DEMAND FOR MONEY

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Demand for Money

 This is the desire to hold money in form of cash other than any other asset.
The demand for money has been variously explained by different economists
hence the theories of money demand

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Theories of Money Demand

There are three theories of money demand namely;

 Classical quantity theory
 Keynes’ Liquidity Preference Theory
 Friedman’s modem quantity theory

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The Classical Quantity Theory

 The quantity theory of money dates back at least to the mid-sixteenth-

century. It is one of the oldest theories in economics. Modern students know
it as the proposition stating that an exogenously given one-time change stock
of money has no lasting effect on real variables but leads ultimately to a
proportionate change in the money price of goods. More simply, it declares
that, all else being equal, money’s value or purchasing power varies inversely
with its quantity.

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 There is nothing mysterious about the quantity theory. Classical and
neoclassical economists never tired of stressing that it is an application of the
ordinary theory of demand and supply to money. Demand-and-supply theory,
of course, predicts that a good’s equilibrium price, or market price, will fall
as the good becomes more abundant relative to the demand for it. In the
same way, the quantity theory predicts that an increase in the nominal supply
of money will, given the real demand for it, lower the value of each unit of
money in terms of the goods it commands. Since the inverse of the general
price level measures money’s value in terms of goods, general prices must
rise.

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 The clearest explanation of the classical quantity theory approach is found in
the work of the American economist Irving Fisher (1867-1947). Fisher wanted
to examine the link between the total quantity of money M and the total
amount of spending on final goods and services produced in the economy
(P*Y) where P is the price level and Y is aggregate output, V is the velocity of
money. Velocity V is defined more precisely as total spending (P*Y) divided
by the quantity of money M: V=

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 By multiplying both sides of this definition by M, we obtain the equation of
exchange, which relates nominal income to the quantity of money and
velocity: MV=PY. The equation of exchange thus states that quantity of
money multiplied by the number of times that this money is spent in a given
year must be equal to nominal income. When M changes, nominal income
(PY) changes in the same direction. To convert the equation of exchange into
a theory of how nominal income is determined requires an understanding of
the factors that determine velocity.

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 Irving Fisher believed that velocity is determined by the institution in an
economy that affects the way individuals conduct transactions. He thought
the institutional and technological features of the economy would affect
velocity only slowly over time, so velocity would normally be reasonably
constant in the short run. Fisher’s view that velocity is fairly constant (V) in
the short run transforms the equation of exchange into the quantity theory
money, which states that nominal income is determined solely by movements
in the quantity of money i.e. MV=PY
 Classical economists believe that markets are stable and work well and that
the economy is always near or quickly approaching full employment.

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The Quantity Theory of Money as a
Demand for Money
 The quantity theory of money is a theory of the demand for money. We can see
this by dividing both sides of the exchange by V, thus rewriting it as; M = PY
 When the money market is in equilibrium, the quantity of money M that people
hold equals the quantity of money demand Md, so we can replace M in the
quantity by Md. Using k to represent the quantity , we can rewrite the quantity
as Md = k*PY . Because k is constant, the level of transaction generated by fixed
level of nominal income the economy (PY) determines the quantity of money Md
that people demand. Therefore, Fisher’s quantity theory of money suggests that
the demand for money is purely a function of income and interest rate have no
effect on the demand for money. Fisher believed that people hold money only to
conduct transactions and have no freedom of action in terms of amount they want
to hold, so he came to the following conclusion.

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The demand for money is determined by:
 The level of transactions generated by the level of nominal income PY
 The institution in the economy that affect the way people conduct
transactions that determine velocity and hence k.

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Limitations to the Theory

 It assumes that velocity of circulation (v) and output/GDP (Y) are constant
which is not true. This is because when M changes, V and Y also changes.
Since they are not independent of one another.
 It recognizes only the transaction motive of holding money and ignores others
like speculative, precautionary, finance motives yet they do exist.
 If a country has many unemployed resources an increase in money makes
price fall or even not change at all.
 An increase in money supply may result into higher savings if MPS is high and
this reduces the velocity of circulation and price may fall.

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By Maria K 12
Introduction
 John Maynard Keynes created the Liquidity Preference Theory in to
explain the role of the interest rate by the supply and demand for money.

 He also said that money is the most liquid asset and the more quickly an
asset can be converted into cash, the more liquid it is.

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Definition..

 Liquidity Preference Theory is a people’s desire to hold their wealth in cash

or near cash form instead of other assets.

 The Liquidity Preference Theory also says that the demand for money is not
to borrow money but the desire to remain liquid. In other words, the interest
rate is the ‘price’ for money.

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The Liquidity Preference Theory Curve

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KEY TAKEAWAYS
 Liquidity preference theory refers to money demand as measured through
liquidity.
 John Maynard Keynes mentioned the concept in his book The General
Theory of Employment, Interest, and Money (1936), discussing the
connection between interest rates and supply/demand.
 In real-world terms, the more quickly an asset can be converted into
currency, the more liquid it becomes.

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Motives for Liquidity

According to Keynes, the demand for

money is brought about or split up into
three motives.

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1. Transactionary motive

 This is the desire to hold a certain amount of

money to carry out day to day transactions.
The amount of liquidity desired depends on
the level of the person’s income. The higher
the income, the more money is required for
increased spending. This is called
transactionary demand.
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2. Precautionary motive

 Precautionary motive is the demand for

liquidity to cover unforeseen expenditure
such as an accident, death or health
emergency. The demand for this type of
money increases as the income level
increases.

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3. Speculative motive

 Speculative motive is the demand to take

advantage of future changes in the interest
rate or bond prices. According to Keynes,
the higher the rate of interest, the lower
the speculative demand for money. And
lower the rate of interest, the higher the
speculative demand for money.
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Speculative motive illustration

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Continuation…

 The curve shows that if the rate of interest

falls, e.g., from O0 to Or1, the demand for
money increases, from OM to OM1. According
to Keynes, at some low rate of interest the
demand for money becomes perfectly elastic
because if the rate falls below this level, no
one would be prepared to buy bonds.

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The liquidity Trap

 It is the lowest interest rate below which the speculative demand for money is Zero.
 In other words, Liquidity trap refers to a situation where the rate of interest is so low
that people prefer to hold money (liquidity preference) rather than invest it in to earn
interest.
 Keynes pointed out that at low rates of interest, the liquidity preference curve becomes
completely elastic. Therefore, the liquidity preference curve is not down­ward sloping
throughout.

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 This usually happens during depression. During
depression any attempt by the central bank to
reduce the rate of interest by increasing the
stock of money will be futile. In such a
situation, no change in money supply is
sufficient to alter the rate of interest.

In fact, any increase in the stock of money by

the central bank will be held by the people in
the form of liquid balance. This will prevent the
rate of interest from falling further.
The illustration below shows a completely
elastic position of the liquidity pre­ference
curve is called liquidity trap
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The Liquidity Trap Curve

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Liquidity trap cotn…..

 The implication is that monetary policy loses its effectiveness if there is a liquidity trap
in the demand curve of money.
 Keynes argued that the only way to stimulate investment in a depressed economy
(which is experiencing liquidity trap) is to use a positive fiscal policy.
 The reason is simple. People feel that the rate of interest has fallen enough. It cannot
fall further. Thus, if it rises in near future the price of bonds (purchased now) will fall.
So purchase of bonds is risky.

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Continuation….

 Thus, people prefer to hold as much money as possible, with the expectation that the
rate of interest will rise in future. As soon as it rises, they will buy bonds.

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Friedman’s modem quantity theory

 Milton Friedman developed a theory of the demand for money in his famous
article, “The Quantity Theory of Money: A Restatement”, in 1956. Friedman’s
analysis of demand for money is close to Keynes than it is to Fisher’s.
Friedman considered that the demand for money must be influenced by the
same factors that influence the demand for any asset. Friedman then applied
the theory of asset demand to money.

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The demand for money is a function of resources available to individuals his and
expected returns on other assets relative to the expected return on money.
Friedman regarded his model of demand for money as follows:
 = f( Yp,rb-rm,re-rm,πe-rm)
 Where = demand for real money balances;
 Yp = permanent income/Friedman’s measure of wealth
 rm = Expected return on money;
 rb = Expected return on bonds
 re = Expected return on equity (common stock/physical assets)
 πe = Expected inflation rate
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 The demand for an asset is positively related to wealth, money demand is
positively related to Friedman’s wealth concept (permanent income).
Permanent income has much smaller short-run fluctuations because many
movements of income are transitory/ temporary. Friedman regarded
permanent income as a determinant of the demand because the demand for
money will not fluctuate much with business cycle movements. Friedman
categorized them into three types of assets: bonds, equity, and goods. The
incentives for holding these assets rather than money are represented by the
expected rate of these assets relative to the expected return on money. The
expected return on money rm is influenced by;
 The service provided by banks on deposits
 The interest payments on money balances

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 In Friedman’s money demand function, the rb-rm means the expected return
on bonds relative to money while re-rm means the expected return on equity
relative to money; when they rise, the relative expected return on money
falls, and the demand for money falls. Πe-rm means the expected return on
goods relative to money. When it raises, the expected return on goods
relative to money rises, and the demand for money falls.

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 END

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