Money and Financial Markets

PART-I (Money)

Chapter 2

Demand for Money

Bibhuti Ranjan Mishra VNIT, Nagpur 1-

Contents

1. Quantity Theory of Money

2.

A. Fisher’s Transaction Approach

B. Cambridge Cash Balance Approach
C.

D.

3. Keynes’s Theory of Demand for Money

Bibhuti Ranjan Mishra VNIT, Nagpur

1. Quantity Theory of Money

QTM 
Crude Version:
Strict proportional relationship between changes in the price level
and the quantity of money.

Sophisticated Version:
Functional relationship between the price level and the quantity
of money.


Early Attempts:
Mercantilists; Locke; and Hume

Bibhuti Ranjan Mishra VNIT, Nagpur

A. Fisher’s Transaction Approach

Fisher, Irving (1911), “Purchasing Power of Money”

“Other things remaining unchanged, as the quantity of money in circulation increases, the price level also increases in direct
proportion and the value of money decreases and vice versa”.

Equation of Exchange




Supply of Money:


Demand for Money:


Equation of Exchange states that Total value of money expenditures  is just equal to total item sold .

Bibhuti Ranjan Mishra VNIT, Nagpur

 Fisher’s Equation Explained
Assuming constant  and , the classical QTM, reveals a direct and proportional
causal relationship between  and  and an inverse relationship between and

Fisher concludes, “…, the level of price varies directly with the quantity of money
in circulation provided the velocity of circulation of that money and the volume
of trade which it is obliged to perform are not changed.”
Extended Equation:



If , , ,  Find  and .
If the money supply is doubled, Find  and .

Bibhuti Ranjan Mishra VNIT, Nagpur

Assumption of Fisher’s Theory

1. Constant Velocity of Money

2. Constant volume of transactions or trade
3. Passive price
4. Money is a medium of exchange
5. Constant relation between  and .
6. Long period

Bibhuti Ranjan Mishra VNIT, Nagpur

Broad Conclusions

1)  can be determined by the equilibrium of  and 

2) Given the , 
3) Neutrality of Money.
4) Role of monetary or fiscal policy is limited under full employment eqm.
condition.
5) Temporary diseqm. can be stabilized with appropriate monetary policy.
6) Monetary authorities can change money supply to control the price, and
thereby economic activity of a nation.

Bibhuti Ranjan Mishra VNIT, Nagpur

Criticism of QTM
Quantity Theory of Money

Interdependence of variables

Unrealistic assumption of full employment and long period.

Static Theory

Simple truism and redundant theory

Technically Inconsistent (M and V)

Fails to explain trade cycle

Fails to integrate monetary theory with price theory

No discussion on V

One sided theory

No direct relation between M and P

Crowther’s Criticism: How it works Vs why it works.

Bibhuti Ranjan Mishra VNIT, Nagpur

Implications of QTM

Proportionality of Money and prices

Neutrality of money
Dichotomous of the price process
Monetary theory of prices
Role of monetary policy

Bibhuti Ranjan Mishra VNIT, Nagpur

B. Cambridge Cash Balance Approach
Marshall, Pigou, Robertson, Keynes etc. popularized the classical Cambridge cash-balance
approach which is based on the store of value function of money.

The theory considers the supply of and demand for money at a particular moment of time rather
than over a period of time as assumed by the transaction approach.

In the Cambridge approach, demand for money implies demand for cash balances.

Cash balance is that proportion of real income which the people desire to hold in the form of
money.

Holding cash for transaction and precautionary motives depends on income, wealth and budget
constraint.

Opportunity cost of holding money: rate of interest, yield on real capital, and the expected rate
of inflation.

Bibhuti Ranjan Mishra VNIT, Nagpur

 Cambridge Equation
Marshall:


, So, 
If , ,  Find  and 
Pigou:

Extending the equation:


Robertson’s Equation:


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 Keynes’ Equation

People demand for money with reference to the consumer goods.

Keynes’ Equation:



Keynes’ Extended Equation:


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Fisherian Vs Cambridge Approaches
(Similarities)

Equations

Fisher Robertson

 
 
  

Conclusion
Phenomenon of Money supply
V and K – Two sides of the same coin

Bibhuti Ranjan Mishra VNIT, Nagpur

Fisherian Vs Cambridge Approaches
(Dissimilarities)

Relative stress of supply and demand for money

Function of money
Flow and Stock concepts
Transaction and Income velocities
Nature of P
Factors affecting V and K
Relationship between M and P
Different approaches to monetary theory

Bibhuti Ranjan Mishra VNIT, Nagpur

Superiority of Cash-balance Approach
Realistic, complete and a broader theory
More Useful
Causal Process
Explanation of cyclical fluctuations
Basis of Liquidity preference theory
Nature of variables
General Demand analysis

Bibhuti Ranjan Mishra VNIT, Nagpur

Criticism of Cash-balance Approach
Simple truism
Unitary elastic demand
Omit of speculative motive, real factors, Investment goods,
interest rate, and real balance effect
Narrow view of K
Two way relationship between K and P
K and T assumed constant
No explanation of trade cycles
Lacks of quantitative analysis

Bibhuti Ranjan Mishra VNIT, Nagpur

2. Keynes’ Theory of Demand for Money

Keynes (1936) The General Theory of Employment, Interest and Money.

Demand for money arises due to its liquidity. (Liquidity Preference)

Demand for Money

Active Cash Balances

i) Transaction motive
ii) Precautionary motive
a.

Idle Cash Balances

iii) Speculative demand for money

Bibhuti Ranjan Mishra VNIT, Nagpur

 a. Active Cash Balances

People receive income discretely, but expenses have to be made

continuously.
Transaction Motive:

Income Motive
Business Motive

Precautionary Motive:



Bibhuti Ranjan Mishra VNIT, Nagpur

b. Idle Cash Balances
(Speculative Demand for Money)
Speculative demand for money is holding certain cash in reserves to make speculative gains out of purchase or
sale of securities and bonds by looking at the expected change in rate of interest.

Inverse relationship between bond price and interest rate

; 

Bond Price 100, r = 3%, Return = 3.

Bond Price = 75, r =4%, Return = 3.

People compare  and  in deciding whether to hold wealth in money or bond form.

If ,currently  is high which is expected to be higher in future (or interest rate would be lower) people
expect capital losses. So they will borrow money at lower interest rate or sale bond. The demand for money will
go up. The reverse is true when 

If , and . The expected capital gain or loss, ;

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Net Yield


But, 
Therefore, 





For Instance: If  critical value of the  will be 


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 Liquidity Trap

Reasons

Compensation for cost and convenience

Possibility of rise in interest rate
Expectation of Capital gains
Preference for money

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Aggregate Demand for Money

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