Supply of and demand for money are quite distinct concepts (different things) from supply of and demand for goods and services. Supply of goods is influenced (affected) by cost of production and desire to buy. While the demand for goods and services fluctuates (goes up and down) with the size of consumers’ income.
Supply of money
- “It is the total amount of money available in a country”.
- It is the total amount of coins and currency notes in circulation plus bank deposits.
Components (types) of money supply
There are three major components (or types) of money supply:
- Coins and currency notes: They are mostly used in under-developed countries.
- Bank Deposits (cheques): They are mostly used in developed countries.
Note: Money stock and money supply are synonyms i.e. they mean the same thing.
Factors influencing supply of money
- Level of economic activities: A high level of economic activities makes the public to have desire for more money for business transactions. And this put pressure on Central bank of Nigeria (CBN) to increase supply of money
- Population size: All things being equal, the larger the population size, the higher the amount of money supply, and vice versa.
- Saving habit: A high level of saving especially not with banks reduces the quantity of money supply; i.e. it reduces the quantity of money available for use, and vise versa.
- Lending – desire to borrow: If there is a high desire by businessmen to borrow money from banks, and banks are also ready to lend, there will be a great increase in supply of money, and visa versa.
- Government policy – inflation and deflation: Government always regulates the supply of money in line with level of economic activities. Government (CBN) can raise and lower supply of money in order to regulate economic activities. During inflation, government reduces supply of money in order to lower prices. While in a period of slump or severe deflation, government puts more money into circulation in order to stimulate the economy (raise level of economic activities).
- Velocity of circulation of money: If there is a rise in the velocity (rate) of circulation of money in the society, there will be a rise in the supply of money, and vice versa.
- Withdrawal of money from circulation: A deliberate action of CBN to withdraw money from circulation reduces the amount of money supply.
- Reduction in deposit money: A halt on the creation of deposit money by banks; i.e. stopping banks from leading money reduces money supply and vise versa.
- Credit squeeze measures: Total credit squeeze measures adopted by monetary authorities (CBN, federal government) adversely affects (reduces) the level of money supply.
- Level of interest rate: A high interest rate discourages businessmen from borrowing; and this reduces supply of money. While a low rate of interest encourages borrowing; and this raises level of money supply.
Effects of a change in supply of money
Fluctuation in supply of money mostly affect the following:-
- National output – Gross domestic products (GDP): Increase in money supply causes a rise in prices which makes profits to increase. This encourages producers and sellers to produce and offer more to the market. While a fall in money supply causes a fall in price level and a fall in profit. This discourages producers; they produce less quantity of goods and services. Thus money supply and national output or gross domestic product have positive relationship.
- General price level – inflation: An increase in money supply always leads to a rise in the general price level, except there is a proportionate rise in national output. If increase in money supply is proportionate to increase in gross domestic product, the price level remains constant. Money supply and the general price level have positive relationship.
- Level of investment: Increase in money supply causes a rise in prices. As increase in prices brings about a rise in the profit margin, many investors tend to undertake new investment and expansion of the existing (old) ones. These raise level of economic activities. While a fall in money stock causes a fall in level of investment.
- Interest Rate: Interest rate rises if there is a high demand for money. And interest rate falls whenever there is a large supply of money. Thus interest rate has inverse relationship with supply of money; and it has direct relationship with demand for money. In other words, a fall in money supply causes a rise in interest rate; while an increase in money supply lowers the rate of interest.
- Aggregate Demand: An increase in money supply causes a rise in price level as well as level of investment. The increase in economic activities raises level of employment of both human and material resources. This leads to a rise in aggregate demand, and vice versa.
- Value of Money: We recall that a rise in money supply leads to a rise in the general price level. And increase in prices causes a fall in value of money, and vice versa.
Demand for money
“It is amount of wealth (money) which individuals” and institutions (firms) wish to hold in form of cash balances (coins and currency notes) for daily or frequent uses.” It is synonymous with (similar to). ‘Liquidity preference’ which is the desire to hold wealth in liquid assets like demand deposit, money at call and short notice, treasury bill, etc rather than invest it on fixed capital goods, like buildings, factories, machines, etc. Briefly, demand for money. is “desire for cash bolding”.
Motives for holding cash – reasons for demand for money
Lord Keynes mentioned three reasons for holding cash; they are transaction, precautionary and speculative motives.
1) Transactions motive
Consumers hold a certain amount of cash for their daily requirements, like foodstuffs, water, matches, firewood, transport fares, petroleum products (petrol, gas & kerosene), etc. Also firms hold a certain amount of money as a petty cash for daily purchases and payment for wages and other expenses. The amount of cash held for this purpose depends on individual income’s size and its interval as well as amount of capital which determines the size of circulating capital in firms.
The amount of cash held for transactions motive is called ‘transactions balances’ or ‘transactions cash’. And the transactions balances have positive relationship with individuals, firms and national income. That is, a rise in income leads to a rise in transactions balances, and vice versa. This is shown in the figure 1.
2) Precautionary motive
Some people also hold money balances (cash) in order to guide against emergency needs, like unforeseen expenses of sudden illness, accidents, sudden breakdown of electronics and vehicles, etc. From the cash held, they can:
- offset medical bills.
- undertake necessary repairs of vehicles and electrical appliances.
- meet unexpected rise in the general price level.
- entertain unexpected visitors, etc.
The amount of cash held for this purpose is called precautionary cash or precautionary balance. Also precautionary cash fluctuates with the level of income and its interval. And the positive relationship between precautionary balance and income is illustrated in figure 2 .
3) Speculative motive
Individuals and firms also hold cash for the purpose of acquiring financial assets – securities in order to earn interest (income). However, people and firms tend to speculate on the expected level of prices and interest rate in the near future.
If they think that the level of prices of securities is going to fall or interest rate is going to rise in the very near future (shortly), they therefore hold more cash to buy bonds whenever their prices might have fallen to the lowest level; and they sell whenever their prices might have risen to the maximum level. From such transactions they make profit, and this encourages people and firms to always hold cash balances referred to as ‘speculative balances’ or ‘speculative cash’. That is, people and firms hold cash or money balances for the purpose of speculation. And this intention is referred to as “speculative motive”.
Conversely; if people think that the prices of bonds are going to rise or interest rates are going to fall in the nearest future, individuals and firms tend to hold less money balances for speculative purposes in order to avert (avoid) risk of bonds holding. These various relationships are illustrated graphically in figures 3 and 4.
Summary of motives for holding money
- Transaction motive is a desire to hold cash in order to buy households’ and firms’ daily requirements, e.g. foodstuffs, stationery, fuel, etc.
- Precautionary motive is a desire to hold cash in order to take care of unforeseen contingencies e.g. sickness, breakdown of vehicles, etc.
- Speculative motive is a desired to hold cash in order to take advantages of changes in prices of securities (bonds, shares, bills) and level of interest rate.
Factors influencing demand for money
- Level of wealth – national income: As national income rises or level of wealth in the society rises, the demand for money also rises, and vise versa.
- Level of economic activities – value of transaction: The demand for money is greatly influenced by level of economic activities or value of transactions in the economy (country). The higher the level of economic activity or overall value of transactions, the higher the demand for money, and vice versa.
- Level of interest rate: Interest rate has positive relationship with demand for money. That is, if it is rising people tend to hold more money as they invest (put) their (surplus) cash in bank deposits especially fixed deposit. These give them the opportunity to earn more income, and vice versa.
- Government policy: Government adopts several measures to regulate the level of money supply and demand for money. Contractionist policies (lowering level of economic activities) have negative effects on (reduce) demand for money. While expansionist policies (raising level of economic activities) have positive effects on (raise) demand for money.
- Population size: All things being equal, a large population size leads to increase in the demand for money, and vice versa.