LESSON- 15:

THEORIES OF DEMAND FOR MONEY

Objectives:

After studying this lesson, you will be able to understood,

 The definition of demand for money

 The different approaches to demand for money
 The difference between quantitative approach and demand for money approach

15.1 Introduction

15.2 Classical approach to demand for money

15.3 Summary

15.4 Glossary

15.5 Model Questions

15.6 Further Readings

15.1 Introduction:

Demand for money is a prominent issue in macroeconomics due to the important role that
monetary demand plays in the determination of the price level, interest income. But, first we
should know the meaning of demand for money. In general peoples demand for money is for in
order to make payments for their day-to-day purchases of goods & services. Further, demand for
money arises from two important functions of money. The first is that money acts as a medium
of exchange and the second is a store of value. Thus, individuals and businessman wish to hold
money partly in cash and partly in the form of assets. Theoretically, speaks, various schools of
thought in economics define differently the demand for money. In fact, people’s demand for
money is not for nominal money holdings but real money balances, because if people are merely
concerned with nominal money holdings irrespective of the price level, they said to suffer from
money illusion.
In the theory, till recently, there were three approaches to demand for money, namely,
transactions approach or Fisher’s quantity theory; cash balances approach or Cambridge equation
and, Keynes theory of liquidity preference. However, in recent years Baumol, Tobin and
Friedman have put forward new theories of demand for money.

15.2 Classical Approach to demand for Money:

Fisher’s Equation:

The classical economists did not explicitly formulate demand for money theory, but their views
are inherent in the quantity theory of money. They considered only the medium of exchange
function of money as an important one i.e., money as a means of purchasing of goods &
services. The cash transactions approach was popularized by Irving Fisher of the USA in 1911,
in his book ‘Purchasing Power of Money’. Through his equation of exchange he made an attempt
to determine price level and value of money.

Symbolically, Fisher’s equation of exchange is written as under

M’V’+ MV = PT --------(1)

Where M is the total quantity of money, M’ is the credit money, V & V’ is its velocity of
circulation of money and credit, ‘P’ is the price level and, ‘T’ is the total amount of goods and
services exchanged for money. This equation equates the demand for money (PT) to supply of
money (MV). As mentioned earlier, he made an attempt to determine price level and value of
money. Value of money is meant by purchasing power of money. In order to find out the effect
of the quantity of money on the price level or the value of money we write the equation as:

MV + M’V’
P = --------------
T
 As per the equation, price is positively associated with money supply and negatively
influenced by the changes in T and value of money is also determined by the same variables but
it has negative association with M and the direct relation with T. In other words, if the quantity
of money is doubled the price level will also double and the value of money will be one half. On
the other hand, if one half reduces the quantity of money, one half will also reduce the price level
and the value of money will be twice. The same theory is explained with the help of fig.

Panel A of fig shows the positive effect of the quantity of money on the price level and in panel
B, the inverse relation between the quantity of money and the value of money is presented.

However, by taking some assumptions about the variables V & T Fisher transformed the
quantity theory equation into a theory of demand for money.

According to Fisher, the nominal quantity of money is fixed by the central bank and is therefore,
treated as an exogenous variable which is assumed to be a given quantity in a particular period of
time. Further, the number of transactions in a period is a function of national income. Since,
Fisher assumed full employment of resources prevailed in the economy; the level of national
income is determined by the amount of the fully employed resources. Thus, with this
assumption, the volume of transactions T is fixed in short run. Fisher made most important
assumption which makes his equation as a theory of demand for money is that, velocity of
circulation (V) remains constant and is independent of M, P and T. this is because he thought
that velocity of circulation of money (V) is determined by institutional & technological factors
involved in the transaction process.

If we want to be in equilibrium, nominal quantity of money supply must be equal to the nominal
quantity of money demand. So that,

Ms = Md = M------(2)

Where M is fixed by central Bank.

With the above assumptions Fishers equation can be rewritten as

PT 1. PT
MD = ----- or MD = ------- --------------(3)
V V

Therefore, according to Fisher, demand for money is depends on the following three factors: 1)
The number of Transactions 2) The average price transfers 3) The velocity of circulation of
money.

This approach is faced some serious difficulties in empirical research 1) in this approach
transactions are not only purchase of goods and services but also purchase of capital assets, so
that when there is a scope for frequent changes in capital assets, it is not appropriate to assume
that T will remain constant even if Y is taken to be constant due to full employment assumption
2) it is difficult to define and determine a general price level that covers not only current goods
and services but also capital assets.
15.3 Summary

Quantity theory of money seeks to explain the value of money in terms of changes in its quantity.
In other words, quantity theory of money says that the level of prices varies directly with
quantity of money. In this regard there are three theories, one is cash transactions theory which
was developed by considering medium of exchange is a function of money, and second one is
cash balances approach based on the store value as a function of money and, thirdly Keynes
theory of liquidity preference.

15.4 Glossary
Quantity theory of money
Velocity of circulation
Transactions motive
Precautionary motive
Cash balances
Demand for money
15.5 Model Questions

Short answer Questions

a) What are the essentials of the Fisher’s Quantity theory?
b) What are the merits of Classical approach to money
Essay answers Questions:
a) Critically examine the quantity theory of money?
b) What are the objections raised against the approach Classical approach to money?
15.6 Further Readings
Ackley Gardner: Macro economic theory
Ward R A: Monetary theory and policy
Rana & Verma: Macro economic analysis
Hajela TN: Monetary economics
Ghatak: Monetary economics in developing economies