Demand For Money In an Open Economy

Back in the days the main medium of exchange was the barter system; exchanging one good for another. But that was not full proof, what if one of the goods is more valuable than another? Will it be rational to exchange an entire goat for a bowl of rice? The answer is no. So then what is the a rational mean of exchange without depreciating the value of a good? Money. In 600BCE, Lydia's King Alyattes minted what is believed to be the first official currency, the Lydian stater. A medium of exchange that is centralized, generally accepted, recognized, and facilitates transactions of goods and services, is known as money. Money is a store of value, unit of account and medium of exchange. Money differs from country to country and government to government. It plays a crucial role in an economy. Most of the functions of an economy are carried out through transaction of money, whether it is to supply goods and services to various sectors such as the defense, etc. or to make welfare payments or benefits to the unemployed or disabled. Not just the government but also the most important part of an economy, the citizens, require money. they use it to fulfil basic needs and wants in their daily life. Money is required to make transactions between two or more countries in the field of trade. Imports and exports run and economy which require foreign currency to take place. Most of these functions are not in hundrends or thousands but in millions and billions. So, in order to keep up with this, there is a constant demand for money in and economy by the government as well as the citizens.

Demand for money is a very profound concept in macroeconomics as well as microeconomics. The demand for money refers to how much assets individuals wish to hold in the form of money (as opposed to illiquid physical assets.) It is sometimes referred to as liquidity preference. The demand for money is related to income, interest rates and whether people prefer to hold cash(money) or illiquid assets like money. Just like every other theory or concept in economics it is divided in classical, Keynesian or neo-classical and modern or post Keynesian. Classical economists didn’t have much of a strong and existing theory for demand for money but their views and ideas are inherent to the future theories. The fisherian approach to demand for money given by Irving Fisher (1911) states that people demand money for transaction purpose so they can purchase goods and services money is only demanded to carry out business transactions. In the equation given by him, known as the Cash Transaction/Equation of Exchange, MV=PT, where M= quantity of money, V=velocity of money, P=price level and T=volume transaction. The right hand side of this equation PT represents the demand for money which, in fact, “depends upon the value of the transactions to be undertaken in the economy, and is equal to a constant fraction of those transactions.” MV represents the supply of money which is given and in equilibrium equals the demand for money. after this came the neoclassical and the kenyesian approach. With marshall and pigou introducing the cash balance approach/Cambridge model. In this model they stated that money is more of a store of value than medium of exchange giving the income, Md=kPY, where Md= money demand which is equal to money supply and kPY= This equation tells us that “other things being equal, the demand for money in normal terms would be proportional to the nominal level of income for each individual, and hence for the aggregate economy as well.” Keynes further added to it saying that demand for money does not mean the actual money balances held by the people, but what amount of money balances they want to hold. In his general theory he used a new term ‘liquidity preference’ and gave three motives to demand money:1) transaction motive 2) precautionary motive and 3) speculative money. he also gave the liquidity trap in which the people are ready at a particular low interest rate to hold whatever stock of money is supplied.

Now the modern theory of demand of money has influences from all the above theories especially from kenynesian theory. Also known as the quantity theory of money, professor Milton Friedman as well as the other monetarists believed that the demand for money is a stable function of explanatory variables such as the permanent level of gdp, the price level and most probably the interest rate. The Keynesian economists argued “money doesn’t matter” but monetarists and Friedman in his essay ‘The Quantity Theory of Money—A Restatement” published in 1956 argued that “money does matter!”

 First of all Friedman says that his quantity theory is a theory of demand for money and not a theory of output, income or prices. Secondly, Friedman distinguishes between two types of demand for money. In the first type, money is demanded for transaction purposes. It serves as a medium of exchange. But in the second type, money is demanded because it is considered as an asset. Money is more basic than the medium of exchange. It is a temporary abode of purchasing power and hence an asset or a part of wealth. Friedman treats the demand for money as a part of the wealth theory. Thirdly, Friedman treats the demand for money just like the demand for any durable consumer good. Considering money like a durable good, Friedman states that it is also subject to the law of diminishing marginal rate of substitution, i,e with an increase in the stock of money held, its value tend to diminish relative to the services other assets are rendering. 

The demand for money depends on three factors:

(a) The total wealth to be held in various forms

(b) The price or return from these various assets and

(c) Tastes and preferences of the asset holders.

Cost of holding cash balance is influenced by:

a) The rate of interest

b)The expected rate of change in price level.

An increase in the rate of interest or the price level causes a declining in the cash balances and vice-versa.

Thus, Friedman distinguishes five form of asset in which wealth can be held

a) Money b) Bonds c) Equities d) Physical and non-human goods e) Human capital.

The demand function for money, as formulated by Friedman

Md = f(W, h, rm, rb, re, ∆P/P, U)

W stands for wealth of the individuals, h for the proportion of human wealth to the total wealth held by the individuals, rm for rate of return or interest on money, rb for rate of interest on bonds, re for rate of return on equities, P for the price level, ∆P/P for the change in price level (i.e., rate of inflation), and U for the institutional factors.

The total value of all transactions in an open economy will further cumulate to the aggregate transaction of demand for money. This total value of all transactions of an open economy can also be referred to the gross national product (gnp), the value of goods and services produced in an economy during a particular period plus the net income from the foreign investments. GNP will influence the aggregate value of all transactions as this gnp produced will be consumed by someone. This will further influence the demand for money since people will also need money to buy these goods, intermediate goods, services and assets. Anytime in an open economy when the gnp rises there will be more demand for money to purchase the extra gnp and when the gnp falls there will less demand for money. One of the most important variable that influences demand for money is the exchange rate. What exactly is an exchange? It is the rate at which one currency will be exchanged for another. In an open economy, international trade of goods and services takes place. Countries hold assets among each other; and the people residing in those countries have the liberty to invest in these assets. Its easy to buy and sell anything in your currency but to perform transactios in other countries we need have their curreny. The currency rate of every currency is not equal. Some may be higher than others due to economic factors like a boom, increase in a particular sector,etc. while some may be lower due to depression, socio-eco-politic instability,etc. suppose a foreign currency has appreciation of value, then the domestic value of the assets held by that foreign country will also appreciate or increase. As a rational human behaviour, people will sell foreign assets and also currency for capital gain. This will increase the demand for money in that country. On the other hand lets assume that the value of foreign currency has depreciated, the values of their foreign assets will also depreciate and result in people buying more or prefer to hold their assets (this is done as a speculative measure). As a result, the demand for money in that country will fall. Hence even a single unit of appreciation or depreciation can have an impact on the demand for money.

Anticipated inflation is the percentage at which the price level increases over a given period of time which the people of the country expect. If rate of inflation over the coming period is stipulated to be high then people will prefer to hold less money ( decrease in demand for money); as rate of inflation also decides the value of money. On the other hand, due to market forces acting globally if the anticipated inflation rate is low, a fall in price level is expected, thus increasing the demand for money.

One of the other factor influencing demand for money in open economy is income level. As we are exposed to a huge market the means of generating income have expanded. Income can be generated at international level increasing its value and volume due to exchange rates. More income means more liquidity to dispose, more transactions can take place whether goods and services or investments, thus increasing the demand of money. 

The demand for money is negatively related to the rate of interest (or return) on bonds, equities and other such non-money assets. If rate of interest rises the opportunity cost to hold money ( which does not give returns ) also rises. A rational human being will debate whether to hold cash which do not give returns or to invest in interest bearing assests. If interest rates are low people will prefer to hold money over investing it. Relating this to open market economy, capital will flow across boundaries in search of best returns, thus fluctuating the demand for money in different countries.

Financial integration also plays an important role. A country which is globally integrated can face changes in its demand for money as response to global events such as inflation in other countries, financial movements, international share markets, etc.

                                 Credits:- Diksha Pawar