VI.6.4. 1.

Basic Concepts

Theories of Demand For Money

 
Demand for Money
Classical Approach : Quantity theory of
money — Cash transaction and cash balance
approaches
The Keynesian approach
Modern theories of the demand for money
• The Classical : Fisher (1911) The Transaction
Balance version – the use of money as a medium
of exchange: MV = PT or M= PT/V.
• Marshall/ Pigou – the Cash Balance version – the
use of money as a store of value: M= KPY
• The Keynesian- JM Keynes (1936) Liquidity
Preference Theory, liquidity motives: transaction,
precautionary and speculative motive. L= Lt + Lp
+ Li
• Chicago Approach – Milton Friedman (1959).
• Income Theory of Money.
• Money acts as medium of exchange.
• It serves as a store of value.
• Money not demanded for its own sake but
needed by households and firms to pay for
goods and service (transactions).
• The quantity of money people held for
transactions depends upon the VOC of
money.
• Price level is a passive variable.
• Total volume of transaction is an independent
but constant variable in the short run.
• VOC is an independent and constant variable
in the short run.
• Full employment in the economy.
• Short period analysis.
• Demand for money is determined by three
factors.
• The volume of transaction.
• The average price level per unit.
• The VOC of money.
MV=PT
• M= stock of money, V= VOC, P = price level, T
= Volume of transaction.
• Demand for money (Md)
• Md = PT/V or Md = 1/V X PT
• Md is product of volume of transactions (T) X
P and divided by V.
• Ex. – V=5 (in a year), T=5000 units and P is 10
per unit.
• Md = 10X5000 / 5 =10,000.
• T & V remaining constant in the short period –
Md changes with changes in price level.
• According to Fisher – Changes in price level are
directly proportional to the changes in money
supply (Ms) in the short period.
• MV = PT, - Ms= PT/V.
• Since Md = PT/V therefore Md = Ms.
• The demand for money Is always equal to supply
of money when economy is equilibrium.
Conti.
• The quantity theory of money says that the level of prices
varies directly with quantity of money. “Double the quantity
of money, and other things being equal, prices will be twice
as high as before, and the value of money one-half. Halve the
quantity of money and, other things being equal, prices will
be one-half of what they were before and the value of money
double.”
• The theory can also be stated in these words: The price level
rises proportionately with a given increase in the quantity of
money. Conversely, the price level falls proportionately with a
given decrease in the quantity of money, other things
remaining the same.
Numerical Example
• Now, with the assumptions that M and V remain constant, the price level P
depends upon the quantity of money M; the greater the quantity of M, the
higher the level of prices. Let us give a Suppose the quantity of money is
Rs. 5, 00,000 in an economy, the velocity of circulation of money (V) is 5;
and the total output to be transacted (T) is 2, 50,000 units, the average
price level (P) will be:
P = MV/T
= 5, 00,000 × 5/ 2, 50,000 = 2,500,000/ 2, 50,000
= Rs. 10 per unit.
If now, other things remaining the same, the quantity of money is doubled, i.e., increased to
Rs. 10, 00,000 then:
P = 10, 00,000 × 5/ 2, 50,000 = Rs. 20 per unit
• We thus see that according to the quantity theory of money, price level
varies in direct proportion to the quantity of money. A doubling of the
quantity of money (M) will lead to the doubling of the price level. Further,
since changes in the quantity of money are assumed to be independent or
autonomous of the price level, the changes in the quantity of money
become the cause of the changes in the price level.
• Money as store of value is stressed upon.
• Demand for money refers to the cash balance
held by people.
• Factors affecting cash balance are interest
rate, wealth possessed by individuals,
purchasing power of money, expectation
about future changes in prices and interest
rate.
Marhsallian Equation
M = kPY
• M = quantity of money, k = proportion of national income
that people desire to hold in form of money balances, P=
Price level and Y = aggregate real income
• where V = 1/k. These few steps of simple mathematics
show the link between the demand for money and the
velocity of money. When people want to hold a lot of
money for each dollar of income (k is large), money
changes hands infrequently (V is small). Conversely, when
people want to hold only a little money (k is small), money
changes hands frequently (V is large). In other words, the
money demand parameter k and the velocity of money V
are opposite sides of the same coin.
• Monetary equilibrium Cambridge cash balance approach is
shown in Fig. 20.2 where demand for money is shown by a
rising straight line kPY which indicates that with k and Y being
held constant demand for money increases proportionately
to the rise in price level. As price level rises people demand
more money for transaction purposes.
• Demand for money does not mean the actual
money balances held by the people, but what
amount of money balances they want to hold.
• Keynes states that the demand for money means
demand for money to hold the demand for cash
balances.
• It can be held as a form of wealth or asset which
commands other forms of wealth in exchange.
• It serves as an efficient store of value.
• It is most liquid in nature.
• This desire for money is liquidity preference.
• Keynes states three motives to hold money.
• The transaction, precautionary and
speculative motive.
• It arises on account of the difference between
receipts and payments (income motive).
• The level of income, the price level, the
spending habits, the time interval.
• The precautionary demand for money
depends largely on the uncertainty of future
receipts and expenditure.
• It is desire for security as to the future cash
equivalent of a certain proportion of total
resources.
• This demand is income determined and
relatively stable. Lp = f(Y).
• This demand arises from uncertainty about
the future rates of interest.
• The holder intends to use for gambling or to
make speculative gain. Ex. Investment in
securities, changes in the value of bond etc.
• There is an inverse relationship b/w the
speculative demand for idle cash balances and
the rate of interest.
• When people expect the price of fixed income
yielding assets to fall more balances are held in
cash.
• L2 = f(i).
• At low rate of interests people prefer to hoard
money rather than buy securities and vice versa.
• When interest rate rise, bond or security prices
fall and when interest rates fall bond or security
prices rise.
• There will be a liquidity trap when the demand
for money becomes perfectly elastic at a low
level of interest.
• This situation is called liquidity trap.
• Reasons
• At low rate of interest on alternative assets the
opportunity cost of holding idle balances is
minimum.
• At minimum interest rate the opportunity cost of
hoarding idle money is expected to rise in the
future.
• Money is demanded by people as a medium of
exchange to meet their transactions.
• It varies directly and proportionately with the
price level.
• The demand for money is influenced by the real
income. Change in real income affects the total
amount of transactions to be effected.
• Apart from 1 and 2 demand for money is also
determined by the cost of holding money or cash
balances.
• Rate of interest that can be earned on
alternative assets (bonds, equities etc )

• The expected rate of change in price level.

• Increase in the rate of interest or price levels

lead to decrease in the cash balances people
wish to hold.
• M = f( P, Y, 1/P × dp/dt, rb, re, w, u)

• M = aggregate demand for money

• P = general price level
• Y = total flow of income
• 1/P × dp/dt = rate of real return on real assets
• rb = the market bond interest rate
• Re = the return on equities
• W = ratio of non human to human capital
• u = utility determining variables which influence tastes
and preferences.
Reference
• Chapter 6 : The Demand for Money, Mithani
D.M, Money, Banking, International trade and
Public Finance, Himalaya Publication, 2007.
Thank You