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.
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.
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.
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.
No comments:
Post a Comment