Macroeconomics (DSE 5.

1A)
Unit 5- Money & Inflation
Lecture – 3
Sub-topic: Money
Money is generally accepted medium for exchange of goods and services, for measuring
value, or for making payments. Money influences the economy in various ways like
determining the rate of interest rates, inflation and the level of economic activity.

The journey of money from the barter system to paper currency tells us what actually money
is or, what money does. In the words of Walker, “Money is what money does”.

Features of Money

 It must be accepted as a means of payments.

 It must be divisible, that is, it must exist in different denominations.
 It must be easily identified.
 It must not be easily duplicated or, counterfeited.
 It must be easily transported.
 It must be durable, allowing it to last for very long periods.

Functions of Money

 Medium of Exchange: The most important function of money is that it is generally

accepted mode of economic transaction. This means no one can refuse to accept the
currency in exchange for goods and services. Since there are small denominations of
money along with large ones, it removes the difficulty of indivisibilities that existed
during the barter system.
 Measure of Value: Money acts as a measure of value of goods and services. The
price of any good or services gives a signal about its market value. In other words,
any goods or services can be expressed in terms of its monetary value.
 Store of Value: Since money is not perishable commodity it can be stored. So one
can save money in terms of as its value remains more or less stable. During inflation
rise in price leads to fall in the value of money. However, in the short term it remains
almost unchanged.
  Standard of deferred Payment: Deferred payment refers to loans. Suppose we
purchase something today but make the payment at a later date. This is only possible
owing to the existence of money. Since money remains stable with the passage of
time it can be used as loans and advances.

Concept of Demand for Money

The demand for money is a desire for holding of financial assets in the form of money.
The Total Demand for Money the total quantity of money demanded in the economy is
the sum of the demand for checking account balances and cash by both households and
firms.

Types of demand for money

1. Transaction demand – money needed to buy goods – this is related to income.
2. Precautionary demand – money needed for financial emergencies.
3. Asset motive/speculative demand – when people wish to hold money rather
than buy assets/bonds/risky investment.
Transaction demand for money

Transaction demand for money – the money we need to purchase goods and services in day
to day life.In the classical quantity theory of money the demand for money is a function of
prices and income (assuming the velocity of circulation is stable.) If income rises, demand for
money will rise.

In an inventory model, the demand for holding money depends on the frequency of getting
paid, and the cost of depositing money in a bank. When employees are paid, they will hold
some money to buy goods. If they are paid once a month, they may deposit half to benefit
from interest payments, and then withdraw after two months. However, electronic transfers
and debit cards have made this less relevant.

Precautionary demand for money

Precautionary demand for money – the money we may need for unexpected purchases or
emergencies. In other words, the precautionary demand for money is the act of holding real
balances of money for use in a contingency. A higher rate of interest represents a higher
opportunity cost of holding money for any reason, including the precautionary reason, and so
leads to lower precautionary holdings.

Speculative Demand for Money

Speculative demand is the holding of real balances for the purpose of avoiding capital loss
from holding bonds or stocks. Thus, people may hold money to avoid the loss from
bonds. Money is thus treated as a form of asset for storing wealth. The asset demand for
money is inversely related to the market interest rate.