Thus, given desired real money holdings, the nominal quantity of money demanded will vary in direct proportion with the price level and in inverse proportion with the nominal value of money. Since the public decides on a desired real money stock, M/P, the rectangular area under DD associated with each given level of M will be a constant equal. First, the money supply refers to the total sum of money available to the public in the economy at a point of time. That is, money supply is a stock concept in sharp contrast to the national income which is a flow representing the value of goods and services produced per unit of time, usually taken as a year.

What Is Real Money Supply And How Is It Determined For A
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What Is Real Money Supply And How Is It Determined As A

Jun 29, 2021 In the U.S., the money supply is influenced by supply and demand—and the actions of the Federal Reserve and commercial banks. The Federal Reserve sets interest rates, which determine what banks. In macroeconomics, the money supply (or money stock) refers to the total volume of money held by the public at a particular point in time in an economy.

Let us make in-depth study of the money market equilibrium in an economy.

Introduction:

Money market is in equilibrium when at a rate of interest demand for and supply of money are equal.

It is worth noting that in the money market people increase or decrease the money they hold by selling short-term bonds that carry a fixed rate of interest. These bonds may be of corporate companies, generally called corporate bonds or debentures or may be securities of government, which are called treasury bills.

Money as a Financial Asset:

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The wealth of a household and a business firm consists of tangible assets such as a house, commercial property and the value of financial assets.

Financial assets include:

(1) Stocks, that is, equity shares of corporate firms (i.e. public limited companies),

(2) Bonds which carry a fixed rate of interest and

(3) Money.

Money is a financial asset.

It is important to note that money is different from income or wealth. In macroeconomics demand for money has a narrower meaning. Demand for money is a part of wealth of the people which they want to hold in the form of money rather than other assets. What part of their wealth people want to hold in the form of money determines the demand for money to hold.

Transactions and Speculative Demand for Money:

Broadly speaking, people demand money for two purposes:

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(1) Transactions demand for money and

(2) Speculative demand for money.

When the number of transactions in the economy increases, demand for money increases. The most important factor determining the volume of transactions is the level of national income or aggregate output. In a modern economy most goods are produced in the various stages of production. Money is required to buy raw materials for production, to make payment of wages to labour and so forth. A larger stock of money is therefore required to undertake more transactions.

A society keeps a certain proportion of national income in the form of money to carry out various transactions. The greater the level of national income, the higher the demand for money, given the proportion of income which a society keeps in the form of money. Thus

M_T^d = kY …(i)

where M_T^d stands for transaction demand for money, Y is the level of national income and k is the proportion of national income which is kept in the form of money. The constant proportion k does not have to be unity because one unit of money is used more than once for exchanging goods and services produced. The number of times a unit of money is used for buying goods and services is called income velocity of money. Thus, V= Y/M where V stands for income velocity of money.

It is worth noting that low income velocity of money implies that demand for money is a higher fraction of income. This indicates that individuals and business organisations keep their money stock for a longer period of time with themselves or in demand deposits with the banks and do not quickly use their money holdings for transaction purposes.

On the other hand, a high income velocity of money implies that demand for money is a smaller fraction of income. This means that individuals and firms quickly use their money stock for purposes of buying goods and services and do not keep it for a longer period with them or in their banks.

Speculative Demand for Money:

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Keynes in his book ‘The General Theory’ emphasized that individuals demand money to hold for speculative purpose. Money demand for speculative purpose means that individuals want to hold money to take advantages of the ‘changes in future rate of interest, that is, changes in bond prices’.

At any given time households or individuals want to keep a certain portfolio of assets consisting of both real and financial assets. When people decide how much money to hold with them for speculative purposes, they make a portfolio choice. At a time some people would like to hold more money and therefore will sell bonds or other assets. Some people may like to hold more bonds or other assets in their portfolio and to achieve this they would withdraw money from demand deposits to buy the bonds and other assets.

Cost of Holding Money and Portfolio Choice:

The money held by the people in their wallets or in demand deposits with the banks do not earn any interest. Instead of holding money in their wallets or demand deposits, they can buy government bonds or corporate bonds and earn higher nominal rate of interest.

The cost of holding money as an asset arises from the fact that money earns no interest or very low interest. Thus, interest rate on government or corporate bonds is the opportunity cost of holding money. The assets other than money such as government bonds or corporate bonds earn higher rate of return. But keeping money and other assets in investment portfolio have advantages and disadvantages.

The advantage of holding money as an asset is that it can be easily and quickly used to purchase goods and services. Its disadvantage is that it earns no interest or very low interest. On the other hand, other assets such as bonds cannot be directly or quickly used for transaction purposes and when they are sold to convert them into money for being used for these purposes, they involve costs such as brokerage fees apart from time and efforts involved in their sale.

Deciding about how much money to hold as an asset is deciding about a portfolio choice. This portfolio choice depends on individuals’ assessment of advantages and disadvantages of holding money as an asset as compared to other financial assets.

At a given interest rate on bonds, an individual or household decides about an investment portfolio after weighing their advantages and costs. If rate of interest on bonds rises, bonds would become more attractive than money. In this case, the holding of money will decline and that of bonds will increase in the portfolio.

Demand for Money and Interest Rate:

It is evident from above analysis that demand for money as an asset, that is, for speculative purposes depends on rate of interest on bonds, which is the opportunity cost of holding money. If rate of interest is higher, the people would demand less money to hold for speculative purposes. This is because at a higher rate of interest they would go in for holding more bonds or other financial assets in their investment portfolio. On the other bond, at a lower rate of interest on bonds, they would demand more money to hold.

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Thus, demand for money to hold for speculative purposes, that is, as an asset is negatively related to rate of interest. Therefore, demand curve for money for speculative purposes slopes downward. This indicates that at a higher rate of interest, less money is held as an asset and at a lower interest rate, more money is held as an asset. Demand for money to hold for speculative purposes is drawn as M^d_sp in Figure 17.1.

Mathematically, we can express the demand for money to hold for speculative purposes as follows:

M^d_sp = f(i) = hi …(ii)

where h is the sensitivity of money demand to hold as an asset to changes in rate of interest (i).

Total Demand for Money:

Demand for money to hold comes fr

What Is Real Money Supply And How Is It Determined