UNIT 3: THE DEMAND FOR MONEY AND OTHER ASSETS

Contents
3.0 Aims and Objectives
3.1 Introduction
3.2 The Determinants of Asset Demand
3.3 The Theory of Demand for Money
3.3.1 Introduction
3.3.2 Micro Economic Foundation of the Demand for Money
3.3.3 Demand for Money: A Macro Perspective
3.4 Summary
3.5 Answer to Check Your Progress Exercise
3.6 References

3.0 AIMS AND OBJECTIVES

The objective of this unit is to examine the demand side of money. It investigates how money
demand is determined. That is it investigates the factors that determine how much money
does on individual wish to hold, given that the more money one hold the less you can hold of
other assets.

After completing this unit you will among others,

 understand various types of asset demand
 differentiate between nominal and real cash balances
 know the various motives of holding money
 understand the role of money on prices, output and the like.

3.1 INTRODUCTION

This unit examines the demand side of money. One of the basic analytical tools for the study
of money and monetary theory is the theory of asset demand. The theory of asset demand is
useful to examine many economic phenomena. The demand for money is an essential
building block to our understanding of how monetary policy affects the economy, because it

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suggests the factors that influence the quantity of money in the economy. This chapter
develops in chronological order the various theories that attempt to explain the demand for
money. We begin with the microeconomic foundations of the demand for money where
Keynes and pertfolio balance approach is discussed. Latter the demand for money at a macro
level will be examined. We begin with the classical theories and move to Mitton Friedman's
modern quantity theory.

3.2 THE DETERMINANTS OF ASSET DEMAND

An asset is a piece of property that is a store of value. Items such as money, bonds, stocks,
land, houses, farm equipment, manufacturing machinery, and so on are all assets.

The asset market are the markets in which money, bonds, stock and other forms of wealth are
traded.
Asset fall into two broad categories: Financial assets and tangible assets. These are:
i) Money ii) Bonds iii) Equities or stocks iv) tangible or real assets.

Money:
Money: Assets that can be immediately used for making payments. It includes currency
and deposits.
Bonds:
Bonds: It is a promise by a borrower to pay the tender a certain amount (the principal) at a
specified date, and 6to pay a given amount of interest per year in the mean time.
Equities or Stock:
Stock: these are claims to share of an enterprise. Share stockholders receive the
return on equity either in dividend form or retained earnings. Thus the return on
stocks, or the yield to a holder of a stock is equal to the dividend plus the capital
gain.
Real Assets or tangible assets:
assets: these are the machines, land and structures owned by
corporations and the consumer durables (cars, etc) and residences owned by
households. These assets are called real to distinguish them from financial assets.

Faced with the question of whether to buy and hold an asset or whether to buy one asset rather
than another, an individual must consider the following factors:
1 Wealth, which is the total resources available to the individual;

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 2 The expected return on one asset relative to the expected return on alternative
assets;
3 The degree of uncertainty or risk associated with the return on one asset
relative to alternative assets;
4 The liquidity of one asset relative to alternative assets; that is, how quickly and
easily it can be turned into cash
A) Wealth
When a person finds that his wealth has increased, he has more resources available with
which to purchase assets and so, not surprisingly, the quantity of assets he demands increases.
Note that the demands for different assets do have different responses to changes in wealth.
The degree of this response is measured by a concept called the wealth elasticity of demand
(which is similar to the concept of income elasticity of demand that you learned in your
introduction to economics course). The wealth elasticity of demand measures how much, with
everything else unchanged, the quantity demanded of an asset changes in percentage terms in
response to a percentage change; in wealth

If for example, the quantity of currency demanded increases only by 50% when wealth
increases by 100%, we say that currency has a wealth elasticity of demand of ½. If for a
common stock, the quantity demanded increases by 200% when wealth increases by 100%,
then the wealth elasticity of demand is 2.

Assets can be sorted into two categories depending on the value of their wealth elasticity of
demand. An asset is a necessity if the percentage increase in the quantity demanded of the
asset is less than the percentage increase in wealth—in other words, its wealth elasticity is less
than 1. Since the quantity demanded of a necessity does not grow proportionally with wealth,
the amount of this asset that people want to hold relative to their wealth falls as wealth grows.
An asset is a luxury if its wealth elasticity is greater than 1, and as wealth grows, the quantity
demanded of this asset grows more than proportionally and the amount that people hold
relative to their wealth grows. Common stocks and bonds are examples of luxury assets, and
currency and checking account deposits are necessities.

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The effect of changes in wealth on the demand for an asset can be summarized as follows. An
increase in wealth raises the quantity demanded of an asset, and the increase in the quantity
demanded is greater if the asset is a luxury rather than a necessity.

B) Expected Returns
The return on an asset measures how much we gain from holding that asset. When we make a
decision to buy an asset, then we are influenced by what we expect the return on that asset to
be. If a particular bond, for example, has a return of 15% half of the time and 5% the other
half of the time, then its expected return (which you can think of as the average return) is
10%." If the expected return on the bond rises relative to expected returns on alter native
assets, holding everything else constant, then it becomes more desirable
desirable to purchase that bond
and the quantity demanded increases. This can occur in either of two ways: 1) when the
expected return on that bond rises while the return on an alternative asset—say, stock in a
particular corporation-remains unchanged, or 2) when the return on that particular
corporations stock, falls while the return on the bond remains unchanged. To summarize note
that an increase in one return relative to that of an alternative asset raises the quantity
demanded of the asset.

C) Risk
The degree of risk or uncertainty on an asset’s returns also affects the demand for the asset.
Consider two assets. That is stock in a certain company (say A) has a return of 15% half the
time and 5% the other half of the time, making its expected return 10%, while stock in another
company (say B) has a fixed return of 10%. Company A's stock has uncertainty associated
with its returns and so has greater risk than company B's stock

A risk-averse person prefers stock in Company B (the sure thing) to Company A's stock (the
riskier asset). On the other hand, a person who prefers risk is a risk preferrer or risk lover and
prefers to hold stock of company A. Most people are risk averse. That is, everything else
being equal; they prefer to hold the less risky asset. Hence, if an asset's risk rises relative to
that of alternative assets, its quantity demanded will fall.

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D) Liquidity
Another factor that affects the demand for an asset is its liquidity, that is, how quickly it can
be converted into cash without incurring large costs. A house, for example, is not a very liquid
asset, because to sell a house quickly in order to pay bills, it might have to be sold for a much
lower price. Treasury bill, on the other hand, is a highly liquid asset. It can be sold with low
transactions costs in a well-organized market where there are many buyers, so it can be sold
quickly with low cost. The more liquid an asset is relative, to alternative assets, (holding
everything else unchanged), the more desirable it is and the greater will be the quantity
demanded.

All the determining factors we have just discussed can be assembled together
together into the theory
of asset demand, which states that, holding all of the other factors constant:
1. The quantity demanded of an asset is usually positively related to wealth, with the
response being greater if the asset is a luxury rather than a necessity.
2. The quantity demanded of an asset is positively related to its expected return relative
to alternative assets.
3. The quantity demanded of an asset is negatively related to the risk of its returns
relative to alternative assets.
4. The quantity demanded of an asset is positively related to its liquidity relative to
alternative assets.

Check Your Progress Exercise 1

1. State the various types of assets.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
2. State and explain determinants of assets demand.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________

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3. Identify the relationship (positive or negative) between asset demand and factors
affecting it.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________

3.3 THE THEORY OF DEMAND FOR MONEY

3.3.1 Introduction
Money is a stock variable. Its stock refers to its quantity in the economy as a whole at a
particular point of time. The demand for money arises from the fact that it is an asset for its
holders. Since it is acceptable to all, people hold it, not only for paying debts, but as a
particular form of an asset-one which is easy to be converted into other goods and services.
Thus, money is a 'perfectly liquid' asset. This quality is not found in any other form of wealth.
Moreover, other assets will also need to be changed first into money-which involves waste of
time, cost and perhaps a capital
capital loss. There is, therefore, a demand for money i.e. to hold
assets in the form of cash and current deposits.

A theory of demand for money is, therefore, merely concerned with the questions: What are
the constituents of the demand for money? And why there is a public demand for money? A
number of explanations have been put forward in this regard.

Before taking up these explanations or theories it would be helpful to clarify the distinction
between nominal and real cash balances. Nominal cash balances are money or the current
purchasing power of a unit of money (say, a birr in the case of Ethiopia, or a dollar in the case
of USA or a pound in the case of UK). Real cash balances arc money of some base year's
purchasing power. A nominal unit of account (a birr or dollar or a pound) is always a unit of
account: but it varies from time to time in its purchasing power, owing to the changes in the
general price level. Hence, the real value, that is, the purchasing power, of a nominal unit of
account keeps on changing over time. Real value comparisons, therefore, involve the selection
of a base year with the wholesale price index number as hundred. A unit of account during
that year had a certain amount of purchasing power at the prices prevailing during that year.

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The average value of the index number of the year for which the changes in the price level are
to be found out is to be calculated. If the average value of index number has risen as
compared to the base year then the real value of the unit of account would decrease and if it
has gone down then the real value of a unit of account will increase, in comparison to the base
year (Recall your discussion of this concept in macroeconomics course). Technically
speaking, real cash balances mean the nominal cash balances divided by the price level.
Symbolically, if M is the nominal money and P is the price level then the real cash balances
will be M/P. Whenever P changes the distinction between
between nominal and real cash balances
would be more relevant. Thus, demand for money refers to real money balance. This is
because people hold money for what it will buy.

3.3.2 Micro Economic Foundations of the Demand for Money

At an individual or micro level demand for money balances will be a function of
 The differential between the perceived yield on money and on other assets
 The cost of transferring between money and other assets
 The price uncertainty of other assets and
 The expected patterns of expenditures and receipts

The following discussion illustrates these cases in one way or another.

I) Keynes Theory of Demand for Money

Keynes theory is contained in a book, 'The General Theory of Employment, Interest and
Money' (1936). According to him the demand for money arises because of its liquidity or
'liquidity preference' as he calls it. In this approach the demand for money arises for three
motives: (i) transactions motive, (ii) the precautionary motive, and (iii) the speculative
motive. According to Keynes the total demand for money means total cash balances which
may be of two types: (i) active and (ii) idle; the former comprising transactions demand and
precautionary demand for money and the latter comprising of speculative demand for money.
Let us examine the three motives in detail

a)Transactions Motive
Money is a medium of exchange and individuals hold money for use in transaction. Thus the
amount of money held for the transaction purpose would vary positively with the volume of

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transaction in which the individual engaged. Keynes explained that the transactions demand
for money can be looked at from two angles. That is, from income and business. The income
motive relates to the households. They need to hold cash balances to cover the time gap
between the receipt of income and its spending. The business motive relates to the business
community which requires cash balances for meeting expenses like, payment of wages and
salaries, rent, purchase of raw-materials, payment of interest, etc. Thus, the transactions
demand for money depends upon (i) the personal income, and (ii) the business turnover. The
demand for money for transactions motive thus varies proportionately to the changes in the
money income. The higher the money income
income the greater the demand for money and vice
versa. Note that the rate of interest has no role to play in determining the transactions demand
for money. It is assumed to be a constant and stable function of income because the
proportion of income to be held for transactions purposes is determined by institutional and
technological

b)Precautionary Motive
According to Keynes people also hold some cash for meeting unexpected contingencies such
as unemployment,
unemployment, sickness, accidents, etc. This is known as a precautionary motive. In the
case of households the decisions are affected by these factors. Similarly, in the case of
business firms the decision is influenced by the element of uncertainty of the future, i.e.
economic fluctuations. Keynes believed that the amount held for this purpose depends
positively on income.

Note that for Keynes both the transactions and the precautionary motives are fairly stable and
constant function of income and both are interest-inelastic. The money balances under these
two motives are referred as 'active balances' by Keynes. This amount varies from one
individual to the other and from one business firm to another. It will depend upon the
frequency of income, credit arrangements, and conversion
conversion of assets into money, degree of
insecurity and uncertainty of future. But, these factors do not normally change in the short
period. Relationship between the demand for active balances and money income is, therefore,
proportionately positive.

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C) Speculative Motive
Speculative motive is the third motive for which people hold money balances. Keynes calls
such balances as 'idle balances'. Speculative demand for money is thus, the demand for
holding cash for making speculative gains from the purchase and sale of bonds and securities
owing to changes in the rate of interest/dividend. Obviously, this demand is determined by the
rate of interest and bond prices. Note that the rate of interest and the bond prices are inversely
related. High bond prices indicate low rate of interest and low bond prices indicate high
interest rate. For deciding, whether wealth should be held in the form of money or bonds, an
individual investor
investor compares the current rate of interest with the future rate of interest (or the
normal
normal interest rate as called by Keynes). If people expect the future rate of interest to rise,
they will anticipate capital losses on bonds. To avoid this people will sell their bonds and
keep cash holdings to lend it in future at a higher rate of interest, because when the rate of
interest is low the bond prices are high and when the rate of interest is high the bond prices
are low. When people expect the future rate of interest to fall in comparison with the current
rate of interest, their demand for money for speculative
speculative motive decreases for buying bonds
and sell them in future to make capital gains.

For deciding whether to hold cash or bond an individual investor would want to know about
the net yield from a bond, i.e. interest earning from the bond plus or minus the capital gain or
loss. If the net yield is greater than zero the individual will hold bonds and if it is less than
zero then he will sell the bonds and if it is zero then the individual would be indifferent
between bonds and money.

Hence, the aggregate speculative demand for money has an inverse relationship with the
current rate of interest. That is, when the interest rate raises the speculative demand for money
falls and when it falls then the speculative demand for money rises. Consider the following
figure

38
  
r  
 
 
 
 
 
 
rm 
 
                   
L
Money Demand

Figure 3.1 Speculative demand for money

Notice that the curve is smooth, reflecting the gradual increase in the speculative demand for
money at successively lower interest rates. The curve flattens out at a very low rate of interest,
reflecting the fact that at this low rate, there is a general expectation of capital losses on bonds
that outweigh interest earnings. At this rate increments to wealth would be held in the form of
money, with no further drop in the interest rate. Keynes termed this situation the Liquidity
Trap

Liquidity trap represents the subjective minimum level of interest rates. An important
characteristic of the speculative demand for money is that when the current rate of interest
becomes very low people have no desire to lend money but they want to keep the whole
money with them. This is the minimum critical level of the current rate of interest at which
everybody becomes a money holder instead of a bond holder. In fact in such a situation the
yield of bonds becomes so low and the risk becomes so high that the people do not want to
keep bonds.
Keynes held that cash balances held for transactions and precautionary motives are primarily
determined by the level of income. That is, LT= f(Y), and the speculative demand for money
is determined by the rate of interest Ls= f(r). In this way, the total demand for money is
determined by both income and interest:

LT + Ls = f(Y) + f(r)
Or L = f(Y) + f(r)
Or L= f (Y, r) ………………………… (3.1)
where L is the total demand for money

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Check Your progress Exercise 2
1. Differentiate between nominal balance and real cash balance.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
2. State and explain the various motives for holding money in Keynes theory of
demand for money.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
3. Define the concept of liquidity trap.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
4. State the total demand for money in according to Keynes.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________

II. The Post-Keynesian Approaches (Portfolio Balance Approach)

The division of aggregate demand according to motives by Keynes has led to certain reactions
from the modern economists. Keynes established a direct relationship
relationship between money-holding
and income for determining transactions demand. According to him the speculative demand
for money is determined by the relative yield on assets in an individual's portfolio. He has
limited his analysis only to two assets, i.e. bonds and money. Thus, this combination of
demand motives with two different approaches has been responsible for the criticisms.

A) Baumol's Analysis
Unlike Keynes Baumol (1952) has established that transactions demand for money also
depends on the rate of interest. That is, he has established the interest-elasticity of the
transactions demand for money. Keynes considered transactions demand for money as a

40
function of the level of income and the relationship between the two as linear and
proportional. Baumol maintains that the relationship between these two is neither linear nor
proportional.

According to Baumol, the holding of cash involves two types of costs: (a) interest
interest costs, and
(b) non-interest costs. Holding cash balances mean that the individual
individual forgoes interest income
by not investing into other interest-yielding assets. This is the interest cost to the individual
money holder. When bonds are converted into cash the investors have to meet certain costs
like brokerage fee, postal charges, etc. These are known as non-interest costs.

According to Baumol "a firm's cash balance can usually be interpreted as an inventory of
money which its holder stands ready to exchange against purchase of labor, raw materials,
etc". People hold cash because there is a time gap between income and expenditure and both
do not take place simultaneously. But it is rather expensive to hold cash because this money
could otherwise be used profitably elsewhere in the firm or invested in securities. Thus, an
alternative to holding cash is investment in bonds which bring interest income. Accordingly, a
firm would always strive for keeping the minimum balances for transactions and earn maxi-
maxi-
mum interest from its investment into assets. The higher the rate of interest on bonds the
lesser would be the transaction balances which a firm would like to hold. Supposing that a
firm can invest in interest yielding assets and can also have cash, and assuming further that
there is a fixed cost involved in the exchange of bonds with cash; the problem would be as to
how a firm should decide about holding of assets. Whenever a firm holds transaction balances
it incurs interest costs as well as non-interest costs. If the rate of interest on bonds rises, it
would be profitable for the firm or individual to invest in bonds and if the rate of interest on
bonds falls, it would be profitable for the individual and the firm to maintain higher optimal
cash balances. When an individual or a firm makes large investment in bonds, it would be left
with small cash balances and vice versa. But every investment
investment in bonds will mean non-
interest costs to the individual/firm. The individual or a firm has; therefore, to maintain a
balance between the incomes to be forgone through fewer bond purchases against the
expenses to be incurred by making large investments in bonds. The higher the rate of interest,
the larger the expenses a firm can bear in making bond purchases. Another important factor
which will affect this decision will be the amount of money involved in these transactions. At

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higher levels of income the average cost of transactions is lower. With an increase in the level
of income the transactions demand for money also increases but this increase would be less
than increase in income. An increase in income would lead to larger investments in bonds and
the investor will enjoy the economics of scale. Baumol also emphasizes, in this connection,
connection,
the importance of demand for real balances. According to Baumol the demand for real
balances "is proportional to the square root of the volume of transactions and inversely
proportional to the square root of the rate of interest". Hence, the relationship between price
level and the transactions demand for money is direct and proportional. If the price level
doubles, the money value of the transactions
transactions will also be doubled. When all prices double,
transaction costs will also be doubled. So people would like to hold high cash balances and
avoid investments withdrawals and the transaction costs which they would otherwise incur.
Hence, the increase in the money value of transactions brings about a rise in the optimal
demand for money in exactly the same proportion as the change in the price level.

Note that Baumol's approach is superior to Keynesian approaches in the following respects:
1. Keynes assumed the relationship between the transactions demand
demand and the level of
income as linear and proportional. Baumol held that transactions
transactions demand does
increase with the increase in income, but less than proportionately.
proportionately.
2. Keynes held that the transactions demand for money is interest-inelastic, while
Baumol has established that it is interest-elastic.
3. While analyzing the transactions demand for money Baumol has emphasized the
absence of money illusion.
4. Finally, Baumol's analysis integrates the transactions demand for money with the
capital theory approach by including assets and their interest and non-interest costs.

B) Tobin's Analysis (The Risk Aversion Theory of Liquidity Preference)

According to Tobin (1956), Keynes theory suffers from two major defects: one, it points out
that liquidity preference is determined by the inelasticity of expectations of future interest
rates and two, that individuals hold either money or bonds. Tobin's analysis removes both
these defects. His analysis is based on the assumption that the expected value of capital gain
or loss from holding interest-bearing assets is always zero. It also explains that the
individual's portfolio contains money as well as bonds and not either of these at a time. He,

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therefore, starts his analysis with this assumption. According to him, money neither brings
any income nor does it impose any risk on the individual asset holder. Bonds do yield interest
and bring about income. It is, however, uncertain and involves a risk of loss or gains. The
greater the investment in bonds, the higher is the risk of capital loss. An indi vidual investor
can court this risk provided he gets an adequate return from bonds.

According to Tobin, there are three types of investors. First, those who love to take risk and
put all their wealth into bonds. They are like gamblers and specula tors. The second category
comprises of those investors who are plungers, i.e. they will either put all their money into
assets or hold cash balances. In the third category fall those, who are risk averters or
diversifiers. A majority of such investors
investors prefer to avoid risk of loss and invest in bonds only
when they expect adequate additional return. Such investors always diversify their portfolios
and hold both money and bonds.

The great advantage of Tobin's reformulation of the theory of liquidity preference is that he
linked it firmly to uncertainty about future asset prices', and thus provided a rationale for
portfolio diversification, beyond the existence of transactions costs. In previous Keynesian
analysis of liquidity preference, and of the speculative demand for money, investors were
treated as holding completely confident expectations of the future yield on the risky asset.
Each investor would then hold all his assets either in the risky asset or in the safe asset
depending on which offered more, so there was no explanation of portfolio diversification at
the individual level. According to Tobin a fall in interest rates on the risky asset below the
'normal level would induce a growing proportion of investors confidently to expect a future
rise in rates, and thus capital losses on holding risky assets, and so switch all their funds into
the safe asset.

Tobin’s reformulation allowed a much more general and plausible interpretation of the theory
of liquidity preference. Portfolio diversification was given a justification at the individual
level. This diversification is consistent with differing investors holding a range of
expectations of future mean yields on the risky asset.

In conclusion we learn that Tobin's analysis is superior to the Keynesian analysis of demand
for money in the following respects:

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 1. Tobin considers his theory as a 'logically more satisfactory foundation for liquidity
preference than the Keynesian theory', because he does not depend on inelasticity of
expectations of future interest rates but starts with the assumption that the expected
value of capital gain or loss from holding interest-bearing assets is always zero.
2. It is more akin to practical life because it explains that individuals and firms diversify
their portfolios and hold both money and bonds and not money or bonds.
3. While agreeing with Keynes that the demand for money is dependant on rates of
interest and also inversely related to them, he does not agree with the view that at very
low rates of interest the demand for money is perfectly elastic. In this respect he is
more practical than Keynes.
4. Lastly, the importance of Tobin's analysis is in "not what it tells directly about the
aggregate economy, but rather it represents an interesting
interesting approach to the problem of
relating demand for money to the existence of uncertainty

Check Your Progress Exercise 3

1. State and explain Baumol's analysis to the demand for money.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
2. In what respects is Baumol's approach superior to Keynesian analysis.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
3. State and explain Tobin's risk aversion theory of liquidity preference.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
4. Compare and contrast Tobin's and Keynesian theory of demand for money.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________

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3.3.3 Demand for Money- Macro Perspective
I. Introduction
This section develops in chronological order the various theories that attempt to explain the
demand for money. We begin with the classical theories refined at the start of the century by
economists such as living Fisher and Neoclassicals like, Alfred Marshall, and A. C. Pigou;
then we move to the Milton Friedman's modern quantity theory.
A central question in monetary theory is whether or to what extent the quantity of money
demanded is affected by changes in interest rates. Since this issue is crucial to how we view
money's effects on aggregate economic activity, we focus on the role of interest rates in the
demand for money.

II. The Quantity Theory of Money- The Classical View

Developed by the classic economists in the nineteenth and early twentieth centuries, the
quantity theory of money is a theory of how the nominal value of aggregate income is
determined. Because it also tells us how much money is held for a given amount of aggregate
income, it is also a theory of the demand for money. The most important feature of this theory
is that it suggests that interest rates have no effect on the demand for money.

The clearest exposition of the classical quantity theory approach is found in the work of the
American economist living Fisher, in his influential book, The Purchasing Power of Money
published in 1911. 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 in
the economy, PY, where P is the price level and Y is aggregate output. (Total spending, PY, is
also thought of equivalently as aggregate nominal income for the economy or as nominal
GNP.) The concept that provides the link between M and PY is called the velocity of money
(or more simply velocity). It refers to the rate of turnover of money, that is, the average
number of times per year that a birr is spent in buying the total amount of goods and services
produced in the economy. Velocity (V) is defined more precisely as total spending, PY,
divided by the quantity of money, M:

………………………………. (3.2)

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If, for example, nominal GNP (PY) in a year is $5 billion birr and the quantity of money is
$10 billion, then velocity is 5, meaning that the average birr bill is spent five times in
purchasing final goods and services in the economy.
economy.

By multiplying both sides of this definition by M, we obtain the equation

equation of exchange, which
relates nominal income to the quantity of money and velocity:
MV = PV ………………………………….. (3.3)
The equation of exchange thus states that the quantity of money multiplied by the number of
times this money is spent in a given year must equal nominal income which is the total
nominal amount spent on goods and services in that year).

As it stands is nothing more than an identity—a relationship that is defined to be true by

definition. It does not tell us, for instance, that when the money supply (PY) changes, nominal
income (PY) changes in the same direction; a rise in M, for example, could he offset by a fall
in V that leaves MV (and therefore PY) unchanged. To convert the equation of exchange
exchange (an
identity) into a theory of how nominal income is determined requires an under-standing of the
factor's that determine velocity.

Irving Fisher reasoned that velocity is determined by the institutions in an economy that affect
the way individuals conduct transactions. If people use charge accounts and credit cards to
conduct their transactions and consequently use money less often when making purchases,
less money is required to conduct the transactions generated by nominal income
income (i.e. M
decreases relative to PY), and velocity (PY/M) will increase. On the other hand, if it is more
convenient for purchases to be paid for with cash or checks (both of which are money), more
money is used to conduct the transactions generated by the same level of nominal income, and
velocity will fall. Fisher took the view that the institutional features of the- economy that
would affect velocity change; slowly over time, so velocity would be fairly constant in the
short run.

Fisher's view that velocity is fairly constant in the short will transform the equation of
exchange into the quantity theory of money, which states that nominal income is determined
solely by movements in the quantity of money: When the quantity of money (M) doubles,
MV doubles and so must , the value of nominal income PY. To see how this works, let's

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assume that velocity is 5 and initially nominal income (GNP) is $50 billion and the money
supply is $10 billion. If the money supply doubles to $20 billion, then the quantity theory of
money tells us that nominal income will double to $100 billion (=50 x $2 billion).

Because the classical economists (including living Fisher-) thought that wages and prices
were completely flexible, they believed that the level of aggregate output produced in the
economy (Y) would always remain at the full employment level, so Y in the equation of
exchange could also be treated as a constant in the short run. The quantity theory of money
then implies that if M doubles, since V and Y are constant, P also must double. In our
preceding example, if aggregate output is $50 billion birr, the velocity of 5 and a money
supply of $10 billion indicate that the price level equals 1, since 10 x $5 billion equals the
nominal income of $50 billion. When the money supply doubles to $20 billion ,the price level
must also double to 2, since 20 x $5 billion equals the nominal income of $100 billion.

For the classical economists, the quantity theory of money provided an explanation of
movements in the price level: Movements in the price level result solely from changes in the
quantity of money.

Note that because the quantity theory of money tells us how much money is held for a given
amount of aggregate income, it is in fact a theory of the demand for money. We can see this
by dividing both sides of the equation of exchange (3.3) by V, thus rewriting it as:

…………………………….. (3.4)

When the money market is in equilibrium, the quantity of money that people hold (M) equals
the quantity of money demanded (Md), and we can replace M in the above equation by M d.
Defining k = (1/V), which is a constant because V is a constant, we can rewrite the above
equation as
Md = k PY ……………………………… (3.5)

Equation (3.5) tells us that because k is a constant (since V is a constant), the level of
transactions generated by a fixed level of nominal income (PY) determines the quantity of
money (Md) that people demand. Therefore, Fisher's quantity theory of money suggests that

47
the demand for money is purely a function of income, and interest rates has no effect on the
demand for money.

Fisher came to this conclusion because he believed that people hold money only to conduct
transactions and have no freedom of action in terms of the amount they want to hold. The
demand for money is determined
determined by (1) the level of transactions generated by the level of
nominal income (PY), and (2) the institutions in the economy that affect the way people
conduct transactions which determine velocity and hence k.
III. The Cambridge Approach to Money Demand
A group of economists in Cambridge, England, which included Alfred Marshall and A. C.
Pigou, have also studied the quantity theory to the demand for money. Although their analysis
led them to an equation that is identical to Fisher's money demand equation (M d = k x PY),
their approach differs significantly. Instead of studying the demand for money by looking
solely at the level of transactions and the institutions that affect the way that people conduct
transactions as the key determinants, the Cambridge economists asked how much money
individuals would want to hold, given a set of circum stances. In the Cambridge model, then,
individuals are allowed some flexibility
flexibility in their decision to hold money and are not
completely bound by institutional constraints such as whether they can use credit cards to
make purchases. Accordingly, the Cambridge approach did not rule out effects of interest
rates on the demand for money.

The Cambridge economists recognized that money has two properties that motivate people to
want to hold it:
1. Money functions us a medium of exchange that people can use to carry out
transactions. The Cambridge economists agreed with Fisher that the demand for
money would be related to (but not determined solely by) the level of transactions and
that there would be a transactions component of money demand proportional to
nominal income.
2. Money functions as a store of wealth: This property of money led the Cambridge
economists to suggest that the level of people's wealth also affects the demand for
money. As an individual's wealth grows, he or she needs to store it by holding a larger
quantity of assets—one of which is money. Because the Cambridge economists

48
 believed that wealth in nominal terms is proportional to nominal income, they also
believed that the wealth component of money demand is proportional to nominal
income.
3. The Cambridge economists concluded that the demand for money would be
proportional to nominal income and expressed the demand for money function as
Md = k PY ……………………….. (3.6)
where k is the constant of proportionality. Since this equation is identical to

Fisher's money demand equation (3.6),

(3.6), it seems that the Cambridge group agreed with Fisher
that interest rates play no role in the demand for money. However, this would be a misleading
characterization of the Cambridge
Cambridge approach.

Although the Cambridge economists often treated k as a constant and agreed with Fisher that
nominal income is determined by the quantity of money, their approach allowed individuals
to choose how much money they wished to hold. It allowed for the possibility that k could
fluctuate, because the decisions about using money to store wealth would depend on the
yields and expected returns of other assets that also function as stores of wealth. If these
characteristics of other assets changed, then k might change as well. Although this seems a
minor distinction between the Fisher and Cambridge approaches, you will see that when John
Maynaitl Keynes (a later Cambridge economist) extended the Cambridge approach,
approach, he arrived
at a very different view from the quantity theorists on the importance of interest rates to the
demand for money.

In conclusion note that both Irving Fisher and the classical Cambridge economists believed
that the demand for money is proportional to income. However, their two approaches differ in
that Fisher's ruled out any possible effect of interest rates on the demand for money while the
Cambridge approach did not.

Check Your Progress Exercise 4

1. State and explain the quantity theory of money.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________

49
2. What are the factors that affect money demand in Fischers approach?
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
3. Discuss the Cambridge approach to money demand.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
4. Compare and contrast the quantity theory and Cambridge approach to money
demand.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________

IV. Friedman’s Reformulation of Quantity Theory of Money

The Chicago School under the leadership of Milton Friedman challenged the pure Keynesian
view by arguing that an addition to the money supply will not be fully absorbed in idle
balances. Instead, it may spill over into the market for goods and services, and thus have an
immediate effect on the price level.

This approach maintain that wealth can be held in five broad forms. That is money, bonds,
equities, physical goods and human wealth. Each of these has distinctive charac teristics and
each offers some return in money or in kind. Money may yield a return in the form of money;
for example, interest on deposits. But it is assumed that money yields its return solely due to
convenience and security. That is, etc. it will make matters rather simple and will also not
involve any loss of generality. So, the quantum of this return in 'real' terms per nominal unit
of money clearly depends upon the volume of goods that unit corresponds to or on the general
general
price level, which may be designated as P. If P falls, money appreciates and represents a
capital gain in real terms which must be added to the nominal yield; and if P rises the real
capital losses must be deducted from the nominal yield.

Bonds are those assets which yield a perpetual income stream of constant nominal
nominal amount.
Their yield can be of two types: (i) the annual income, and (ii) any change in the price of bond

50
over time—a return which can be positive as well as negative. If the rate of interest on the
bonds is rb, the nominal rate of return can be approximated by r b (1/rb) drb/dt, where (1/rb)
drb/dt measures the rate of capital appreciation owing to changes in the rate of interest and t
stands for time. This sum together with P defines the real return from holding of wealth in the
form of bonds.

Equities are assets which yield a perpetual income stream of 'constant real' amount. The
nominal return on equities can be in the form of either (i) the constant nominal amount
accuring annually in the absence of any change in P; or (ii) the increment or decrement to the
nominal amount by way of adjustment to changes in P, or (iii) any change in the nominal
price of the equity over time due to changes either in the interest rates, or in the price level.
The nominal rate of return on equities can be approximated by r e + 1/p (dp/dt) – re (dre/dt).
This sum together with P is the real return from equities.

Physical goods are similar to equities, the only difference being that the annual stream they
yield is in kind rather than in money. If we suppose that P applies equally to the value of these
physical goods, then the nominal rate of return on them can be approximated as 1/p (dp/dt).
Together with P, this sum would be the real return from holding wealth in the form of
physical goods.

Human wealth is the discounted value of the expected stream of earned income.
income. Since the
market of human capital is a limited one, it is very difficult to define in market prices the
terms of substitution of human capital for other forms of capital. Some substitution is always
possible; say for example, people can sell assets in order to pay for training which will
enhance their future income. The substitution of human capital for other forms of wealth takes
place mainly through direct investment and disinvestment in the human agent. Regarding this
form of capital therefore, the obstacles obstructing the alternative composition of wealth
available to an individual cannot be expressed in terms of market prices or rates of return.
Nevertheless, there is certainly, some rough division between human and non-human wealth
in an individual's portfolio of assets at any point of time and he may change this over time,
but for the sake of simplification it may be treated as given at a point of time. Let w be the
ratio of non-human to human wealth or of income from non-human to human wealth. The
ultimate wealth owning unit is considered as dividing his wealth among the other forms so as

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to maximize utility subject to whatever restrictions affect the possibility of converting one
form of wealth into another. This implies that the individual will seek an apportionment of
this wealth such that the rate at which he can substitute one form of wealth for another is
equal to the rate at which he is willing to do.

Friedman holds that the most important factors influencing the demand for money are the
rates of return from the different forms of wealth, the level of permanent income and the ratio
of non-human to total wealth. For example, an increase in the expectation of inflation would
cause a fall in the demand for money holdings. This results in a rise in velocity. Thus, velocity
instead of being constant (as was assumed by classical and neo-classical writers) would now
be affected by changes in the above variables. But these variables are generally subject to
only slow change over time while the supply of money may undergo sudden changes. If this is
so, then it means that the demand for money is independent of its supply. In other words,
there is complete independence between the money stock and its velocity since it is money
demand that affect the velocity. This is an important element in the reformulated theory. It
also means that the changes in the value of money are almost always determined by supply.

Another important postulate of the theory is that the demand for money is normally insen-
insen-
sitive to changes in the interest rate. Had the demand for money been substantially interest-
elastic, then any change in the money stock could be absorbed by a comparatively
comparatively small
change in the interest rates inducing people to extend their demand
demand for money to match the
supply. In such a situation, a change in the money stock would be of no significance. On the
other hand, if the demand for money had been substantially interest-elastic, people instead of
holding additional money would spend on goods and services influencing the level of money
incomes in the economy. Thus, interest rate insensitivity implies that the transactions motive
dominates
dominates the assets motive in the total demand for money. It is because money as an asset is
able to act as a temporary home of purchasing power, that the relationship between changes in
the monetary variable and increased expenditures is more indirect and more complex than
assumed by the classical economists. That is why modern economists do not consider
monetary policy as a viable counter-cyclical measure.

Friedman pursued the question of why people choose to hold money. Instead of analyzing the
specific motives for holding money, as did Keynes, Friedman simply stated that the demand

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for money must he influenced by the same factors that influence the demand for any asset.
Friedman then applied the theory of asset demand to money.

The theory of asset demand indicates that the demand for money should he a function of the
resources available to individuals (that is, their wealth) and the expected returns on other-
assets relative to the expected return on money. Like Keynes, Friedman recognized that
people want to hold a certain amount of real money balances (the quantity of money in real
terms). From this reasoning, Friedman expressed his formulation
formulation of the demand for money as
follows:
Md = f (Yp, rb – rm, re – rm - e – rm)
P + _ _ _
in which the signs underneath the equation indicate whether the demand for money is
positively or negatively related to The terms immediately
immediately above them, and
Md/P = the demand for real money balances
Yp = Friedman's measure of wealth known as permanent income (technically, the
present discounted value of all expected future
future income, but more easily
described as expected average long-run income)
rm = the expected return on money
rb = the expected turn on bonds
re = the expected return on equity (common stocks)
e = the expected inflation rate

Let us look in more detail at the variables in Friedman's money demand function and what
they imply for the demand for money. Since the demand for an asset is positively related to
wealth, money demand is positively related to Friedman's wealth concept, permanent income
(indicated by the + sign underneath it). Unlike our usual concept of income, permanent
income (which can be thought of as expected average long-run income) has much smaller
short-run fluctuations, because many movements of income are transitory (short-lived)
[ Students are strongly advised to refresh their knowledge regarding the various income
hypothesis from their Macroeconomic course discussion]. For' example, in a business
business cycle
boom income increases rapidly, but because some of this increase
increase is temporary, average long-
run income does not change very much. Thus in a boom permanent income rises much less

53
than does income. During a recession much of the income decline is transitory, and average
long-run income (hence permanent income) falls less than does income. One implication of
Friedman's use of the concept of permanent income as a determinant of the demand for
money is that the demand for- money will not fluctuate much with business cycle movements.

An individual can hold wealth in several forms besides money. Friedman

Friedman categorized them
into three types of assets: bonds, equity (common stocks), and goods. The incentives for
holding these assets rather than money is represented by the expected return on each of these
assets relative to the expected return on money, as shown in the last three terms in the money
demand function. The minus sign underneath each indicates that, as each term rises, the
demand for money will fall.

The expected return on money (rm), which appears in all three terms, is influenced by two
factors:
1. The services provided by banks on deposits. When these services are increased, the
expected return from holding money rises.
2. The interest payments on money balances. As these interest payments rise, the
expected return on money rises.

The terms rb – rm and re – rm represent the expected returns on bonds and equity relative to
money; as they rise, the relative expected return of money falls and the demand for money
falls. The final term (e – rm) represents the expected return on goods relative to money. The
expected return from holding goods is the expected rate of capital gains that occurs when their
prices rise and thus is equal to the expected inflation rate ( e). For example if the expected
inflation rate is 10%, then goods prices are expected to rise at a 10% rate and their expected
return is 10%. When e – rm rises, the expected return on goods relative to money rises and the
demand for money falls.

Check Your Progress Exercise 5

1. State and explain Friedman's reformulation of quantity theory of many demand.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________

54
2. State Friedman's money demand function.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
3. State and explain the relationship between money demand and factors affecting it.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________

3.4 SUMMARY

In summary we can raise the following main points discussed in this unit. Recall that we said
an asset is a piece of property that is a store of value. Items such as money, bonds, stocks,
land, houses, farm equipment, manufacturing machinery, and so on are all assets.

The demand for a particular asset depends on the wealth of an individual, the expected return
on one asset relative to the expected return on alternative assets; the degree of uncertainty or
risk associated with the return on one asset relative to alternative assets; and the liquidity of
one asset relative to alternative assets.

The demand for money arises from the fact that it is an asset for its holders It refers to real
money demand since people hold money for what it will buy. The theory of demand for
money examines (investigates) the constituents of the demand for money

In this regard Keynes argued that demand for money arises due to the transactions motive, the
precautionary motive, and the speculative motive that an individual has. The theory of
Baumol argued that the transactions demand for money also depends on the rate of interest.
He further pointed out that the relationship between demand for money and income is neither
linear nor proportional.

Tobin's approach linked the theory of liquidity preference to uncertainty about future asset
prices, and thus provided a rationale for portfolio diversification.

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This unit also examined the demand for money at a macro level. It explained the classical
quantity theory of money and Friedman's approach. Both Irving Fisher and the Cambridge
economists believed that the demand for money is proportional to income. However, Fisher's
ruled out any possible effect of interest rates on the demand for money while the Cambridge
approach did not. Friedman on the other hand reformulated the quantity theory of money by
incorporating among others human capital and expectations on the money demand function.

3.5 Answer to Check Your Progress

Answer to Check Your Progress 1

 The answers are explicitly discussed in section 3.2
Answer to Check Your Progress 2
 Refer section 3.3.2 (I) for the answer
Answer to Check Your Progress 3
 Refer section 3.3.2 (II) for the answer
Answer to Check Your Progress 4
 Refer section 3.3.3 (II & III ) for the answer
Answer to Check Your Progress 5
 Refer section 3.3.3 (IV) for the answer

3.6 REFERENCE

 Goodhart, Charles (1992), Money, Information and Uncertainty, 2nd ed., Macmillan
 Laidler, D (1990), Taking Money Seriously and Other Essays, Phillip Allan, New
York
 Mayer, T. Duesenberry, J. and Aliber, R. (1987) ' Money Banking and the Economy',
3rd ed. W.W. Norton & Company
 Mishkin, F.S. (1986) The economics of Money, Banking and Financial Markets, Little
Brown and Company, Boston
 Stiglitz, Joseph (1997), Principles of Macroeconomics, W. W Norton & Company,
New York

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