The Theory of

Money Demand

By
Dr Mohamad Shukri
Johari
 This is the outline of Chapter 7

I. Fisher's Quantity Theory of Money

a) Velocity of money and equation of
exchange
b) Quantity Theory
c) Quantity Theory of Money Demand
II. Cambridge Approach to Money Demand
III. Keynesian Liquidity Preference Theory
IV. Friedman's Modern Quantity Theory of Money

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 To understand deeply this topic,
you can also refer to my powerpoint slide,

Text book Manual book

(pg 526-540) (pg 104-117)

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 The objective of this chapter is

i. To assess the relationship between money

growth and inflation
ii. To summarize the three motives underlying the
liquidity preference theory of money demand
iii. To identify the factor underlying the portfolio
choice theory of money demand

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 Preview of the Chapter 7

1. Monetary theory is the study of the effect of money in the

economy.
2. In previous chapter, we learned how to determine interest
rate (or, price of money) based on the interaction between
supply of money (Ms) and demand for money (Md).
3. For instance, the interest rate (or, price of money) in money
market can be determined when;

Ms = Md (1)

where; Ms is money supply, Md is money demand; and (1) is Equation 1.

4. Generally, the money supply curve is vertically shaped

because we assume that a central bank controls the amount of
money supplied (please refer to Chapter 4).

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 Question

• Q: How about money demand? Does it also

controlled by central bank? What is factors
that determine peoples demand for money?

• A: In order to answer these question

therefore, this chapter will going to explain
a few theories of money demand and factors
that determine why peoples demand for
money.
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 Theories of Money Demand

Four theories of money demand:

I. Fisher's Quantity Theory of Money

II. Cambridge Approach to Money Demand
III. Keynesian Liquidity Preference Theory
IV. Friedman's Modern Quantity Theory of
Money

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(I) Fisher's Quantity
Theory of Money
(1910)
 Fisher's Quantity Theory of
Money
1. We begin with Classical economist such as Irving Fisher.

2. The theory tells us how much money is held for a given

amount of aggregate income.

3. The most important is that it suggests that interest rate has

no effect on the demand for money.

4. Fisher’s Quantity Theory of Money suggests three (3)

concepts why peoples demand for money. The concepts can
be explained as below:
a) Velocity of money and equation of exchange
b) Quantity Theory
c) Quantity Theory of Money Demand
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 a) Velocity of money and equation
of exchange
• Fisher wanted to examine the link between the total
quantity of money M (the money supply), and the
total amount of spending on final goods and
services produced on the economy P*Y
where;
P is the price level,
Y is aggregate output (income), and
P*Y is total spending (also considered as aggregate
nominal income/nominal GDP)
• This concept is called the velocity of money (or,
velocity)

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 Question

• Q: What is velocity?

• A: Velocity is the average number of times

per year (turnover) that a RM is spent in
buying the total amount of goods and
services produced in the economy.

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 a) Velocity of money and equation
of exchange (continue)
• Velocity is defined more precisely as total spending,
P*Y, divided by the quantity of money, M. This can
be expressed by following equation:

V = P*Y / M (2)
where; V is velocity, P*Y is total spending, and M is
money supply.

From Eq. (2),

(multiplying both sides by M)
MV = PY (3)
where; Equation (3) is known as Equation of Exchange.
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b) Quantity Theory
b) Quantity Theory

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c) Quantity Theory
of Money Demand
c) Quantity Theory of Money Demand

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c) Quantity Theory of Money Demand
(continue)

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 c) Quantity Theory of Money Demand
(continue)

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 c) Quantity Theory of Money Demand
(continue)

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(II) Cambridge
Approach to
Money Demand
 Cambridge Approach to Money Demand
1. Introduced by a group of classical economists in Cambridge
such as Alfred Marshall and A. C. Pigou.

2. Almost similar to study conducted by Fisher (please refer to

Eq (8) above), but their approach differed significantly.

3. In Cambridge approach, economists asked HOW MUCH

MONEY INDIVIDUALS WOULD WANT TO HOLD?.

4. Thus, the Cambridge model, individuals are allowed some

flexibility in their decision to hold money (demand for
money).

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 Cambridge Approach to Money
Demand (continue)
5. Fisher’s quantity theory of money demand concluded that
peoples demand for money determined by:
1. Transaction
2. Institutions
6. On the other hand, Cambridge’s approach to money demand
suggest that 2 properties of money that motivate peoples to
hold money determined by:
1. Medium of exchange (transactions) – same as Fisher’s theory.
2. Store of wealth
• The level of people’s wealth also affects the demand for money. As
wealth grows and individual needs to store it by holding a larger
quantity of assets – one of which is money.
• The Cambridge economists also believed that the wealth component
of money demand is proportional to nominal income.

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 Cambridge Approach to Money
Demand (continue)

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 Cambridge Approach to Money
Demand (continue)
• Based on Eq. (9), k is interest rate/expected return on assets
(r) and always fluctuate because peoples want to hold money
to increase wealth (by increase assets such as bond and etc.)

– where; if interest rates/expected return on assets (r) increase, thus

money demand for holding assets will increase as well.

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(III) Keynesian
Liquidity
Preference
Theory
 Keynesian Liquidity Preference
Theory
• WE HAD ALREADY DISCUSSED THIS TOPIC
IN CHAPTER 4.

• Please read again by your ownself.

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(IV) Friedman's
Modern Quantity
Theory of Money
 Friedman's Modern Quantity
Theory of Money
1. Friedman’s analysis is based on the question of
WHY PEOPLES CHOOSE TO HOLD MONEY (why
peoples choose to demand for money)?

2. Friedman’s simply stated that the demand for

money must be influenced by the same factors that
influence the demand for any asset.

3. Therefore, Friedman developed a model for money

demand based on the general theory of asset
demand to money.

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 Friedman's Modern Quantity Theory
of Money (continue)

4. Money demand, like the demand for any other

asset, should be a function of wealth and the
returns of other assets relative to the
expected return on money.
5. This statement can be expressed by using simple
equation as below:

Md = Assets demand = f(“wealth”, “returns of other assets

relative to the expected return on money”) (1)

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 Friedman's Modern Quantity Theory
of Money (continue)

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 Friedman's Modern Quantity Theory of
Money (continue)
Based on Eq. (2) above,

Friedman suggest that peoples demand for real money depends

on 4 factors:
1. Wealth/Income
- if income increase, thus the demand for real money
increase as well.
(money demand and wealth are positively related)

2. The expected return on bonds relative to money

- if the expected return on bonds relative to money
increase, thus the demand for real money decrease.
(money demand and the expected return on bonds
relative to money are negatively related)

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 Friedman's Modern Quantity
Theory of Money (continue)
3. The expected return on stocks/equities relative to money
- if the expected return on stocks/equities relative to money
increase, thus the demand for real money decrease.
(money demand and the expected return on stocks/equities
relative to money are negatively related)

4. The expected inflation rate relative to money

- if the expected inflation rate relative to money increase, thus
the demand for real money decrease.
(money demand and the expected inflation rate relative to
money are negatively related)

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 Thank you for your attention
END OF CHAPTER 7

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