Demand for Money

Introduction
The classical economists recognized only the medium of exchange
function of money.
Keynes, in addition, emphasized the store of value function of money
also.
According to Keynes, money was demanded due to three motives—
transactions motive, precautionary motive and speculative motive.

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 Transactions Demand
The transactions demand for money is the
demand for cash by the public for carrying on
its various current transactions. This money is
held due to the time gap involved between
which the income is received and the
payments are made out.
An increase in the frequency of the receipts
decreases the average holdings of transactions
balances by the individual decreases.

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 Transactions Demand
A stable and direct relationship
exists between income and
transactions money balances. Keynes
had argued that the transactions
demand for money is perfectly
interest inelastic.

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 Precautionary Demand
The precautionary demand for money is the demand for cash by the public for
contingencies. The precautionary demand for money varies directly with the
income level.
At high rates of interest one may feel tempted to hold smaller precautionary
balances.
Precautionary balances are put together as a function of the income level and as
interest inelastic.

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 Speculative Demand
According to Keynes, individuals hold only money and perpetual bonds in their
asset portfolio. The existence of uncertainty about the future gives rise to
speculative demand for money. There exists an inverse relationship between
market rate of interest and the price of a bond.
The speculators can be grouped into two categories. Bulls expect the price of
bonds to rise in the future. Bears expect the price of bonds to fall in the future.
The speculative demand for money arises from the bears. The asset holders
either hold only bonds or they hold only money. They do not have a diversified
portfolio.

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 Speculative Demand ( cont.)
A very significant contribution of Keynes is the liquidity trap. The liquidity trap is
a situation when at some very low rate of interest all asset holders become bears.
In the liquidity trap, no additions to the money supply can lower the interest rates
any further.
Keynes had emphasized that at any point in time there will exist a rate of interest
which is the benchmark or yard-stick. The aggregate speculative demand for
money curve is a smooth downward sloping curve.

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 Speculative Demand (cont.)
• It shows an inverse relationship
between the speculative demand for
money and the current rate of
interest.

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 The Total Demand for Money
The total demand for money can be written as md = mt+p +msp
or md = k(Y) + g (r).
It represents the Keynesian demand curve for money and is downward sloping.

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 Criticism of Keynes’ Theory of Demand for Money
In reality, individuals do not hold either just money or only bonds and in fact,
hold a diversified asset portfolio.
The possibilities of the occurrence of a liquidity trap are quite far-flung.
Keynes’ division of money into transaction, precautionary and speculative
demands is not realistic. Often the same unit of money can be used to serve all
the three motives.

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 Keynesian Theory of Interest
In Keynes’ theory, the rate of interest is a
monetary phenomenon.
 It is determined by the equality between
the demand for and supply of money. Thus,
k(Y) + g (r) = ms
Whenever disequilibrium occurs, variations
in r alone act as the adjustment mechanism
for bringing about equilibrium in the money
market.
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 Changes in the Money Supply and its
Effect on the Interest Rate
• Analyze the increases in the supply
of money, given the demand for
money curve, leading to a decrease
in the interest rate and vice versa.
• Depict the liquidity trap where any
increase in the supply of money do
not lower the rate of interest any
further.
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 Changes in the Demand for Money and
its Effect on the Interest Rate
• Analyze the changes in the demand for
money occurring either due to a change in
the transactions demand for money or due
to change in the speculative demand for
money.
• Analyze the changes in the transactions
demand for money and the effect on the
interest rate. Analyze the changes in the
speculative demand for and the effect on
the interest rate.
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 Criticism of the Keynesian Approach

• Discuss that since the money market equilibrium equation of Keynes

is actually one equation and two unknowns, it can be argued that
Keynes theory is indeterminate.

• Explain the Keynes had denied the influence of the real factors, saving
and investment, in the determination of the rate of interest.
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 Thank You

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