow money supply

concepts, whereas, M3 and M4 are known as broad money

supply concepts.

Solved Example for You

Q: State the two components of the money supply

a. Currency and term deposits

b. Demand deposits with the banks

c. Currency (notes and coins) with the people

d. b and c both

Ans: The correct answer is option D. Money supply refers to the stock

of money held by the people and those who demand money.

Instruments of Monetary Policy and the Reserve Bank of India

The RBI is the main body that controls the monetary policy in India.

They control the flow of money into the market through various

instruments of monetary policy. This helps the RBI control the

inflation and liquidity in the economy. Let us take a look at the

instruments of monetary policy the RBI uses.

The Reserve Bank of India

The RBI is the central bank of India. It was established in 1935 under

a special act of the parliament. The RBI is the main authority for the

monetary policy of the country. The main functions of the RBI are to

maintain financial stability and the required level of liquidity in the

economy.

The RBI also controls and regulates the currency system of our

economy. It is the sole issuer of currency notes in India. The RBI is

the central banks that control all the other commercial banks, financial

institutes, finance firms etc. It supervises the entire financial sector of

the country.

Instruments of Monetary Policy

Monetary policy is a way for the RBI to control the supply of money

in the economy. So these credit policies help control the inflation and

in turn help with the economic growth and development of the

country. So now let us take a look at the various instruments of

monetary policy that the RBI has at its disposal.

1] Open Market Operations

Open Market Operations is when the RBI involves itself directly and

buys or sells short-term securities in the open market. This is a direct

and effective way to increase or decrease the supply of money in the

market. It also has a direct effect on the ongoing rate of interest in the

market.

Let us say the market is in equilibrium. Then the RBI decides to sell

short-term securities in the market. The supply of money in the market

will reduce. And subsequently, the demand for credit facilities would

increase. And so correspondingly the rate of interest would also see a

boost.

On the other hand, if RBI was purchasing securities from the open

market it would have the opposite effect. The supply of money to the

market would increase. And so, in turn, the rate of interest would go

down since the demand for credit would fall.

2] Bank Rate

One of the most effective instruments of monetary policy is the bank

rate. A bank rate is essentially the rate at which the RBI lends money

to commercial banks without any security or collateral. It is also the

standard rate at which the RBI will buy or discount bills of exchange

and other such commercial instruments.

So now if the RBI were to increase the bank rate, the commercial

banks would also have to increase their lending rates. And this will

help control the supply of money in the market. And the reverse will

obviously increase the supply of money in the market.

3] Variable Reserve Requirement

There are two components to this instrument of monetary policy,

namely – The Cash Reserve Ratio (CLR) and the Statutory Liquidity

Ratio (SLR). Let us understand them both.

Cash Reserve Ratio (CRR) is the portion of deposits with the

commercial banks that it has to deposit to the RBI. So CRR is the

percent of deposits the commercial banks have to keep with the RBI.

The RBI will adjust the said percentage to control the supply of

money available with the bank. And accordingly, the loans given by

the bank will either become cheaper or more expensive. The CRR is a

great tool to control inflation.

The Statutory Liquidity Ratio (SLR) is the percent of total deposits

that the commercial banks have to keep with themselves in form of

cash reserves or gold. So increasing the SLR will mean the banks have

fewer funds to give as loans thus controlling the supply of money in

the economy. And the opposite is true as well.

4] Liquidity Adjustment Facility

The Liquidity Adjustment Facility (LAF) is an indirect instrument for

monetary control. It controls the flow of money through repo rates and

reverse repo rates. The repo rate is actually the rate at which

commercial banks and other institutes obtain short-term loans from the

Central Bank.

And the reverse repo rate is the rate at which the RBI parks its funds

with the commercial banks for short time periods. So the RBI

constantly changes these rates to control the flow of money in the

market according to the economic situations.

5] Moral Suasion

This is an informal method of monetary control. The RBI is the

Central Bank of the country and thus enjoys a supervisory position in

the banking system. If there is a need it can urge the banks to exercise

credit control at times to maintain the balance of funds in the market.

This method is actually quite effective since banks tend to follow the

policies set by the RBI.

Solved Question for You

Q: To control/decrease the supply of money in the market the RBI will

decrease the bank rate. True or False?

Ans: No, this statement is False. The bank rate is the rate at which the

RBI lends money to the commercial banks. If the bank rate is

decreased the commercial banks will borrow more funds and give

more loans. This will decrease the interest rates as well. And in

general, the supply of money in the market will actually increase.