Page 148 - DECO201_MACRO_ECONOMICS_ENGLISH

Unit 8: Money

the first option he loses the interest he could earn. This loss of interest is the opportunity cost of Notes
holding money.
From this it seems that natural choice is buying bonds. But there is cost involved in buying and
selling of bonds. The cost is in the form of brokerage and other incidental expenses. It is called
‘cost of switching’ from money to bonds and back to money. There is a benefit of switching, the
interest earned. Therefore, to decide how frequently to switchover during the month the
individual compares benefit with cost. This is the principle on the basis of which the individual
makes a choice.

Example: Suppose a person’s monthly income is 12000 and he spends 400 each day.
The person can follow many strategies to decide as how much of monthly income to hold as
money and how much to hold as interest bearing bonds.
First strategy is to hold the entire income. He earns no interest by following this strategy. The
second strategy can be buying bonds for 6000 and sell the same after 15 days, so that he
continues to spend 400 each day. Now he earns some interest. The third strategy can be buying
bonds for 8000, and sell 4000 worth after 10 days, and another 4000 worth after another 10
days. He now earns more interest. The extreme strategy can be to invest the entire monthly
income in bonds, and sells bond whenever he requires to spend. Like these, there can be many
other possible strategies.
In the first strategy, the starting balance of money is 12000 and the end of the month balance is
zero. The average of the two is called “average balance”. The average balance in the first strategy
is 6000 = [(12000+0)/2]. In the second strategy, it is 3000 = [(6000+0)/2]. In the third, it is 2000
and in the extreme strategy it is zero. The question is that what is that optimal average balance.
Optimal means the most profitable. Switching from cash to bonds and bonds to cash involves
cost, e.g. brokerage, etc. At the same time switching also means more interest (more switching
also means less average balance). The person compares “interest income” with the “cost” of
switching. The optimum switching strategy is one in which the difference between interest income
and cost is maximum.
Whatever the strategy, one thing is clear that when R/I is high people want to take advantage of
high return on bonds, so they choose to hold less money. This established inverse relation
between the R/I and Md.

Notes Precautionary Demand for Money

Transaction demand arises due to unevenness between receipts and expenditures. Similarly,
precautionary demand arises due to uncertainty of future receipts and expenditures. The
precautionary demand enables persons to meet unanticipated increases in expenditures
or unanticipated delays in receipts.
This type of demand for money may be expected to vary with the level of income. People
need more money and are better able to set aside more money for this purpose at higher
income levels. Precautionary demand may also be expected to vary inversely with interest
rate.
In practice there is some rate of interest at which both transaction demand and precautionary
demand become “interest inelastic”. There is no longer a simple linear relation between
the demand for money (both transaction and precautionary) and rate of interest.

Contd...

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