MONETARY POLICY

INTRODUCTION

• As citizens of a free nation, we have many dreams about what ought to be the state of affairs in our economy. We value stable prices and low rates of inflation. We share a quest for well-being through high levels of growth which ensure jobs and prosperity and we work towards it. 
• Unfortunately, in reality, we live in a crisis prone economy with nightmares of financial downturns, of being laid- off or being battered by financial crises. We observe that the Reserve Bank of India is occasionally manipulating policy rates for maneuvering liquidity conditions with reasons thereof explicitly notified. 
• In fact, we have only a limited understanding of the monetary phenomena which coutld strengthen or paralyse the domestic economy. The discussion that follows is an attempt to throw light on the well- acknowledged monetary measures undertaken by governments to fight economic instability.

 MONETARY POLICY DEFINED

• Monetary policy refers to the use of monetary policy instruments which are at the disposal of the central bank to regulate the availability, cost and use of money and credit to promote economic growth, price stability, optimum levels of output and employment, balance of payments equilibrium, stable currency or any other goal of government's economic policy. 
• In other words, monetary policy is essentially a programme of action undertaken by the monetary authorities, normally the central bank, to control and regulate the demand for and supply of money with the public and the flow of credit with a view to achieving predetermined macroeconomic goals.
•  Monetary policy encompasses all actions of the central bank which are aimed at directly controlling the money supply and indirectly at regulating the demand for money. Monetary policy is in the nature of ‘demand-side’ macroeconomic policy and works by stimulating or discouraging investment and consumption spending on goods and services. It is no surprise that monetary policy is regarded as an indispensable policy instrument in an economy.

 THE MONETARY POLICY FRAMEWORK

The central bank, in its execution of monetary policy, functions within an articulated monetary policy framework which has three basic components, viz.

(i) the objectives of monetary policy,

(ii) the analytics of monetary policy which focus on the transmission mechanisms, and

(iii) the operating procedure which focuses on the operating targets and instruments.

MONEY SUPPLY

 EFFECT OF GOVERNMENT EXPENDITURE ON MONEY SUPPLY

• Whenever the central and the state governments’ cash balances fall short of the minimum requirement, they are eligible to avail of a facility called Ways and Means Advances (WMA)/overdraft (OD) facility. 
• When the Reserve Bank of India lends to the governments under WMA /OD, it results in the generation of excess reserves (i.e., excess balances of commercial banks with the Reserve Bank). This happens because when government incurs expenditure, it involves debiting the government balances with the Reserve Bank and crediting the receiver (for e.g., salary account of government employee) account with the commercial bank. 
• The excess reserves thus created can potentially lead to an increase in money supply through the money multiplier process.

The Credit Multiplier

• The Credit Multiplier also referred to as the deposit multiplier or the deposit expansion multiplier, describes the amount of additional money created by commercial bank through the process of lending the available money it has in excess of the central bank's reserve requirements. 
• The deposit multiplier is, thus inextricably tied to the bank's reserve requirement. This measure tells us how much new money will be created by the banking system for a given increase in the high- powered money. It reflects a bank's ability to increase the money supply.

The credit multiplier is the reciprocal of the required reserve ratio. If reserve ratio is 20%, then credit multiplier = 1/0.20 = 5.

                           Credit Multiplier =_____1________________
                                                           Required Reserve Ratio



The existence of the credit multiplier is the outcome of fractional reserve banking. It explains how increase in money supply is caused by the commercial banks’ use of depositors’ funds to lend money. When a bank uses the deposited money for lending, the bank generates another claim on a given amount of deposited money. For example, if A deposits ` 1000/ in cash at a bank (Bank X), this constitutes the bank's current total cash deposits. If the required reserve is 10 percent, the bank would lend` 900/ to B. By lending B ` 900/, the bank creates a deposit for ` 900/ that B can now use. It is as though B owns ` 900/. This in turn means that A will continue to have a claim against ` 1000/ while B will have a claim against ` 900/.

The bank has ` 1000/ in cash against claims of `1900/. In short, the bank has created` 900/ out of "thin air" since these ` 900/ are not supported by any genuine money. At any time, the fractional reserve commercial banks have more cash liabilities than cash in their vaults.

Now suppose B buys goods worth ` 900/ from C and pays C by cheque. C places the cheque with his bank, Bank Y. After clearing the cheque, Bank Y will have an increase in cash of ` 900/, which it may take advantage of and use to lend out ` 810/ to D which may again be deposited in another bank, say Bank Z. Again 10 per cent of ` 810 (` 81) has to be kept as required reserves and the remaining `. 719/ can be lent out, say to E. This sequence keeps on continuing until the initial deposit amount `. 1,000 grows exactly by the multiple of required reserves(in this case, 10%). Ultimately, the expanded credit availability would be 1000 + 900 (90% of 1000) + 810 (90% of 900) + 729 (90% of 810) + (90% of 719) +… …. This summation would end with an amount which is equivalent to 1/10% of 1000, which is `. 10,000. Thus, in our example, the initial deposit is capable of multiplying itself out 10 times. In short, we find that the fact that banks make use of demand deposits for lending it sets in motion a series of activities leading to expansion of money that is not backed by money proper. It is interesting to know that there is no difference between the type of money created by commercial banks and that which are issued by the central bank.

The deposit multiplier and the money multiplier though closely related are not identical because :
a) generally banks do not lend out all of their available money but instead maintain reserves at a level above the minimum required reserve.

b) all borrowers do not spend every Rupee they have borrowed. They are likely to convert some portion of it to cash.

MONEY MULTIPLIER APPROACH

 THE MONEY MULTIPLIER APPROACH TO SUPPLY OF MONEY

The money multiplier approach to money supply propounded by Milton Friedman and Anna Schwartz, (1963) considers three factors as immediate determinants of money supply, namely:

(a) the stock of high-powered money (H)

(b) the ratio of reserves to deposites, e = {ER/D} and

(c) the ratio of currency to depoists, c ={C/D}

You may note that these represent the behaviour of the central bank, behaviour of the commercial banks and the behaviour of the general public respectively. We shall now describe how each of the above contributes to the determination of aggregate money supply in an economy.

a) The Behaviour of the Central Bank
The behaviour of the central bank which controls the issue of currency is reflected in the supply of the nominal high-powered money. Money stock is determined by the money multiplier and the monetary base is controlled by the monetary authority. If the behaviour of the public and the commercial banks remains unchanged over time, the total supply of nominal money in the economy will vary directly with the supply of the nominal high-powered money issued by the central bank.

b) The Behaviour of Commercial Banks

By creating credit, the commercial banks determine the total amount of nominal demand deposits. The behaviour of the commercial banks in the economy is reflected in the ratio of their cash reserves to deposits known as the ‘reserve ratio’. If the required reserve ratio on demand deposits increases while all the other vari- ables remain the same, more reserves would be needed. This implies that banks must contract their loans, causing a decline in deposits and hence in the money supply. If the required reserve ratio falls, there will be greater expansions of deposits because the same level of reserves can now support more deposits and the money supply will increase.

In actual practice, however, the commercial banks keep only a part or fraction of their total deposits in the form of cash reserves. However, for the commercial banking system as a whole, the actual reserves ratio is greater than the required  reserve ratio since the banks keep with them a higher than the statutorily required percentage of their deposits in the form of cash reserves. The additional units of high-powered money that goes into ‘excess reserves’ of the commercial banks do not lead to any additional loans, and therefore, these excess reserves do not lead to creation of money. Therefore, if the central bank injects money into the banking system and these are held as excess reserves by the banking system, there will be no effect on deposits or currency and hence no effect on money supply.

When the costs of holding excess reserves rise, we should expect the level of excess reserves to fall; when the benefits of holding excess reserves rise, we would expect the level of excess reserves to rise. Two primary factors namely market interest rates and expected deposit outflows affect these costs and benefits and hence in turn affect the excess reserves ratio.

We know that the cost to a bank while holding excess reserves is in terms of its opportunity cost, i.e. the interest that could have been earned on loans or securities if the bank had chosen to invest in them instead of excess reserves. If interest rate increases, it means that the opportunity cost of holding excess reserves rises because the banks have to sacrifice possible higher earnings and hence the desired ratio of excess reserves to deposits falls. Conversely, a decrease in interest rate will reduce the opportunity cost of excess reserves, and excess reserves will rise. Therefore, we conclude that the banking system's excess reserves ratio e is neg- atively related to the market interest rate.

If banks fear that deposit outflows are likely to increase (that is, if expected deposit outflows increase), they will want more assurance against this possibility and will increase the excess reserves ratio. Conversely, a decline in expected deposit outflows will reduce the benefit of holding excess reserves and excess reserves will fall.

As we know, money is mostly held in the form of deposits with commercial banks. Therefore, money supply may become subject to ‘shocks’ on account of behaviour of commercial banks which may present variations overtime either cyclically and more permanently. For instance, in times of financial crises, banks may be unwilling to lend to the small and medium scale industries who may become credit constrained facing a higher risk premia on their borrowings. The rising interest rates on bank credit to the commercial sector reflecting higher risk premia can co-exist with the lowering of policy rates by the central bank. The lower credit demand can lead to a sharp deceleration in monetary growth at a time when the central bank pursues an easy monetary policy.

c) The Behaviour of the Public

We shall now turn to the next determinant viz. the behaviour of the public. The public, by their decisions in respect of the amount of nominal currency in hand (how much money they wish to hold as cash) is in a position to influence the amount of the nominal demand deposits of the commercial banks. The behaviour of the public influences bank credit through the decision on ratio of currency to the money supply designated as the ‘currency ratio’.

What would be the behaviour of money supply when depositors decide to increase currency holding, with all other variables unchanged? In other words, you decide to keep more money in your pocket and less money in your bank. That means you are converting some of your demand deposits into currency. If many people like you do so, technically we say there is an increase in currency ratio. As we know, demand deposits undergo multiple expansions while currency in your hands does not. Hence, when bank deposits are being converted into currency, banks can create only less credit money. The overall level of multiple expansion declines, and therefore, money multiplier also falls. Therefore, we conclude that money multiplier and the money supply are negatively related to the currency ratio c.

The currency-deposit ratio (c) represents the degree of adoption of banking habits by the people. This is related to the level of economic activities or the GDP growth and is influenced by the degree of financial sophistication in terms of ease and access to financial services, availability of a richer array of liquid financial assets, financial innovations, institutional changes etc.
          The time deposit-demand deposit ratio i.e. how much money is kept as time deposits compared to demand deposits, also has an important implication for the money multiplier and, hence for the money stock in the economy. An increase in TD/DD ratio means that greater availability of free reserves and consequent enlargement of volume of multiple deposit expansion and monetary expansion.

To summarise the money multiplier approach, the size of the money multiplier is determined by the required reserve ratio (r) at the central bank, the excess reserve ratio (e) of commercial banks and the currency ratio (c) of the public. The lower these ratios are, the larger the money multiplier is. In other words, the money supply is determined by high powered money (H) and the money multiplier (m) and varies directly with changes in the monetary base, and inversely with the currency and reserve ratios. Although these three variables do not completely explain changes in the nominal money supply, nevertheless they serve as usefuldevices for analysing such changes. Consequently, these variables are designated as the ‘proximate determinants’ of the nominal money supply in the economy.

MONEY SUPPLY

DETERMINANTS OF MONEY SUPPLY
There are two alternate theories in respect of determination of money supply. According to the first view, money supply is determined exogenously by the central bank. The second view holds that the money supply is determined endogenously by changes in the economic activities which affect people’s desire to hold currency relative to deposits, rate of interest, etc. The current practice is to explain the determinants of money supply based on ‘money multiplier approach’ which focuses on the relation between the money stock and money supply in terms of the monetary base or high-powered money. This approach holds that total supply of nominal money in the economy is determined by the joint behaviour of the central bank, the commercial banks and the public. Before we discuss the determinants of money supply, it is necessary that we know the concept of money multiplier.

 THE CONCEPT OF MONEY MULTIPLIER

The money supply is defined as

            M = m X MB

Where M is the money supply, m is money multiplier and MB is the monetary base or high powered money. From the above equation we can derive the money multiplier (m) as

                     Money Multiplier (m)= Money supply/monetary base
Money multiplier m is defined as a ratio that relates the changes in the money supply to a given change in the monetary base. It denotes by how much the money supply will change for a given change in high-powered money. The multiplier indicates what multiple of the monetary base is transformed into money supply.
                If some portion of the increase in high-powered money finds its way into currency, this portion does not undergo multiple deposit expansion. In other words, as a rule, an increase in the monetary base that goes into currency is not multiplied, whereas an increase in monetary base that goes into supporting deposits is multiplied.

MEASUREMENT OF MONEY SUPPLY

 MEASUREMENT OF MONEY SUPPLY

• There is virtually a profusion of different types of money, especially credit money, and this makes measurement of money supply a difficult task. Different countries follow different practices in measuring money supply. 
• The measures of money supply vary from country to country, from time to time and from purpose to purpose. Reference to such different measures is beyond the scope of this unit. Just as other countries do, a range of monetary and liquidity measures are compiled and published by the RBI. Money supply will change if the magnitude of any of its constituents changes.
• In this unit, we shall be concentrating on the Indian case only and in the following discussion, we shall focus on alternative measures of money supply prepared and published by the Reserve Bank of India.
• Since July 1935, the Reserve Bank of India has been compiling and disseminating monetary statistics. Till 1967-68, the RBI used to publish only a single ‘narrow measure of money supply’ (M1) defined as the sum of currency and demand deposits held by the public. From 1967-68, a 'broader' measure of money supply, called 'aggregate monetary resources' (AMR) was additionally published by the RBI. From April 1977, following the recommendations of the Second Working Group on Money Supply (SWG), the RBI has been publishing data on four alternative measures of money supply denoted by M1, M2, M3 and M4 besides the reserve money. The respective empirical definitions of these measures are given below:

M1 = Currency notes and coins with the people + demand deposits of banks (Current and Saving deposit accounts) + other deposits of the RBI.
                         
M2 = M1 + savings deposits with post office savings banks.

M3 = M1 + net time deposits with the banking system. M4= M3 + total deposits with the Post Office Savings Organization (excluding National Savings Certificates).

• The RBI regards these four measures of money stock as representing different degrees of liquidity. It has specified them in the descending order of liquidity, M1 being the most liquid and M4the least liquid of the four measures.
• We shall briefly discuss the important components of each. Currency consists of paper currency as well as coins. Demand deposits comprise the current-account deposits and the demand deposit portion of savings deposits, all held by the public.
•  These are also called CASA deposits and these are cheapest sources of finance for a commercial bank. It should be noted that it is the net demand deposits of banks, and not their total demand deposits that get included in the measure of money supply. 
• The total deposits include both deposits from the public as well as inter- bank deposits. Money is deemed as something held by the ‘public’. Since inter- bank deposits are not held by the public, they are netted out of the total demand deposits to arrive at net demand deposits.
• 'Other deposits’ of the RBI are its deposits other than those held by the government (the Central and state governments), and include demand deposits of quasi- government institutions, other financial institutions, balances in the accounts of foreign central banks and governments, and accounts of international agencies such as IMF and the World Bank. Empirically, whatever the measure of money supply, these 'other deposits' of the RBI constitute a very small proportion (less than one per cent) of the total money supply

Following the recommendations of the Working Group on Money (1998), the RBI has started publishing a set of four new monetary aggregates on the basis of the balance sheet of the banking sector in conformity with the norms of progressive liquidity. The new monetary aggregates are:

Reserve Money = Currency in circulation + Bankers’ deposits with the RBI + Other deposits with the RBI
                = Net RBI credit to the Government + RBI credit to the Commercial sector + RBI’s Claims on banks + RBI’s net Foreign assets + Government’s Currency liabilities to the public– RBI’s net non  - monetary Liabilities

NM1 = Currency with the public + Demand deposits with the banking system + ‘Other’ deposits with the RBI.

NM2 = NM1 + Short-term time deposits of residents (including and up to contractual maturity of one year).

NM3 = NM2 + Long-term time deposits of residents + Call/Term funding from financial institutions

• In the monetary literature, money is usually defined in alternative ways ranging from narrow to broad money. Empirically the M1 (narrow money) is defined as the sum of currency held by the public, demand deposits of the banks and other deposits of RBI. 
• Reserve money is comprised of the currency held by the public, cash reserves of banks and other deposits of RBI. On comparison, we find that the difference between M1 and reserve money is that the former includes the demand deposits while the latter includes the cash reserves of banks. Reserves are commercial banks’ deposits with the central bank for maintaining cash reserve ratio (CRR) and as working funds for clearing adjustments.
• Reserve money, also known as central bank money, base money or high-powered money, needs a special mention as it plays a critical role in the determination of the total supply of money. Reserve money determines the level of liquidity and price level in the economy and, therefore, its management is of crucial importance to stabilize liquidity, growth, and price level in an economy.

The central bank also measures macroeconomic liquidity by formulating various ‘liquidity’ aggregates in addition to the monetary aggregates. While the instruments issued by the banking system are included in ‘money’, instruments, those which are close substitutes of money but are issued by the non-banking financial institutions are also included in liquidity aggregates.

L1= NM3 + All deposits with the post office savings banks (excluding National Savings Certificates).

L2= L1 +Term deposits with term lending institutions and refinancing institutions (FIs) + Term borrowing by FIs + Certificates of deposit issued by FIs.

L3 = L2+ Public deposits of non-banking financial companies

MONEY SUPPLY

INTRODUCTION

• In the previous unit, we have discussed the theories related to demand for money. Money plays a crucial role in the smooth functioning of an economy. Money supply is considered as a very important macroeconomic variable responsible for changes in many other significant macroeconomic variables in an economy and is therefore considered as a matter of considerable interest to the economists and policy makers. 
•  Economic stability requires that the supply of money at any time should to be maintained at an optimum level. A pre-requisite for achieving this is to accurately estimate the stock of money supply on a regular basis and appropriately regulate it in accordance with the monetary requirements of the country.
•  In this unit, we shall look into various aspects related to the supply of money.
• The term money supply denotes the total quantity of money available to the people in an economy. 

The quantity of money at any point of time is a measurable concept. It is important to note two things about any measure of money supply:

(i) The supply of money is a stock variable i.e. it refers to the total amount of money at any particular point of time. It is the change in the stock of money (say, increase or decrease per month or year,) , which is a flow.

(ii) The stock of money always refers to the stock of money available to the ‘public’ as a means of payments and store of value. This is always smaller than the total stock of money that really exists in an economy.

• The term ‘public’ is defined to include all economic units (households, firms and institutions) except the producers of money (i.e. the government and the banking system). The government, in this context, includes the central government and all state governments and local bodies; and the banking system means the Reserve Bank of India and all the banks that accept demand deposits (i.e. deposits from which money can be withdrawn by cheque mainly CASA deposits). 
• The word ‘public’ is inclusive of all local authorities, non-banking financial institutions, and non- departmental public-sector undertakings, foreign central banks and governments and the International Monetary Fund which holds a part of Indian money in India in the form of deposits with the RBI. In other words, in the standard measures of money, interbank deposits and money held by the government and the banking system are not included.

 RATIONALE OF MEASURING MONEY SUPPLY 

Empirical analysis of money supply is important for two reasons:

1. It facilitates analysis of monetary developments in order to provide a deeper understanding of the causes of money growth.

2. It is essential from a monetary policy perspective as it provides a framework to evaluate whether the stock of money in the economy is consistent with the standards for price stability and to understand the nature of deviations from this standard. The central banks all over the world adopt monetary policy to stabilise price level and GDP growth by directly controlling the supply of money. This is achieved mainly by managing the quantity of monetary base. The success of monetary policy depends to a large extent on the controllability of money supply and the monetary base. 

THE SOURCES OF MONEY SUPPLY

The supply of money in the economy depends on:

(a) the decision of the central bank based on the authority conferred on it , and

(b) the supply responses of the commercial banking system of the country to the changes in policy variables initiated by the central bank to influence the total money supply in the economy.

• The central banks of all countries are empowered to issue currency and, therefore, the central bank is the primary source of money supply in all countries. In effect, high powered money issued by monetary authorities is the source of all other forms of money.
•  The currency issued by the central bank is ‘fiat money’ and is backed by supporting reserves and its value is guaranteed by the government. The currency issued by the central bank is, in fact, a liability of the central bank and the government.
•  Therefore, in principle, it must be backed by an equal value of assets mainly consisting of gold and foreign exchange reserves. In practice, however, most countries have adopted a ‘minimum reserve system ’wherein the central bank is empowered to issue currency to any extent by keeping only a certain minimum reserve of gold and foreign securities. 
• The second major source of money supply is the banking system of the country. The total supply of money in the economy is also determined by the extent of credit created by the commercial banks in the country. 
• Banks create money supply in the process of borrowing and lending transactions with the public. Money so created by the commercial banks is called 'credit money’. The high powered money and the credit money broadly constitute the most common measure of money supply, or the total money stock of a country. (For a brief note on the process of creation of credit money, refer to Box 1, end of this chapter).

DEVELOPMENTS IN THE THEORY OF DEMAND FOR MONEY

 POST-KEYNESIAN DEVELOPMENTS IN THE THEORY OF DEMAND FOR MONEY
Most post-Keynesian theories of demand for money emphasize the store-of-value or the asset function of money.

Inventory Approach to Transaction Balances

Baumol (1952) and Tobin (1956) developed a deterministic theory of transaction demand for money, known as Inventory Theoretic Approach, in which money or ‘real cash balance’ was essentially viewed as an inventory held for transaction purposes.

• Inventory models assume that there are two media for storing value: money and an interest-bearing alternative financial asset. There is a fixed cost of making transfers between money and the alternative assets e.g. broker charges. 
• While relatively liquid financial assets other than money (such as, bank deposits) offer a positive return, the above said transaction cost of going between money and these assets justifies holding money.
• Baumol used business inventory approach to analyze the behaviour of individuals. Just as businesses keep money to facilitate their business transactions, people also hold cash balance which involves an opportunity cost in terms of lost interest. Therefore, they hold an optimum combination of bonds and cash balance, i.e., an amount that minimizes the opportunity cost.
• Baumol’s propositions in his theory of transaction demand for money hold that receipt of income, say Y takes place once per unit of time but expenditure is spread at a constant rate over the entire period of time. Excess cash over and above what is required for transactions during the period under consideration will be invested in bonds or put in an interest-bearing account. Money holdings on an average will be lower if people hold bonds or other interest yielding assets.
• The higher the income, the higher is the average level or inventory of money holdings. The level of inventory holding also depends also upon the carrying cost, which is the interest forgone by holding money and not bonds, net of the cost to the individual of making a transfer between money and bonds, say for example brokerage fee. The individual will choose the number of times the transfer between money and bonds takes place in such a way that the net profits from bond transactions are maximized.
• The average transaction balance (money) holding is a function of the number of times the transfer between money and bonds takes place. The more the number of times the bond transaction is made, the lesser will be the average transaction balance holdings. In other words, the choice of the number of times the bond transaction is made determines the split of money and bond holdings for a given income.
• The inventory-theoretic approach also suggests that the demand for money and bonds depend on the cost of making a transfer between money and bonds e.g. the brokerage fee. An increase the brokerage fee raises the marginal cost of bond market transactions and consequently lowers the number of such transactions. The increase in the brokerage fee raises the transactions demand for money and lowers the average bond holding over the period. This result follows because an increase in the brokerage fee makes it more costly to switch funds temporarily into bond holdings. An individual combines his asset portfolio of cash and bond in such proportions that his cost is minimized.

 Friedman's Restatement of the Quantity Theory
Milton Friedman (1956) extended Keynes’ speculative money demand within the framework of asset price theory. Friedman treats the demand for money as nothing more than the application of a more general theory of demand for capital assets. Demand for money is affected by the same factors as demand for any other asset, namely

1. Permanent income.

2. Relative returns on assets. (which incorporate risk)

Friedman maintains that it is permanent income – and not current income as in the Keynesian theory – that determines the demand for money. Permanent income which is Friedman’s measure of wealth is the present expected value of all future income. To Friedman, money is a good as any other durable consumption good and its demand is a function of a great number of factors.

Friedman identifies the following four determinants of the demand for money. The nominal demand for money:

•  is a function of total wealth, which is represented by permanent income divided by the discount rate, defined as the average return on the five asset classes in the monetarist theory world, namely money, bonds, equity, physical capital and human capital.
•  is positively related to the price level, P. If the price level rises the demand for money increases and vice versa.
•  rises if the opportunity costs of money holdings (i.e. returns on bonds and stock) decline and vice versa.
• is influenced by inflation, a positive inflation rate reduces the real value of money balances, thereby increasing the opportunity costs of money holdings.

 The Demand for Money as Behavior toward Risk

In his classic article, ‘Liquidity Preference as Behavior towards Risk’ (1958), Tobin established that the theory of risk-avoiding behavior of individuals. provided the foundation for the liquidity preference and for a negative relationship between the demand for money and the interest rate. The risk-aversion theory is based on the principles of portfolio management. According to Tobin, the optimal portfolio structure is determined by

(i) the risk/reward characteristics of different assets

(ii) the taste of the individual in maximizing his utility consistent with the existing opportunities

In his theory which analyzes the individual's portfolio allocation between money and bond holdings, the demand for money is considered as a store of wealth. Tobin hypothesized that an individual would hold a portion of his wealth in the form of money in the portfolio because the rate of return on holding money was more certain than the rate of return on holding interest earning assets and entails no capital gains or losses. It is riskier to hold alternative assets vis-à-vis holding interest just money alone because government bonds and equities are subject to market price volatility, while money is not. Thus, bonds pay an expected return of r, but as asset, they are unlike money because they are risky; and their actual return is uncertain. Despite this, the individual will be willing to face this risk because the expected rate of return from the alternative financial assets exceeds that of money.

          According to Tobin, rational behaviour of a risk-averse economic agent induces him to hold an optimally structured wealth portfolio which is comprised of both bonds and money. The overall expected return on the portfolio would be higher if the portfolio were all bonds, but an investor who is ‘risk-averse’ will be willing to exercise a trade- off and sacrifice to some extent the higher return for a reduction in risk. Tobin's theory implies that the amount of money held as an asset depends on the level of interest rate. An increase in the interest rate will improve the terms on which the expected return on the portfolio can be increased by accepting greater risk. In response to the increase in the interest, the individual will increase the proportion of wealth held in the interest-bearing asset, say bonds, and will decrease the holding of money. Within Tobin's framework, an increase  in  the rate of interest can be considered as an increase in the payment received  for undertaking risk. When this payment is increased, the individual investor is willing  to put a greater proportion of the portfolio into the risky asset, (bonds) and thus a smaller proportion into the safe asset, money. His analysis implies that the demand for money as a store of wealth will decline with an increase in the interest rate. Tobin's analysis also indicates that uncertainty about future changes in bond prices, and hence the risk involved in buying bonds, may be a determinant of money demand. Just as Keynes’ theory, Tobin's theory implies that the demand for money as a store of wealth depends negatively on the interest rate.

 CONCLUSION

We have discussed the important theories pertaining to demand for money. All the theories have provided significant insights into the concept of demand for money. While the transactions version of Fisher focused on the supply of money as determining prices, the cash balance approach of the Cambridge University economists established the formal relationship between demand for real money and the real income. Keynes developed the money demand theory on the basis of explicit motives for holding money and formally introduced the interest rate as an additional explanatory variable that determines the demand for real balances. The post-Keynesian economists developed a number of models to provide alternative explanations to confirm the formulation relating real money balances with real income and interest rates. However, we find that all these theories establish a positive relation of demand for money to real income and an inverse relation to the rate of return on earning assets, i.e. the interest rate. However, the propositions in these theories need to be supported by empirical evidence. As countries differ in respect of various determinants of demand for money, we cannot expect any uniform pattern of behaviour. Broadly speaking, real income, interest rates and expectations in respect to inflation are significant predictors of demand for money.