Money – SS2 Economics Lesson Note (Third Term)

Demand for money is the amount of money a person wishes to hold in liquid form instead of spending it, and it is also called liquidity preference. Supply of money is the total amount of money available for use in the economy at a given period. This note also covers the quantity theory of money.

Behavioural objectives

By the end of the lesson, students should be able to:

• define demand for money and state the three motives for holding money;
• define supply of money and list the factors that affect it;
• state the quantity theory equation MV=PT and use it to calculate the velocity of money;
• state the criticisms of the quantity theory of money;
• explain the value of money and calculate a price index.

What is demand for money?

Demand for money is the total amount of money which an individual, for various reasons, wishes to hold. That is, it is the desire to hold money in liquid form rather than spending it. The demand for money in economics is known as liquidity preference.

Motives for holding money

John Maynard Keynes gave three motives for holding money:

1. Transactionary motive: when people desire to hold money in liquid or raw cash for day-to-day transactions or to meet current expenditures. That is, to cater for the interval between the receipt of incomes and their expenditures.
2. Precautionary motive: when people desire to hold money in liquid form to meet unforeseen contingencies or unexpected expenditures, such as sickness, unexpected visitors and accidents.
3. Speculative motive: when people desire to hold money to carry out speculative dealings in the bond (security) market.

What is the supply of money?

The supply of money is the total amount of money available for use in the economy at a given period. It includes currency in the form of banknotes and coins circulating outside the banking system, as well as bank deposits in current accounts, which can be withdrawn by cheque (i.e. bank money).

Factors affecting the supply of money

1. Bank rate: the rate of interest that the Central Bank charges the commercial banks for lending money to or borrowing from them and discounting bills.
2. Cash reserve ratio: also known as the cash ratio or liquidity ratio, it is the percentage of deposits that commercial banks are expected to keep with them. When the cash reserve ratio is high, the supply of money will be low, and vice versa.
3. Economic situation: the Central Bank reduces the supply of money during a period of inflation and increases it during a period of deflation.
4. Demand for excess reserves: when commercial banks demand excess reserves, the supply of money will increase.
5. Total reserves of the Central Bank: if the total reserve supplied by the Central Bank is high, the money supply will also be high, and vice versa.

What is the quantity theory of money?

The quantity theory of money was propounded by Irving Fisher, an American economist. Fisher postulated that the value of money depends on the quantity of it in circulation. This has traditionally been explained as the relationship between the quantity of money in circulation and the amount of production of goods and services within the economy. Fisher stated that the total stock of money multiplied by the velocity of its circulation is equal to the total transactions multiplied by the price level.

The connection between money on one hand and output and price on the other can be stated formally using Fisher’s identity, known as the quantity theory equation: MV=PT, where:

• M = the stock of money
• V = the velocity of money
• P = the average price level
• T = the total volume of transactions

The velocity of money (circulation) is a measure of the speed at which money changes hands in the economy. It is determined by the rate at which money is passed from one person to another and the length of time for which money is held as wealth or an asset.

Example: calculating the velocity of money

From the quantity theory equation MV=PT, assume P=20, M=200,000 and T=20,000. Calculate the velocity of money (V).

Solution

MV = PT
V = PT/M
V = (20 × 20,000) / 200,000
V = 2

Criticisms of the quantity theory of money

The following criticisms were levelled against the quantity theory of money:

1. It was more of a truism than a theory.
2. It rests mainly on the assumption that some variables are constant.
3. Changes in prices may result from other factors not included in the theory.
4. Its claim to be a theory of money is wrong because it failed to discuss the effect of the rate of interest.
5. It places much emphasis on changes in the value of money and ignores the determinants of the original value of money.
6. The theory did not recognise the demand for money and concentrated on the supply of money.

What is the value of money?

The value of money is the purchasing power of money. That is, the quantity of goods and services that a given sum of money can buy over a given period.

Factors that determine the value of money

1. The general price level.
2. Inflation and deflation.
3. Supply of money or velocity of money.
4. Volume or quantity of goods and services produced.

How is the value of money measured?

The value of money can be measured using the price index, which is also called the index of retail prices.

An index number is a statistical measure designed to show changes in a variable or group of related variables with respect to geographical location or other features such as income and profession, or with respect to time. It can simply be defined as a ratio of two numbers, usually expressed as a percentage (%).

It is calculated by determining the average change in the prices of a set of goods and services. The types include the Wholesale Price Index, Consumer Price Index, GDP Price Index, Retail Price Index, Cost of Living Index, and Import and Export Price Indices.

The formula for calculating the index number is:

Index number = (Price of the current year ÷ Price of the previous (base) year) × 100

Example: calculating a price index

The price of a radio set in 2010 was ₦338 but rose to ₦362 in 2011. Calculate the price index of the radio.

Solution

Price index = (Pn / Po) × 100, where Pn is the current year price and Po is the base year price.
= (362 / 338) × 100
= 107.1%

Interpretation of the result: the price of radio sets increased from 100% in 2010 to 107.1% in 2011, an overall increase of 7.1%.

Evaluation

1. Define demand for money. What is another name for it?
2. State and explain the three motives for holding money.
3. List four factors that affect the supply of money.
4. State the quantity theory equation and explain what each letter stands for.
5. Write down the formula for calculating an index number.

Assignment

1. Which of the following is a factor that affects the supply of money? (a) citizens (b) bank rate (c) level of education (d) level of literacy
2. Liquidity preference in the concept of demand for money is the same as ____ (a) the velocity of money (b) the supply of money (c) desire to hold money in cash (d) value of money
3. The quantity theory of money was propounded by an American economist known as ____ (a) Sir Donald Cameron (b) Adam Smith (c) Irving Fisher (d) David Ricardo
4. The determinants of the value of money include all the following factors except ____ (a) price index (b) general price level (c) supply of money (d) volume of goods and services produced
5. The statistical measure designed to show changes in a variable or group of related variables with respect to geographical location or other features such as income, profession, population, etc, is known as ____ (a) a relative price level (b) an index number (c) a liquidity ratio (d) an accelerated principle