THEORIES OF DEMAND FOR MONEY
Classical Approach:
The Neo classical Approach: The Cambridge approach
In the early 1900s, Cambridge Economists Alfred Marshall, A.C. Pigou, D.H. Robertson and John Maynard Keynes (then associated with Cambridge) put forward a fundamentally different approach to quantity theory, known as neoclassical theory or cash balance approach. The Cambridge version holds that money increases utility in the following two ways:
1. enabling the possibility of split-up of sale and purchase to two different points of time rather than being simultaneous ,and
2. being a hedge against uncertainty.
While the first above represents transaction motive, just as Fisher envisaged, the second points to money’s role as a temporary store of wealth. Since sale andpurchase of commodities by individuals do not take place simultaneously, they need a ‘temporary abode’ of purchasing power as a hedge against uncertainty. As such, demand for money also involves a precautionary motive in Cambridge approach. Since money gives utility in its store of wealth and precautionary modes, one can say that money is demanded for itself.
Now, the question is how much money will be demanded? The answer is: it depends partly on income and partly on other factors of which important ones are wealth and interest rates. The former determinant of demand i.e. income, points to transactions demand such that higher the income, the greater the quantity of purchases and as a consequence greater will be the need for money as a temporary abode of value to overcome transactions costs. The Cambridge equation is stated as:
Md = k PY
Where
Md = is the demand for money
The Keynesian Theory of Demand for Money
Keynes’ theory of demand for money is known as ‘Liquidity Preference Theory’. ‘Liquidity preference’, a term that was coined by John Maynard Keynes in his masterpiece ‘The General Theory of Employment, Interest and Money’(1936), denotes people’s desire to hold money rather than securities or long-term interest-bearing investments.
According to Keynes, people hold money (M) in cash for three motives:
(i) Transactions motive ,
(ii) Precautionary motive, and
(iii) Speculative motive.
(a) The Transactions Motive
The transactions motive for holding cash relates to ‘the need for cash for current transactions for personal and business exchange.’ The need for holding money arises because there is lack of synchronization between receipts and expenditures. The transaction motive is further classified into income motive and business (trade) motive, both of which stressed on the requirement of individuals and businesses respectively to bridge the time gap between receipt of income and planned expenditures.
Keynes did not consider the transaction balances as being affected by interest rates. The transaction demand for money is directly related to the level of income. The transactions demand for money is a direct proportional and positive function of the level of income and is stated as follows:
(b) The Precautionary Motive
Many unforeseen and unpredictable contingencies involving money payments occur in our day to day life. Individuals as well as businesses keep a portion of their income to finance such unanticipated expenditures. The amount of money demanded under the precautionary motive depends on the size of income,prevailing economic as well as political conditions and personal characteristics of the individual such as optimism/ pessimism, farsightedness etc. Keynes regarded the precautionary balances just as balances under transactions motive as income elastic and by itself not very sensitive to rate of interest.
(c) The Speculative Demand for Money
The speculative motive reflects people’s desire to hold cash in order to be equipped to exploit any attractive investment opportunity requiring cash expenditure. According to Keynes, people demand to hold money balances to take advantage of the future changes in the rate of interest, which is the same as future changes in bond prices. It is implicit in Keynes theory, that the ‘rate of interest’, i, is really the return on bonds. Keynes assumed that that the expected return on money is zero, while the expected returns on bonds are of two types, namely:
(i) the interest payment
(ii) the expected rate of capital gain.
The market value of bonds and the market rate of interest are inversely related. A rise in the market rate of interest leads to a decrease in the market value of the bond, and vice versa. Investors have a relatively fixed conception of the ’normal’ or ‘critical’ interest rate and compare the current rate of interest with such ‘normal’ or ‘critical’ rate of interest.
If wealth-holders consider that the current rate of interest is high compared to the ‘normal or critical rate of interest’, they expect a fall in the interest rate (rise in bond prices). At the high current rate of interest, they will convert their cash balances into bonds because:
(i) they can earn high rate of return on bonds
(ii) they expect capital gains resulting from a rise in bond prices consequent upon an expected fall in the market rate of interest in future.
Conversely, if the wealth-holders consider the current interest rate as low, compared to the ‘normal or critical rate of interest’, i.e., if they expect the rate of interest to rise in future (fall in bond prices), they would have an incentive to hold their wealth in the form of liquid cash rather than bonds because:
(i) the loss suffered by way of interest income forgone is small,
(ii) they can avoid the capital losses that would result from the anticipated increase in interest rates, and
Classical Approach:
The Quantity Theory of Money (QTM) The quantity theory of money, one of the oldest theories in Economics, was first propounded by Irving Fisher of Yale University in his book ‘The Purchasing Power of Money’ published in 1911 and later by the neoclassical economists. Both versions of the QTM demonstrate that there is strong relationship between money and price level and the quantity of money is the main determinant of the price level or the value of money. In other words, changes in the general level of commodity prices or changes in the value or purchasing power of money are determined first and foremost by changes in the quantity of money in circulation.
Fisher’s version, also termed as ‘equation of exchange’ or ‘transaction approach’ is formally stated as follows:
Fisher’s version, also termed as ‘equation of exchange’ or ‘transaction approach’ is formally stated as follows:
MV = PT
Where,
Where,
M= the total amount of money in circulation (on an average) in an economy
V = transactions velocity of circulation i.e. the average number of times across all transactions a unit of money(say Rupee) is spent in purchasing goods and services
P = average price level (P= MV/T)
T = the total number of transactions.
Later, Fisher extended the equation of exchange to include demand (bank) deposits (M’) and their velocity (V’) in the total supply of money. Thus, the expanded form of the equation of exchange becomes:
V = transactions velocity of circulation i.e. the average number of times across all transactions a unit of money(say Rupee) is spent in purchasing goods and services
P = average price level (P= MV/T)
T = the total number of transactions.
Later, Fisher extended the equation of exchange to include demand (bank) deposits (M’) and their velocity (V’) in the total supply of money. Thus, the expanded form of the equation of exchange becomes:
MV + M'V' = PT
Where
Where
M' = the total quantity of credit money
V' = velocity of circulation of credit money
The total supply of money in the community consists of the quantity of actual money (M) and its velocity of circulation (V). Velocity of money in circulation (V) and the velocity of credit money (V') remain constant. T is a function of national income. Since full employment prevails, the volume of transactions T is fixed in the short run. Briefly put, the total volume of transactions (T) multiplied by the price level (P) represents the demand for money. The demand for money (PT) is equal to the supply of money (MV + M'V)'. In any given period, the total value of transactions made is equal to PT and the value of money flow is equal to MV+ M'V'.
We shall now look into the classical idea of the demand for money. Fisher did not specifically mention anything about the demand for money; but the same is embedded in his theory as dependent on the total value of transactions undertaken in the economy. Thus, there is an aggregate demand for money for transactions purpose and more the number of transactions people want, greater will be the demand for money. The total volume of transactions multiplied by the price level (PT) represents the demand for money.
V' = velocity of circulation of credit money
The total supply of money in the community consists of the quantity of actual money (M) and its velocity of circulation (V). Velocity of money in circulation (V) and the velocity of credit money (V') remain constant. T is a function of national income. Since full employment prevails, the volume of transactions T is fixed in the short run. Briefly put, the total volume of transactions (T) multiplied by the price level (P) represents the demand for money. The demand for money (PT) is equal to the supply of money (MV + M'V)'. In any given period, the total value of transactions made is equal to PT and the value of money flow is equal to MV+ M'V'.
We shall now look into the classical idea of the demand for money. Fisher did not specifically mention anything about the demand for money; but the same is embedded in his theory as dependent on the total value of transactions undertaken in the economy. Thus, there is an aggregate demand for money for transactions purpose and more the number of transactions people want, greater will be the demand for money. The total volume of transactions multiplied by the price level (PT) represents the demand for money.
The Neo classical Approach: The Cambridge approach
In the early 1900s, Cambridge Economists Alfred Marshall, A.C. Pigou, D.H. Robertson and John Maynard Keynes (then associated with Cambridge) put forward a fundamentally different approach to quantity theory, known as neoclassical theory or cash balance approach. The Cambridge version holds that money increases utility in the following two ways:
1. enabling the possibility of split-up of sale and purchase to two different points of time rather than being simultaneous ,and
2. being a hedge against uncertainty.
While the first above represents transaction motive, just as Fisher envisaged, the second points to money’s role as a temporary store of wealth. Since sale andpurchase of commodities by individuals do not take place simultaneously, they need a ‘temporary abode’ of purchasing power as a hedge against uncertainty. As such, demand for money also involves a precautionary motive in Cambridge approach. Since money gives utility in its store of wealth and precautionary modes, one can say that money is demanded for itself.
Now, the question is how much money will be demanded? The answer is: it depends partly on income and partly on other factors of which important ones are wealth and interest rates. The former determinant of demand i.e. income, points to transactions demand such that higher the income, the greater the quantity of purchases and as a consequence greater will be the need for money as a temporary abode of value to overcome transactions costs. The Cambridge equation is stated as:
Md = k PY
Where
Md = is the demand for money
Y = real national income
P = average price level of currently produced goods and services
P = average price level of currently produced goods and services
PY = nominal income
k = proportion of nominal income (PY) that people want to hold as cash balances
The term ‘k’ in the above equation is called ‘Cambridge k’. The equation above explains that the demand for money (M) equals k proportion of the total money income.
Thus we see that the neoclassical theory changed the focus of the quantity theory of money to money demand and hypothesized that demand for money is a function of only money income. Both these versions are chiefly concerned with money as a means of transactions or exchange, and therefore, they present models of the transaction demand for money.
k = proportion of nominal income (PY) that people want to hold as cash balances
The term ‘k’ in the above equation is called ‘Cambridge k’. The equation above explains that the demand for money (M) equals k proportion of the total money income.
Thus we see that the neoclassical theory changed the focus of the quantity theory of money to money demand and hypothesized that demand for money is a function of only money income. Both these versions are chiefly concerned with money as a means of transactions or exchange, and therefore, they present models of the transaction demand for money.
The Keynesian Theory of Demand for Money
Keynes’ theory of demand for money is known as ‘Liquidity Preference Theory’. ‘Liquidity preference’, a term that was coined by John Maynard Keynes in his masterpiece ‘The General Theory of Employment, Interest and Money’(1936), denotes people’s desire to hold money rather than securities or long-term interest-bearing investments.
According to Keynes, people hold money (M) in cash for three motives:
(i) Transactions motive ,
(ii) Precautionary motive, and
(iii) Speculative motive.
(a) The Transactions Motive
The transactions motive for holding cash relates to ‘the need for cash for current transactions for personal and business exchange.’ The need for holding money arises because there is lack of synchronization between receipts and expenditures. The transaction motive is further classified into income motive and business (trade) motive, both of which stressed on the requirement of individuals and businesses respectively to bridge the time gap between receipt of income and planned expenditures.
Keynes did not consider the transaction balances as being affected by interest rates. The transaction demand for money is directly related to the level of income. The transactions demand for money is a direct proportional and positive function of the level of income and is stated as follows:
Lr
= kY
Where
Lr, is the transactions demand for money,
k is the ratio of earnings which is kept for transactions purposes
Where
Lr, is the transactions demand for money,
k is the ratio of earnings which is kept for transactions purposes
Y is the earnings.
Keynes considered the aggregate demand for money for transaction purposes as the sum of individual demand and therefore, the aggregate transaction demand for money is a function of national income.
Keynes considered the aggregate demand for money for transaction purposes as the sum of individual demand and therefore, the aggregate transaction demand for money is a function of national income.
(b) The Precautionary Motive
Many unforeseen and unpredictable contingencies involving money payments occur in our day to day life. Individuals as well as businesses keep a portion of their income to finance such unanticipated expenditures. The amount of money demanded under the precautionary motive depends on the size of income,prevailing economic as well as political conditions and personal characteristics of the individual such as optimism/ pessimism, farsightedness etc. Keynes regarded the precautionary balances just as balances under transactions motive as income elastic and by itself not very sensitive to rate of interest.
(c) The Speculative Demand for Money
The speculative motive reflects people’s desire to hold cash in order to be equipped to exploit any attractive investment opportunity requiring cash expenditure. According to Keynes, people demand to hold money balances to take advantage of the future changes in the rate of interest, which is the same as future changes in bond prices. It is implicit in Keynes theory, that the ‘rate of interest’, i, is really the return on bonds. Keynes assumed that that the expected return on money is zero, while the expected returns on bonds are of two types, namely:
(i) the interest payment
(ii) the expected rate of capital gain.
The market value of bonds and the market rate of interest are inversely related. A rise in the market rate of interest leads to a decrease in the market value of the bond, and vice versa. Investors have a relatively fixed conception of the ’normal’ or ‘critical’ interest rate and compare the current rate of interest with such ‘normal’ or ‘critical’ rate of interest.
If wealth-holders consider that the current rate of interest is high compared to the ‘normal or critical rate of interest’, they expect a fall in the interest rate (rise in bond prices). At the high current rate of interest, they will convert their cash balances into bonds because:
(i) they can earn high rate of return on bonds
(ii) they expect capital gains resulting from a rise in bond prices consequent upon an expected fall in the market rate of interest in future.
Conversely, if the wealth-holders consider the current interest rate as low, compared to the ‘normal or critical rate of interest’, i.e., if they expect the rate of interest to rise in future (fall in bond prices), they would have an incentive to hold their wealth in the form of liquid cash rather than bonds because:
(i) the loss suffered by way of interest income forgone is small,
(ii) they can avoid the capital losses that would result from the anticipated increase in interest rates, and
(iii) the return on money balances will be greater than the return on alternative assets
(iv) If the interest rate does increase in future, the bond prices will fall and the idle cash balances held can be used to buy bonds at lower price and can thereby make a capital-gain.
Summing up, so long as the current rate of interest is higher than the critical rate of interest, a typical wealth-holder would hold in his asset portfolio only government bonds while if the current rate of interest is lower than the critical rate of interest, his asset portfolio would consist wholly of cash. When the current rate of interest is equal to the critical rate of interest, a wealth-holder is indifferent to holding either cash or bonds. The inference from the above is that the speculative demand for money and interest are inversely related.
The speculative demand for money of individuals can be diagrammatically presented as follows:
Individual’s Speculative Demand for
The discontinuous portfolio decision of a typical individual investor is shown in the figure above. When the current rate of interest rn is higher than the critical rate of interest rc, the entire wealth is held by the individual wealth-holder in the form of government bonds. If the rate of interest falls below the critical rate of interest rc, the individual will hold his entire wealth in the form of speculative cash balances.
When we go from the individual speculative demand for money to the aggregate speculative demand for money, the discontinuity of the individual wealth-holder's demand curve for the speculative cash balances disappears and we obtain a continuous downward sloping demand function showing the inverse relationship between the current rate of interest and the speculative demand for money as shown in figure below:
Aggregate Speculative Demand for Money
According to Keynes, higher the rate of interest, lower the speculative demand for money, and lower the rate of interest, the higher the speculative demand for money. The sum of the transaction and precautionary demand, and the speculative demand, is the total demand for money.
To sum up, an increase in income increases the transaction and precautionary demand for money and a rise in the rate of interest decreases the demand for speculative demand money.
(iv) If the interest rate does increase in future, the bond prices will fall and the idle cash balances held can be used to buy bonds at lower price and can thereby make a capital-gain.
Summing up, so long as the current rate of interest is higher than the critical rate of interest, a typical wealth-holder would hold in his asset portfolio only government bonds while if the current rate of interest is lower than the critical rate of interest, his asset portfolio would consist wholly of cash. When the current rate of interest is equal to the critical rate of interest, a wealth-holder is indifferent to holding either cash or bonds. The inference from the above is that the speculative demand for money and interest are inversely related.
The speculative demand for money of individuals can be diagrammatically presented as follows:
Individual’s Speculative Demand for
The discontinuous portfolio decision of a typical individual investor is shown in the figure above. When the current rate of interest rn is higher than the critical rate of interest rc, the entire wealth is held by the individual wealth-holder in the form of government bonds. If the rate of interest falls below the critical rate of interest rc, the individual will hold his entire wealth in the form of speculative cash balances.
When we go from the individual speculative demand for money to the aggregate speculative demand for money, the discontinuity of the individual wealth-holder's demand curve for the speculative cash balances disappears and we obtain a continuous downward sloping demand function showing the inverse relationship between the current rate of interest and the speculative demand for money as shown in figure below:
Aggregate Speculative Demand for Money
According to Keynes, higher the rate of interest, lower the speculative demand for money, and lower the rate of interest, the higher the speculative demand for money. The sum of the transaction and precautionary demand, and the speculative demand, is the total demand for money.
To sum up, an increase in income increases the transaction and precautionary demand for money and a rise in the rate of interest decreases the demand for speculative demand money.
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