Value of Money, Supply and Demand for Money and Quantity Theory of Money

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Money is a legal tender issued by the central bank and used for exchange of goods and services and this has been discussed in this article Money: Functions and Types. Here, we will learn the Value and Supply of Money, Demand for money, the Quantity theory of Money and Greshams law.

Demand for Money

The demand for money simply refers to the desire to rather own money than to invest it. The desire that one has to hold his or her wealth in the form of money (making it liquid that is, to be able to spend it or use it anytime) rather than holding wealth in the form of investments (e.g. real estate, bonds, stocks etc).

There is a reason why people demand money and the demand for money is not the same as demand for other commodities as you dont just need money in other to just have it as with other commodities

According to Lord Keynes, there are three (3) reasons or motives behind the demand for money

  1. Transactional motive for demand for money
  2. Precautionary motive
  3. Speculative motive

Transactional motive of holding money

People hold and keep money in other to purchase their daily needs such as food, clothing and shelter and for other services. In this type of motive, the amount of money kept is proportional to the level of income the higher the income, the higher the amount of money held.

The Precautionary motive of demand for money

People also keep money for unforeseen circumstances such as sudden illnesses where money is needed for medical treatment, repairs of household electronics and automobiles, and other emergencies. The level of income also determines the amount kept for this purpose.

Speculative motive

The speculative motive for holding money relates to the desire to hold money for the purpose of taking advantage of investment opportunities largely based on future probability or expectation of price fluctuations. This occurs commonly with stocks; when people think prices of shares will drop, they will sell their shares, but when the expectation is of price rise in the future, people will hold money. Those involved with this type of demand for money for the purpose of speculation are called Speculators. The demand for money in the speculative motive therefore is inversely proportional to the current rate of interest.

This motive of holding money is not just restricted to investments but also applies to behavior of consumers who expect price increase they increase their purchases and when they think the price will reduce in the future, they will reduce their consumption or purchase. This is seen mostly during festivities and certain celebrations or change of policies affecting availability or supply of certain commodities.

The Quantity Theory of Money

The quantity theory of money explains the relationship between demand for money and supply of money and how they affect prices of commodities.

The quantity theory of money states that when there is an excess supply of money over demand, it causes people to hold more money than they require and therefore will spend the surplus of the money on currently produced goods and services leading to increase of price level; but when there is excess demand over supply, people will reduce their expenditure on goods and services and this leads to reduction of price level.

Therefore, whenever there is disequilibrium between the demand for money and supply of money causes changes in the total demand for currently produced goods and services.

The quantity theory of money also explains the relationship between the quantity of money in circulation, the average level of prices, the rate at which money circulates and the quantity of available goods. According to the quantity theory of money, the value of money is not only determined by the supply of money (which is the quantity of currency in circulation) but also determined by the rate at which money circulates and also by the available quantity of goods and services.

The quantity theory of money corrects the notion that increase in prices profits the producers and sellers as prices of goods and services alone does not affect supply of money in circulation.

Quantity theory of money equation: MV = PT

Where:

M = Supply of money

V = Velocity of circulation of money (i.e. rate of circulation of money)

P = Price level

T = Quantity of goods

Criticisms of the Quantity Theory of Money

  1. The quantity theory of money places more emphasis on the supply of money and less on the demand for money
  2. It cannot claim to be a theory of money since the effects of interest rate of money is not included which is a major concern in most monetary theories.
  3. Price changes may be affected by other factors not mentioned by the quantity theory of money such as increase in population leads to increase in demand for goods and services leading to increase in prices without a necessary change in the supply of money.

Greshams Law

Sir Thomas Gresham stated a law that bad money has a tendency to drive out good money this refers to the fact that debasement of coins by merchants and monetary authorities leads to further debasement. According to Gresham, if some coins have a high content of valuable metal while others have a low content, then holders of coins with valuable metal may not want to put them into circulation but may go ahead to melt them and this encourages the continuous reduction of the value of these coins thereby increasing the quantity of bad money in circulation.

The Supply of Money

The supply of money simply refers to the total stock of money available for use in an economy. The total stock of money available for use in an economy includes two major types.

  1. Currency in the form of bank notes and coins that are outside of the banking system
  2. Bank deposits that can be withdrawn with cheques that are in current accounts this refers to bank money.

The supply of money is determined by the credit policy of banks and the amount of money in circulation that was printed by the central bank.

The Value of Money

The value of money refers to the amount of goods and services which a certain amount of money can buy. It refers to the purchasing power of money. To understand this, you need comparison of two currencies: dollar and naira. If 1 dollar can buy a loaf bread but you need 350 naira to buy the same loaf of bread, then the dollar has more purchasing power than the naira because a little quantity of the dollar can purchase what you need a larger quantity of naira to purchase.

Another example of the value of money can be seen when a specific amount was able to buy more goods and services some years back but unable to purchase the same goods or services because the value of the money has fallen. But if the same amount can now buy even more compare to what it was, then the value of money can be said to have increased.

Factors determining the Value of Money

  1. Price level: the value of money varies inversely with the price level this means that an increase in the price level reduces the value of money. By an increase in the price level, you will need more money to buy goods that were ordinarily bought with fewer money. Also, a fall in prices leads to increase in the value of money this means that small amount of money is needed to buy more goods that were initially bought with larger amount of money.
  2. The supply of money and speed or velocity of circulation: the value of money is also affected by the quantity of money in circulation and also the rate at which it changes hands. If there is increase in the supply of money without corresponding increase in goods and services, it means that more money will be needed to buy the scarce goods and services thereby leading to a fall in the value of money. But a reduction in supply of money means there will little amount of money for purchase of goods and services thereby leading to increase in the value of money. The supply of money alone is not enough to change the value of money but also the speed of circulation because when people have the money issued into circulation but decide to hoard and not make use of it, the quantity available for purchase of goods and services will still be low and therefore the value will be increased; but if the rate of circulation is increased, there will be more money in circulation and therefore the prices of goods and services will increase and that will reduce the value of money.
  3. The volume of goods and services: as explained earlier while discussing on the price level, the quantity of goods and services available can modify the value of money. The more the production of goods and services while the supply of money remains constant, the more the value of money will be because the amount of money in circulation can now buy more of the goods being produced due to competition among producers. On the other hand, if there is scarcity of goods and services, then more money will be need to buy the goods and services as there will be competition between consumers.

These factors affecting the value of money play out during inflation and deflation as inflation reduces the value of money while deflation increases the value of money.

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