UNIT-V. Investment Spending and Demand and Supply of Money

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1 UNIT-V Investment Spending and Demand and Supply of Money 95

2 LESSON: 1 UNIT-V Investment Spending and Demand and Supply of Money 1. STRUCTURE 1.1 Objective 1.2 Introduction 1.3 Concept of Investment Spending 1.4 Theories of Money Demand 1.5 Supply of Money 1.6 Summary 1.7 Self Assessment Questions 1.8 Suggested Readings 1.1 OBJECTIVE After reading this lesson, you should be able to: a) Differentiate between different types of investment spending. b) Determine demand of money using different theories. c) Determination of money supply. d) Analyze how money supply is created by banks e) Examine the relation between various monetary policies and its impact on money supply 1.2 INTRODUCTION The equilibrium in macro economics is when aggregate demand and aggregate supply are equal and aggregate demand in a macro economics consists of consumption by households, investment by the firms, expenditure by government and net exports. The previous chapters have talked about consumption, government expenditure and net exports and investment was assumed to be autonomous in all the previous chapters. This chapter discusses about different forms of investment and factors on which investment depends. Equilibrium in the money market is when money demand and money supply are equal. To explain the concept of money demand it explains various theories that help in determining the demand of money. It also explains how banks help in creation of money through credit creation process and various monetary policies of the central bank that have an impact on the money supply. 95

3 1.3 CONCEPT OF INVESTMENT SPENDING Expenditures made by the business sector on final goods and services, or gross domestic product, especially the purchase of productive capital goods. It can be broadly divided into three types: Business Fixed Investment: It is the most common form of investment that includes expenditure by firms on the fixed investment that is capital goods like machinery, equipments, building for factory etc. It is one of the main contributors to economic growth and one of the most crucial decisions that have to be undertaken. While deciding about whether to go ahead with a particular investment or not firms use discounted techniques which is because of the fact that the revenues take place in the future whereas costs are usually incurred in the present, to calculate the viability the future stream of revenue has to be discounted to get its present value. These decisions are very crucial because of the fact the once started it is very difficult to reverse them without incurring any costs. Residential Investment: It includes expenditures on houses, buildings, and similar types of shelter. Residential fixed investment includes structures built, owned, and occupied by individuals and it also includes residential places developed by businessman whose business is to sell or give on rent such property. To decide whether to go for this type of investment or not the benefits and costs associated with it has to be seen. Benefits include the imputed rent if the house is being used for self accommodation or earned rent if it has been rented out and the capital gain (or loss) because of change in the value of the investment. Cost includes the interest payments if investment has been taken on loan and depreciation or annual expenditure on maintenance. If benefits outweigh the cost the investment should be done otherwise it should not be. Inventory Investment: Firms not only invest in fixed assets but also in raw materials, work in progress and finished goods that are kept in the stock in anticipation of to be sold in the future. Firms usually keep a ratio of inventory to the sales to ensure they do not lose out any opportunity in the market. Although inventories are a relatively small portion of the overall investment sector, inventories are a critical component of changes in GDP over the business cycle. If the economy is slowing down then inventories and that too unexpected inventory would pile up and if there is boom in the economy then inventories would come down. Thus changes in the inventory determine the production level of the firm whether it needs to increase the production or reduce it. 96

4 1.4 THEORIES OF MONEY DEMAND Money demand and money supply needs to be understood to establish the money market equilibrium. Money demand refers to demand for real money that is demand of money for transactionary purposes. People hold money with them because they need to enter into transactions and for that liquidity is needed. Demand of money for transactionary purpose is directly related to income level and inversely related to real rate of interest. This is the simplest theory of money demand as was also done in LM or money market equilibrium. Other motive for holding money is for precautionary motive and speculative motive. Tobin s Portfolio Theory: Portfolio refers to a mix or combination of different assets that people hold in with them to satisfy their requirements. The different proportions of assets that individuals hold depends on the risk and return of different assets and the total wealth that they have. So the demand function can be written as: (M/P) d = f(r s, r b, π e, W) Where (M/P) d refers to real demand of money for transactionary purpose. r s = Expected real return on stocks r b = Expected real return on stocks π e = Expected Inflation rate W = Real Wealth An increase in real return on stocks or bonds reduces the demand for real money as the opportunity cost of holding money increases and stocks and bonds become more attractive. an increase in expected inflation also reduces demand of real money. An increase in wealth however increases the demand of real money. Thus this theory emphasize that demand function of money should include expected returns on other assets too. However the theory is applicable only if M2 measure of money is considered and fails if M1 is taken into consideration. There is another theory by Tobin which takes into consideration behaviour of individual wealth holder and assumes only two components to be a part of the portfolio - money and bonds. The expected proportion of money and bond that an individual would hold depends on expected gain and expected risk of the portfolio. Earlier theory ignored the determination of the transactions demand for money and considered only the demand for money as a store of wealth. Here the focus is on an individual s portfolio allocation between money-holding and bondholding, subject to the wealth constraint. The theory is based on certain assumptions like: 97

5 1. Wealth is considered as an economic good and risk is an economic bad 2. In case of money there is no return or risk. 3. The expected capital gain on bonds is zero. This is because the individual investor expects capital gains and losses to be equally likely. 4. Bonds pay an expected return of interest, but they are a risky asset. Their actual return is uncertain due to the fact that the market rate of interest fluctuates even in the short run. The theory can be explained using the following figure: Figure 1: Tobin s Portfolio Theory Here W is the initial wealth that the individual has which has to be divided between money and bonds. If the individual holds the entire wealth in form of money then after a year his wealth would be the same as money earns neither any return nor any risk. However if the investor invests entire wealth in the bond with an expected real interest rate of r% the wealth after a year would be w(1+r) and the risk as measured by standard deviation is max shown by R1. But the portfolio that investor chooses depends upon the point of tangency between indifference curve and the budget constraint where the highest possible indifference curve is tangent to the budget constraint it is the equilibrium showing the proportion of wealth between money and bonds. The shape of the indifference curve is such that because on x axis there is an economic bad and on y axis there is economic good. If there is change in the interest rate the budget constraint would change and the portfolio of the investor would also 98

6 change depending upon whether the investor is risk averse, risk neuter or risk lover. It can be shown as follows: Figure 2: Tobin s Portfolio Theory: Risk Neuter Investor A risk neuter is one who is indifferent towards risk and is only concerned about return, so with increase in the rate of interest the risk neuter brings no change in the proportion as he gets more return now with the same portfolio because of increase in the rate of interest. Figure 3: Tobin s Portfolio Theory: Risk Lover Investor 99

7 A risk lover is one who seeks risk and is willing to take more risk. Thus with an increase in the rate of interest on bonds the risk lover increases his holding of bonds such that both the risk and return increases and the investor is satisfied because of higher risk. Thus he moves to a higher indifference curve which is to the right showing greater proportion of bonds as compared to previous portfolio. Figure 4: Tobin s Portfolio Theory: Risk Averse Investor A risk averse investor is one who prefers less risk and tries to avoid risk. Thus with an increase in rate of interest as he can earn the same wealth by investing less in bonds, so a risk averse investor reduces the proportion of bonds in his portfolio to reduce the overall risk and to keep the return constant. Thus there is a leftward shift in the indifference curve. Though he is on a higher indifference curve because of increased satisfaction due to reduced risk his return is the same as earlier. Baumol-Tobin Model of Cash Management: This theory focuses on the transactionary function of money as people hold money worth them because they need to enter into transactions and to maintain liquidity cash is needed. The amount of money that people will hold with them depends on the cost associated with holding money which involves the interest foregone on the money being held with the individual. The benefit includes the convenience as there is no need of going to banks to acquire money for entering into transactions. Thus taking into consideration the cost and benefit involved the investor has to decide the optimum sum that he needs to hold with them such that the cost is minimum. Let us assume that investor requires 100

8 Y sum of money to enter into transactions for the whole year and he withdraws this at the beginning of the year and then uses it and by the year end it becomes zero. Thus it can be presented diagrammatically as: Figure 5: One trip to Bank The figure shows that in the beginning of the year itself individual withdraws Y amount of money that is needed for the transaction in the whole year. This money is then spent evenly throughout the year such that by the year end it becomes zero. So the average holding throughout the year is Y/2 that is opening + closing balance divided by 2. Now if we assume that investor makes two trips to bank then the above figure would change as: Figure 6: Two trips to Bank 101

9 The figure shows that in the beginning of the year itself individual withdraws Y/2 amount of money that is half the amount needed for the transaction in the whole year. This money is then spent evenly throughout the half year such that by the end of six months it becomes zero and then again he makes a visit to the bank and withdraws Y/2 such that by the year end it again becomes zero. So the average holding throughout the year is Y/4 that is opening + closing balance divided by 2. The above figure can be expanded to show what will happen if he makes N trips to bank. Figure 7: N trips to Bank The figure shows that in the beginning of the year itself individual withdraws Y/N amount of money that is one by Nth of the amount needed for the transaction in the whole year. This money is then spent evenly throughout the 1 by Nth of the year such that by the end of it, it becomes zero and then again he makes a visit to the bank and withdraws Y/N such that by the period end it again becomes zero. This process continues for the whole year such that by the year end it is again zero and the transactionary need of the whole period has been met by making N trips to the bank. So the average holding throughout the year is Y/2N that is opening + closing balance divided by 2. Now to decide how many trips to make to bank we need to use the following derivation: To minimize cost to the banks we have to do the following derivation: Total cost = Interest foregone + Costs of trips to bank TC = iy/2n + FN where i is the rate of interest and F is the cost of per trip to bank. 102

10 dc/dn = -iy/2n 2 + F = 0, N = iy/2f Average cash holding is directly related to the income level (Y) and (F) but indirectly related interest rate (i) If F is greater or Y is the greater or i is lower (where Y is the expenditure), then the individual holds more money, that is, demand for money depends positively on expenditure (Y) and negatively on the interest rate. Failure of the Model: Figure 8: Minimum cost at optimal number of trips 1. The Model failed because some people have less discretion over their money holdings than the model assumes 2. Empirical studies of money demand find that the income elasticity of money demand is greater than half and the interest elasticity of money demand is less than half. Thus, the model is not completely correct. 1.5 SUPPLY OF MONEY Credit creation which is the most important function of banks refers to the power of the banks to expand or contract demand deposits through the process of more loans, advances and investments. It is based on certain assumptions like all the receipts and payments in the economy are done through the banking system and all the deposits 103

11 that are made in the banks are not given out as loan but a part of it is reserved with the banks in the form of legal reserve ratio and the rest is lent out. Let us take an example that there is LRR requirement of 20% and bank receives initial deposit of Rs 1000 so banks keep Rs 200 with them and give away Rs 800 as loan. Now the bank that receives this Rs 800 would keep Rs 160 with them as reserve and give away Rs 640 as loan. This process would continue till money supply of 1/0.20 * 1000 that is Rs 5000 is created with just an initial money supply of Rs Thus how much money is created is inversely related to the legal reserve ratio. the above process can also be shown as: Balance Sheet of Bank "1" Liabilities Amount Assets Amount A's deposits 1000 Cash Reserve 200 Loan to "B" 800 Total 1000 Total 1000 Now suppose that money that borrowed from bank "1" is paid to individual "C" in settlement of his past debts. The individual "C" deposits the money in his bank say, bank 2. Now bank 2 carries out its banking transaction. It keeps a cash reserve to the extend of 20%, that is Rs. 160 and lend Rs. 640 to a borrower D. at the end of the process the balance sheet of Bank 2 would look like:- Balance Sheet of Bank "2" Liabilities Amount Assets Amount B's deposits 800 Cash Reserve 160 Loan to "C" 640 Total 800 Total 800 The amount advanced to D will return ultimately to the banking system, as described in case of B and the process of deposits and credit creation will continue until the reserve with the banks is reduced to zero. The final picture that would emerge at the end of the process of deposit & credit creation by the banking system is presented in the consolidated balance sheet of all banks are as under: 104

12 The combined Balance sheet of Banks Bank Liabilities Assets Credits Reserve Total Assets Deposits Bank Bank Bank Bank n Total It can be seen from the combined balance sheet that a primary deposits of Rs in a bank 1 leads to the creation of the total deposit of Rs. 5,000. The combined balance sheet also shows that the banks have created a total credit of Rs. 4,000. And maintained a total cash reserve of Rs.1000.Which equals the primary deposits. The total deposit created by the commercial banks constitutes the money supply by the banks. There are various instruments through which the central bank can control the money supply in an economy like open market operations where the central bank buys and/or sells the government securities in the open market to reduce or increase the money supply in the economy, reserve requirements that is cash reserve ratio that is the proportion of net demand and time liabilities that banks are required to keep with the central bank or statutory liquidity ratio that refers to the proportion of net demand and time liabilities that banks are required to buy the government securities, discount rate that is the rate of interest charged by the central bank to the banks on the loans being made. There are other measures also like moral suasion and selective credit controls that also helps in determining the money supply in the economy. 1.6 SUMMARY In macro economics equilibrium is when aggregate demand and aggregate supply are equal. Aggregate demand consists of expenditure by households in the form of consumption which is a function of disposable income, expenditure by private firms in the form of investment, by government in the form of receipt of taxes, expenditure on transfer payments and government purchases and external sector s exports and imports. This chapter talks about investment expenditure which can be broadly 105

13 divided into residential fixed investment, business fixed investment and inventory investment. Various theories have been given that explain the demand and supply of money like Tobin s portfolio theory which determines how an individual forms his portfolio and determine the proportion of different assets to hold. Similarly Baumol explained how much money an investor would hold which depends on the transactionary need of the investor and a comparison between the holding cost and carrying cost. Similarly money supply is determined by the central bank and it takes various policies that is quantitative and qualitative to alter the money supply as and when required. The most important function of the banks that leads to money supply in the economy is the process of credit creation through which money supply is created in the economy. This process in turn depends on the legal reserve requirement that is mandatory for the banks to hold and is a combination of cash reserve ratio and statutory liquidity ratio in our country. Thus in this manner equilibrium is attained in the money market when money demand and money supply become equal. 1.7 SELF ASSESSMENT QUESTIONS Exercise 1: True and False (a) Demand of money means demand for transactionary purpose. (b) Risk is measured by standard deviation in Tobin s Portfolio. (c) Tobins theory is successful in case of M1 measure but not M2. (d) Credit creation by banks is dependent on the legal reserve requirement of banks. (e) High powered money includes cash and reserves. Ans. 1(T), 2(T), 3(F), 4(T), 5(T) Exercise 2: Fill in the Blanks (a) Demand of money means demand for _. (b) Bonds have expected return which is equal to zero because. (c) Exchange rate is the rate at which currency of one country is exchanged for currency of country. (d) Monetary policy includes and _ measures. Ans 1. Transactionary, speculative and precautionary motive 2. Expected gains and losses are equal 3. Another 4. Qualitative and quantitative 106

14 Exercise 3: Questions 1. Differentiate between Tobin and Baumol s theory 2. What is the process of credit creation by banks. 3. Explain the concept of money multiplier. 4. How does central bank affects money supply in the economy. 5. Explain qualitative measures of monetary policy. 6. Explain the concept of floating and fixed rate system 7. Explain the various components of investment. 8. Derive aggregate demand curve in a small open economy. _ 1.8 SUGGESTED READINGS Mankiw, N. Gregory, Macro Economics, Macmillan Worth Publishers New York, Hampshire U.K.. Dornbusch, Rudiger and Stanley, Fischer, Macro Economics Theory, McGraw-Hill Barro Robert J., Macroeconomics Theory and Applications, MIT Press. 107

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Fluctuations in the economy s output. 1. Three Components of Investment

ECON 3560/5040 INVESTMENT - Investment is the most volatile component of GDP Fluctuations in the economy s output - Why is investment negatively related to the interest rate? - What causes the investment