Money is an asset t tank ia aes Gees Public. As stich, it has its demand and supply and also a market © is made by its producers, he ieee eect public (excluding the producers of money). The supply of we ‘who demand and su aes » the government and the banking system. The money market is comprised of ns 15 Necessary ane hae ite study of the nature and determinants of demand and supply ty the price level, the intereet ree tt hanges in demand and supply of money tend to influence Sous developments in theories of esi ae ‘The present chapter makes a general survey of the 1, THE CLASSICAL THEORY OF DEMAND FOR MONEY The classical theory of demand for money is i has two approaches: the Fisherian approach "and the coannage ae hi dale 1. Fisherian Approach. To the classical ‘economists, the demand for money is transactions demand for money. Money is demanded by the people not for its own sake, but as a medium of exchange. Thus, the demand for money is essentially to spend or for carrying on transactions and thus is determined by the total quantity of goods and services to be transacted during a given period. Further, the demand for money also depends upon velocity of circulation of money. In Fisher's equation, PT = MV, the demand for money (Ma) is the product of the volume of transactions over a period of time (T) and the price level (P). Thus, Mg = PT In Fisherian approach, the demand for money is defined only in a mechanical sense and no attention is paid to various motives for which money is demanded. 2. Cambridge Approach. While Fisher's transactions approach emphasized the medium of exchange function of money, the Cambridge cash-balance approach is based on the store of value function of money. ‘According to the Cambridge economists, the demand for money comes from those who want to hold it for various motives and not from those who want to exchange it for goods and services. This amounts to the same thing as saying that the real demand for houses comes from those who want to live in them, and not from those ‘who simply want to construct and sell them. Thus, in the Cambridge approach, the demand for money implies demand for cash balances. : ‘The Cambridge economists considered a number of factors which tend to influence the demand for holding money. They are as follows : (® People tend to hold money for transactions motive. Money is generally acceptable in exchange for goods and services and thus holding of money avoids the inconveniences of barter transactions ii) Money is also demanded for precautionary motive since money holding provides a degree of security against future uncertainties, (if) Given the transactions and precautionary motives for holding money, the amount of money which ‘an individual will choose to hold depends upon income and wealth forming the budget constraints for the individual. (iv) Within the absolute constraint set by wealth and income, the actual proportion held in money form depends, among other things, upon the opportunity cost of holding money as opposed t0 other assets, For Cambridge School, the opportunity cost of holding money consists of rate of interest, the yield on real capital and the expected rate of inflation, chMonetary Econom, the Cambridge School, are habit, Of the i ni individual, the system of payments in the community, Ce pe es as sis th density of population, the system of communication, the g¢ ah saicls* hora ‘After recognising the importance of the above factors, the Cambri ee (a) in cons mt the demand for money function by assuming, that the demand for mony Porton (K) of money income (PY) alone. Thus, Mz = KPY ‘The value of K has been assumed to be stable in the sense that the determinants of K donot change significantly in the long run. The purpose of this simplification of the demand for money function by the Cambridge economists vwas to show that K in the Cambridge equation was just the reciprocal of V in Fisher's equation (i.e., K =1/V). In Figure 1, the demand for money is represented by My = KPY curve drawn on the assumption of demand for holding money having a proportional positive relationship ‘with money income, AS nominal income rises, the community will want to hold proportionally more in money balances. Output of goods or real income (¥) and K being given, a doubling of the price level (P, to P,) causes nominal income to double (from P, ¥ to P; ¥) and, in turn, demand for money will also double (from M, to M,). This is because, in order to make the same tratisactions at a price level that NOMINAL is twice as high, double money is required. COME In the end, the classical theory of demand for money may be summarised as under : () Money is only a medium of exchange. (ii) The ratio of desired money balances to nominal income is assumed to be constant at its minimum, or, in other words, velocity of money is constant at its maximum (because K =1/V). (iii) The public holds a constant fraction of its nominal income in non-interest-earning cash balances for transactions and precautionary motives. (i) Hoarding, i.e., holding money above the minimum desired for transaction purposes, is considered irrational because money in itscif has no value. (v) Quantity of money demanded is directly related to the price level. 2. KEYNES’ THEORY OF DEMAND FOR MONEY Keynes formulated his theory of demand for money in his well- known book, The General Theory of Employment, Interest and Money (1936). According to Keynes, demand for money arises because of its liquidity. Liquidity means the convertibility of an asset into cash. The assct with more liquidity is desired more as compared to that with less liquidity. Money being most liquid asset is desired most. Thus, in tbe Keynesian sense, the demand for money is the desire for holding money balances or the desire for liquidity or, as described by Keynes, the liquidity preference. Keynes identified three motives for the demand for money or the liquidity preference: (a) the transactions motive, (6) the precautionary motive, and (c) the speculative motive, For Keynes, the total demand for money implies total cash balances and total cash balances may be classified into two categories: (a) active cash balances-consisting of transactions demand for money and precautionary demand for money, and (6) idle cast balances-consisting of speculative demand for money. Active Cash Balances Transactions demand for money and precautionary demand for money together consititue active cs" 142-8 (0) Other factors influencing money demand according to DEMAND FOR MONEY balances. eet adipemand for Money Bere nsactions Motive Money being a medium of exchange, the prima ises for making day-to-day ictions. In daily sits the individual or business lecene and apendince o not perfectly synchronised people receive income in periods that donot correspond to the times they want to spend it. Generally income jg received at discrete intervals (for example, once in a week of in a month), but expenditures are made more ores nT ie ‘amount of money is needed by the people in order to carry out their frequent jons smoothly. is Way, transactions motive refe for money for bridging the gap a perl odie ond a fers to the demand for money While discussing the transactions demand for money, Keynes recognized hoth the income and the pusiness motive: 1. Income Motive. The income motive relates ‘0 the transactions motive of the households. The households need to hold money to bridge the time gap between the receipt of their income and its spending jn daily transactions. 2, Business Motive. The business motive refers to the transactions motive of the business community. ‘The businessmen require cash balances to mect their business expenses, such as, payment of wages, salaries, for raw materials, etc, Given society's basic institutional and technical customs and practices which govern the receipt of income and the flow of expenditures, the transactions demand for money depends upon (a) the personal income and (b) the business turnover. The demand for money for transactions motive, thus, varies in direct proportion tochange in money income, The higher the level of money income, the greater the demand for money to make transactions and vice versa. The transaction demand for money is not influenced by the rate of interest; it is interest- inelastic, Symbolically, the transaction demand for the money function can be stated as Lr=k, ) where L, sepresent the transactions demand for money, k, represents the fraction of money income society desires to hold as money because its income and expenditure are not synchronised, and Y represents money income. The transactions demand for money is assumed to be a constant and stable function of income because the proportion of income to be kept for transactions purpose is influenced by the institutional and technological arrangements influencing the payment and receipt of money and these arrangements do not change in the short period. Hence, the value of k; is assumed to be constant in the short period. Precautionary Motive ‘Apart from transactions motive, people hold some additional amount of cash in order to meet emergencies ‘and unexpected contingencies, such as, sickness, accidents, unemployment, etc, For the households, unexpected ‘conomic circumstances affect their decision to keep money for precautionary motive. For businessmen, the expectations regarding the future and prosperity and depression influence the precautionary demand for money. The precautionary demand for money depends upon the uncertainty of the future. fing to Keynes, the precautionary demand for money (L;), like the transactions demand, is also a (K,) function of the level of money income (¥), and is insensitive to the change in the rate of interest: Ly = tp) Keynes Jumps the transactions and the precautionary demands for money together on the ground that both are fairly stable and constant functions of income and both are interest inelastic, The combined sum of ‘Money balances held under the transactions and precautionary motives is referred to as ‘active balances” by ‘Ths, the demand for active balances (Ly = L; + L,) is a constant (k = k, + k,) function of income (Y) and can be symbolically written as Ly = Ly + Ly = hy (¥) + hy (Y) =k (Y) The amount of money-required to be kept as active balances varies with individuals and business firms spending upon the frequency of income, credit arrangements, ease with which other assets can be converted io money, the individuals’s degree of insecurity, and 80 on. However aus over all stable k has been assumed the community as a whole, Or, in other words, the determinants of k do not chaige in the shor. period. = Se Teal144-a Monetary Economic, 7 Figure 2 represents the demand for active balances (Ly = Ly + Ly) as a constant (& = ky + kp) function of money income (Y)’ There is a proportionate positive relationship between the demand for active balances and money income: The L, curve represents transactions: demand for money, the LL curve represents piccantionary demand for money, and the Ly = L, + L, curve, which is the vertical summation of the Lt curve and the Lp curve, represents demand for active balances. At OY’ income level, the demand for active balances is YL) (=~ Y’ L', + Y' L’,). When income increases to OY’. the demand for active balance also rises wo YL” (= ¥" Ly+ ¥" Lp). Idle Cash Balances or Speculative Demand for DEMAND FOR [ACTIVE BALANCES (L, Money The demand for idle cash balances relates to the MONEY INCOME (Y) demand of money for speculative motive. The speculative Fae demand for holding money balances is the unique Keynesian contribution. According to the classical economists, people hold money only for transactions and precautionary motives. In other words, people trade off interest earnings for the convenience of transactions and the security against future uncertainties that holding money gives. They do not hold money above the active balances (L;) . Thus, hoarding (i.e. to hold money above active balances) 1s considered irrational by the classical economists. Speculatve demand for money refers to the demand for holding certain amount of cash in reserve to make speculative gains out of the purchase and sale of bonds and securities through future changes in the rate of interest. Demand for speculative motives is essentially related with the rate of interest and bond prices. There ts an inverse relationship between the rate of interest and the bond prices. For example, a bond with the price of Rs 100 yields a fixed amount of Rs. 3 at 3% rate of interest. If the rate of interest rises to 4%, the price ‘of the bond must fall. to Rs. 75 to yield the same fixed income of Rs. 3. People desire to have money in order to take advantages from knowing better than others about ‘the future: changes in the rate of interest (or bond prices). In deciding whether to hold wealth in money or a bond form, an individual compares the current rate of interest (ic) with the rate of interest expected to prevail in future (i,). ‘The latter is called by Keynes as the normal interest rate. If people feel that the current rate of interest is low (or bond prices are high) and it is expected to rise in future (or bond prices will fall in future), then they sMhicipate capital losses, and in order to avoid expected losses on bonds, they will borrow money at a lower eens eee nlcrest (or sell their already purchased bonds), and keep cash in hand with a view to lend it in future i's higher rate of interest (or to purchase the bonds at cheaper rate in future). Thus, when the expected rate at entereat is higher than the current rate of interest (I, >> é<) the demand for money for speculative motivs oil nice Similarly, if people feel that in future the rate of interest is going to fall (or bond prices going to rise), they will reduce the demand for money meant for speculative purpose. For example, if the current rate of interest (i,) is .02 and the expected rate of interest (ig) is 04 (abat is. Je >> 1 the market value of one rupee invested today in a bond yielding 02 pet year would be cempcted to decline to 5 rupees and the bond holder would suffer a potential capital oss equal to one-half the ee or the holding of bond. The expected capital gain or loss (g) can be computed by subtracting the current Jnvestment of one rupee from the ratio of current rate of interest to the expected rate of interest, org = idle -1 = 02.08 ~ 1 = Rs, 0.5 ~ Rs 1= Rs-5. while deciding whether to hold a bond or money, an individual requires to know about the net yield ae Jeare net yield consists of the interest eaming from the bond plus or minus de capital gain of Jos a bond. THe ong. as the net yield fiom bond is greater than zero, the individual will Hold only bonds. he Gi, + 8 fo, the individual will be indifferent between bonds and money. The critical value of i actly 22 net a Te en ‘at which the net yield is zero, can be solved in the following way : current i ne¥ nd tor Money 145-0 oa wt ‘Therefore. s£4i=1 « Tee 1 o o i tet « eee nels i o =e 1+, For example, if i- is .04, the critical value of the current rate, i, , Will be .04/1 + .04 = 0385. Thus, whenever the arent market rate of interest is above the critical rate, 0385, the speculator, (Whose i. is .04) will hold bonds and if the current rate is below .0385, he will hold only money. Suppose i= 04 and i, = 039. Then g = id/ie~1 = Rs, 025, and, by folding bonds, the wealth owner ‘will earn a net yield, ier g= Rs 039 + Rs (~ .025) = Rs .014 per rupee invested Hence, net yield from bond is greater than zero (+g >> 0) and the wealth owner will hold bonds rather than cash to realise a positive net capital gain. Thus, to conclude, given the level of income, the | ° ,. L ‘peculative demand for money and the current rate of interest 2 ate inversely related. As the current rate of interest falls, the tunber of individuals whose critical current rate lies above the fallen rate, decreases and thus the speculative demand Toney increases. Conversely, as the current rate of interest Fig. 3. ‘ses, the speculative demand for money falls, Thus, the demand for money for speculative motive (Lz) is highly sensitive to and is a negative function of the rate of ‘nies. It can be symbolically expressed as : L=f@) the pit inverse relationship between the speculative demand for money and the rate of interest is shown by mc o¥Ward sloping Ly curve in Figure 3. At O, rate of interest level, the current rate is equal to the expected . i, and therefore the speculative demand for money is zero, This is the maxinnim critical value of denange it Ht at or above which the society will hold only bonds. Ata lower interest rate, Op, the speculative iat for money is OA. As the current rate of interest falls © Oy, the speculative demand for money to & s 3 8 SPECULATIVE DEMAND FOR MONEY \auldity Trap ating important feature of the speculative demand curve (L2 curve in Figure 3) is that if the current rate emg alls to a very low level (say Oi*), the Lo curve becomes perfectly elastic. It means that at this ' Tow rate of interest, people have no desire to lend money and will keep the whole money with them.Monetary Economics 146-8 becomes a money holder This is the minimum critical value of the current rate at which every one becanse holding bonds means a net loss. Here virtually everyone is convin, Liquidity trap represents a subjective minimum level of interes rate, Hor vitally eterone i conv a that the market rate of interest is below the expected or normal rat cto hold limitless amount of money 3 fae, bonds are considered so risk tat the specilatrs are prepared to hold Toniess amouet of mon Wealth Yield on the earning asses (bonds) is so low and the rsk of holding earning assets is so high th holders are not ready to keep earning assets and decide to substitute money for earning asset The rate of interest becomes sticky and cannot decline further after reaching a critically low eve, because of the following reasons : ; , 1. Compensation for Cost and inconvenience. Investing in beans fnvaves cet cost and inconvenience and some minimum return (in the form of interest earning) is required to neut is cost and inconvenience, So rate of interest must remain positive and cannot become zero, 2. Possibility of Rise in Interest Rate, When the rate of interest reaches its lowest level, there is very possibility that it will increase and the bond prices will fall in the near future. The speculators will under such circumstances prefer to sell their already held bonds, postpone their purchases of new bonds and keep ‘money with them. A 8. Expectation of Capital Gains. At the very low level of interest rate, the investors hope that the Fate of interest will increase and reach its normal level. A rise in the interest rate from an extremely low level involves greater capital losses than a rise in the interest rate from a relatively higher level. 4. Preference for Money. At the very low level of rate of interest, people develop a strong preference for holding wealth in the form of money rather than in the form of bonds and securities. ‘The policy implication of the liquidity trap is that the rate of interest cannot be lowered any more and {he monetary policy becomes ineffective in the liquidity trap region of the speculative demand for money Sarve: Changes in the money supply will have no effect on the interest rate, For example, In Figure 3. increase “money supply from M, to M;does not lower the interest rate. Keynes believes that a liquidity trap situation arises uring the periods of depression. During such periods, interest rates are already very low and the Sronomy is in the flatter ranges of the speculative demand for money curve, and therefore, changes ir. the Jena) Supply cannot further reduce the rate of interest. Thus, expansionary monetary policy is ineffective during depression. The analysis of the liquidity trap, therefore, explains why Keynes considered monetary poli ineffective and hence favoured fiscal policy which influences aggregate demand and in tum employment and output through changes in government expenditure and taxes, leaving the rate of interest unatfpevcd, Total Demand for Money ye community's total demand for money (L) consist of (a) the demand for active cash balances, ff, the transactions demand for money plus the precautionary demand for money (Ly), (b) the idle cach balances, 1.e. the speculative demand for money (Lz). Thus, L=Lj+ly Je Gemand for transactions and precautionary motives, which is more or less stable, depends upon the level of income. and is interest-inelastic, except when interest rate is very high (Ly = k (¥)). he demu ine Speaulative motive is a function rate of interest and an inverse relationship exists between the two (a=f@. ‘Thus, the community's total demand for money depends upon the level of income and the rate of incerest¢ L=kY)+s@ Total demand for money curve ( L curve) can be derived by the lateral summation of the demand curve for active balances and the demand curve for idle balances, Figure 4-A shows the demand curves for active balances (Ly curves) at different levels of income; L(Y) represents the demand for active balances at Y, income level, Ly(¥2 Jat Y2 income level, and Ly(Y3) at Y3 income level. The L; curves are vertical straight Jines, showing that the demand for active balances is interest inelastic. It may be noted that at very high rate of interest, the Ly curves slightly turn to the left, indicating that the transactions demand for money may become somewhat inversely related to the interest rate, The Lz curve in figure 4-B is the demand curve for idle balances, Tepresenting an inverse relationship between the demand for money for speculative motive and the interest rate. In Figure 4-C, the, total demantpemand for Money money curves (L curves) are d; a different income levels) and the Ly ee ne Lourves indicate the money demanded for ui the thee aes (le, transactions, Precautionary and speculative) gee (ots of the rate of interest. The position pea function the level of income; an increase in 4) will shift the L curve to the right (tron a decrease in income (from Y> to Y,) wil the let (from L(¥2) to L(Y). The sha determined by the Lp curve, 3. PORTFOLIO BALANCE APPROACH Keynes’ liquidity theory unnecessarily bifi B demand for money into transactions demand and see demand. The transaction demand depends upon the level of i and Keynes assumed a constant elation betneen nonce hoc and income. The speculative demand is based on portfolio approach which considers the yields of assets and compete with money in the individual’s portfolio. Keynes limits his analysis to two assets : money and bonds. The combination of demand motives with two different approaches is inconsistent. In the post-Keynesian period, two major attempts have been made to correct this inconsistency. (a) William-Baumol and James Tobin applied the portfolio analysis to the transactions demand, and (6) Milton Friedman attempted to blur the sharp distinction between motives of holding money balances, emphasising that money is held for many purposes and that demand for money is sensitive to various economic variables. Baumol’s Analysis Baumol! maintains that transactions demand for money also depends on the rate of interest. In fact, holding of cash involves two types of costs : (a) Interest costs - When cash balances are held, we forgo interest-income by not holding other forms of interest-yielding ‘assets. (0) Non-interest Costs - When bonds are converted into ash, certain costs like brokerage fee, postage charges, etc. accrue. I shift the L curve to Pe Of the L curve is Ly 147-8 LLOYD Ly (Y2) Uy (Vs) AATE OF INTEREST ° a) DEMAND FOR ACTIVE BALANCES (L,) 6 ly ° (8) DEMAND FOR IDLE BALANCES (L;) S| Leder) Lvs) Fa 6 TOTAL DEMAND. (C)_ FOR MONEY (Lp Fig. 44,8 &C. his algebric model of the demand for transaction balances at the micro level. He ia o avests his money income in interest-bearing bonds and these bonds are converted assumes that an individuals ‘or money in equal lots of amount M cacl fh to finance his expenditure, It is also assumed that the individual to make over a given time period. Each conversion will involve a tas uni or transactions eile expenditures f will be equal (0 the number of conversions into money times the rage fee. The total brokerage fe & "The Transaction Baumol 91952) na oT952) pp. 545-58. °f Economics, Vol. 66, No. 4 (t Ani ‘Quarterly Joumal jory Theorelie Approa- ~ Monetary Economie, 148. brokerage foc, or b (T/M), where T represents total transactio and b, the brokerage fee. a Every time when bonds are conver interest-income forgone over the expenditure period is, M, the amount of bonds converted to i interest-income and the i | the individual forgoes interest-inc ba easier is equal to the average money holding Pet Some {I interest income forgone ultiplied by the interest rate (i). That is, total il any rea ie serdiaa cash balances over the expenditure period (C) will be written io c-o(f)*«(3) ©) to minimise the cost associated with money holding which can be done by is san Canin ospect to MM setting the result equal to zero and solving the equation. ifferentiating C with respect to a 1 by a ™ 2° wu? as 3) os toa oe M = 2 ) 2 we PE Ee i Thus, equation (5) is the demand for money function which implies that the nominal money holdings for ‘the cost-numimising individuals will vary directly with the square root of planned nominal expenditures and inversely with the square root of market interest rate. This demand function can be expressed in terms of real money balances (M/P), by making expenditures and the brokerage fee real magnitudes, i.e., by dividing each nominal magnitude by a suitable price index. . Baumol’s model suggests a number of conclusions : (9 The demand for real cash balances (M/P) will rise by less than the real income (or real expenditures), implying that there are economies of scale in holding money balances. This further implies that ancome velocity should rise over time with real income. (wi) The demand for real balances is invariant with respect to changes in the price level and, thus, inflation can affect the demand for money only by altering the rate of interest. (4) The power of the monetary policy has been greatly increased, With an increase in money supply, the model implies that for a given interest rate, nominal income must rise by the square of any increase in nominal balances before equilibrium can be restored. (#) Transactions demand has been formally recognised with the speculative demand, Now, an individual, when deciding whether to hold wealth in money or bond form, must consider the market rate of snterest Tobin's Analysis Keynes" liquidity preference analysis requires an investor to put all his wealth either in cash or in some other single asset. But, according to Tobin, the real explanation attempts to show the reasons for which an investor holds a variety of assets, In fact what is needed is a theory of portfolio balancing. Tobin formulated imultancous desire to avert risk and to maximise the utility from wealth will lead an individual to choose a diversified portfolio consisting of both money and bonds. Tobin introduced the concept of risk aversion, The basic idea of risk aversion is that given two assets with same average return, an investor prefers that asset which has less dispersion or standard deviation. The fact of risk aversion is explained by two things : (a) There is always the risk that an asset with an unstable yield would peo 2 waa average rca, itis bus to be sold before maturity. (6) Income being subject i the law of dimi lity, the gains of utility to the wealth-holder iods of higher yiel would be smaller than the loss of wility during periods of low yicld. nn Cons Petiods of higher y James Tobin (1958) qty Preference as Behaviour Towards Risi . . Review of E je Studies, Vol. 25 if (Feb. 1958) pp. 6 ‘of Economic; vanavoroney 149-A ga represents the part of funds invested Prsjue of total return, ja will be Coma | resents interest rate and g represents capital gains, ye * ¥ HAG + tg) if cpital gains (g)i8 zero then average wl) "mesa hea value of total return will depend on A and i because rate of interest is fixe 1, the i“ ee ‘hy the standard deviti earot capi te sik Risk is only due to capital gains of losses. The ry i stor (0) 8 represented as gains and is designated by a,. Thus, the standard deviation of oho oo ae ee in A @) substituting (3) in (2), we get, inet et Ad) gquation (4) thus indicates that the average of gal ejun depends upon the rate of interest andthe wo8 capital gains and losses on the investment in z aS Tobin's model is graphically illustrated in ia Figure 5- g in order to find out the division of wealth into ‘ (1+io) soney and bonds, let us assume that intially the total otth of an individual, if held only in money terms, ‘feral to Mo, Let us also assume that if he holds all Bexealth in the form of bonds, the expected value of ti wealth at the end of the holding period would be Mj (1 + io) where the interest rate is i and the risk ia wed is dp, Then the line joining Mo and ig can be tensidered as the budget constraint line. ‘The indifference curves, designated a8 Io, In, lz | slope downward and to the lef, indicting that ‘@ to induce the individual to bear more risk, the expected value of his wealth must increase, and () because increases in wealth yields diminishing uility, ever-larger increases in ed wealth are tecesary to induce him bear additional uniform increments of risk. A higher indifference curve indicates larger amount of expected wealth with the same level of risk. Every wealth-holder tries 10 choose that combination of money and bonds that enables him to nach the highest accessible indifference curve. Initially, when interest is lo, the equilbriom is 5: tiven by E,, where the budget constraint line is tangent to indifference curve Ip, If the rate of interest falls to i, bu risk component remains unchanged (70), then the new budget constraint Tine will be Mo iy and the Yedth-holder will be in equilibrium at E, on the if "The new equilibrium position (Ei) itt the let to the original position (Eo) which i he wealth-holder bears less risk and therefore more money and less bonds. However, Es my ‘pe tothe right of Eg of may be just below Ey depending Yon the way the wealth holder weights risk return empirically. In short, Tobi Judes that (a) a8 the market rate of interest rises, the individual is willing to bear bee by holding me nes a (yan) ibe evel of fr ese nes nie, et bond nod mmere money, will be held in the individual's portfolio.Monetary Economicg 150A {finitely an improvement over that of Keynes, the contributions of Baumol and ra a ie applying optimum inventory analysis tavthe demand for money in a functional form, in ide it possible to express the total de 1 Pa : SS Seething oe pth mat possible to explain diversified asset holding while retaining the slope o! . 4. FRIEDMAN’S WEALTH THEORY OF DEMAND FOR MONEY To Sum Up, Baumol methodologically unified Keynesian monetary 1! Fviotman's theory of demand for money is pal Keynesian and parly non-Keynesian. Tt is non-Kemesin ‘because Friedman completely ignores Keynes classification of the motives for holding money. Is Keynesian because Friedman generalises Keynes’ analysis of the speculative demand for money by treating demand for ‘money as a part of the theory of capital or wealth, - Friedman's theory of demand for money is a wealth theory of demand. In his view, money is 'a durable SDasumer Hood held forthe services it renders, and yielding a flow a services proportional to the stock.” Money 2 Spe of capital good which is held for the services it provides. Thus, money is demanded as an asset cy ‘april and the theory of demand for money is a part of the capital or wealth theory. Friedman analyses the demand for money as a whole instead of examining it in terns of specific motives, He does not distinguish between transaction and speculative balances as Keynes did. Rather money is regarded &S Tendering a variety of services because of the fact that it serves as a temporary abode for generalised Purchasing power. Friedman applies general demand analysis to the case of money. The ultimate wealth-holders are households who regard money as a durabl. theme! good. He also assumes that money is subject to the law of, ‘diminishing marginal rate of substitution, Determinants of Demand for Money Broadly speaking, the dem: OF positive as on saving But money is demanded 0 y soods and services. Thus, money to command goods anger" Ne price index (P) beoween level of prices govern the ability of jond is conside i ai rid a petri Security, or consol, which Yields an income stream whose terms, on bond (r,) consists of the sum of its coupon plus anyv and or Money 151-A jpated capital gain due to an expected fall j ge an nae in the marion eed fil i the market interest rate or less any anticipated capital loss ity. The equity is identi wove trea trays ecicin ea to the bond except that it contains a cost- of-living escalator so that ents * (a) its coupon yield, (b) ty epson power. The yield on equity (7) is composed of three oan a ted ehanee fn the general pice capital gains of losses due to changes in interest rates, and mmodities. Physi 6. CommociivesFnsical goods held by wealh-owners yield income in kind (ei) which canna te meastases the nominal yield o: te, However, their real return is affected by the changes in the price level. ried: commodities (r,) to consist of their expected rate of price change per unit of time: 7. Human Capital. In the absence of st: i 5 aon this form of wealth cannot be compucd direct fix heman copia] ens oa a, Other Variables. Friedman introduces a variable desi other r ence ssn income that can be expected to affect tastes and ‘reference or money ue friedman’s Demand-for-Money Function The demand function for money, as formulated by Friedman, given.below: M=SCY, #, P, ro Pe Fo W). 0) Where, M = aggregate demand for money. ¥ = total flow of income. w = ratio of non-human to human wealth P = general price level. rs = bond yields, the market bond interest rate. rr, = equity yields, the market interest rate of equities. r,= the expected rate of change of prices of commodities. 1 = utility determined variables which tend to influence tastes and preferences. ‘The demand function for money in Equation (1) is independent of the normal units used for measuring money variables, It indicates that the amount of money demanded changes ‘proportionately to the changes in tects in which prices and money income are expressed, The equation thus expresses the first degree tomogeneous function of P and Y. Or, in other words, if price level and money increases to A times their original level, demand for money also increases to 2 times its original quantity Thus, we can write, AM = AY, , AP, 16) Te Tor W) (2) ia = 3, then x a1 (Eomotetert 8) Equatio smand for money as a demand for real balances, which is a function of real variables, eed Set values. "according to Friedman, money is a luxury like durable consumer foods, With a change in per capita income, people's standard of living changes and, as result, they may desire to hold cash balunces move or Tess according to the change in the per capita income. But the income to which cash balances are adjusted is permanent income rather than current income. Friedman and Keynes Compared Friedman's theoretical demand function differs Land - sere by Keynes in many ways : K ae three motives for holding money balances, i.e. aaa aoe @ Rejees dl bert speculative motive (or between active and idle balances). Fri makes no distinction between the motives for holding money balances. For him, money is held because it is a temporary abode for eneralisd purchasing power which provides varios services to its possessor, including as a productive factor. f money than that used by Keynes, While Friedman defines ‘ ‘a broader definition ® oo a promis that serve as a temporary abode for generalised purchasing power, theMonetary Economies 182-8 : , Keynesian definition includes demand deposits and the noninterest-bearing debt of the blir tunity cost of money and specifies their it ariables to express the oppor 5} wort ne a tal gain or =xpect vis is the sum of the coupon and capit I i wocnens tn te market tate of interest Inthe Keynesian formulation the interest rate ig the ‘Current rate relative to some normal or expected rate. : (In Friedman's demand function, an explicit rate is included for the equity and commodity opin ‘but both of them are generally excluded by the Keynesian assumption that they are perfect substitutes Prctman i hhereas in the Keynesi (») Friedman introduces permanent income and prices as arguments, whereas ynesian formulation, they are generally taken to be the current measured magnitudes of these variables, Result of Empirical Studies A mumber of empirical studies have been conducted in the western countries to identify the demand function for money and to estimate the best values of its parameters ‘The following are the broad conclusions of these studies :! (©) The demand for money appears to be more a function of wealth, permanent income than of current income, fo Coneycabonse of demand for money to the price level has been found to be Proportional. To Conclude. Although there exists a difference i . between demand- for-money functi i {vc such difference shrinks considerably when we view the Pbk cae Tesults of the empirical studic ic found permanent income and the actual rate of interest, and change fa hate studies have not the rate of change in the price level, as {s responsive to the interest isk and returns on the real ney May NOt affect W terest Keynesian theory may not be applicable in the underdeveloped eountien 5" significantly. Hence, the 1. Based on D. E. W Laide (197) The Demand To Nanay Theories and Evidenceoman for Money 3, Influence of Non-Econo: ‘ - mic Foy inerest rate is administered rather than pees It is argued that in most of the underdeveloped countries, ene organised sector. In the unorganised termined by the market forces of demand ‘and supply of money in Mona factors. Tn tho rua sector the Sector, the inleest rate is determined by both eeonomic and i and on the Supply side, the rural the detrminaton of interest rate is generally viewed from the supply “opportunity cost, and the degree of mong ate in normally inivencad by risk premium, administrative 4 Unstable Income Velocity, Some rscarlen soeernd son ntact seone velo of one) for undereve Tesearchersobverved short-run fluctuations in their estimates of icant theory of money to explain ee! countries. In view of the unstable income velocity, the use of im yf cass, the expoctd rate of ia jemand for money wil not be suitable, This is the reason that in aver mportant variable influencing the ation (indicating the Opportunity ‘cost of money holdings) is observed yr money in these economics. 5, Interest-Inelastic Dem: 7 eldias Sepropeats and. In the underdeveloped countries, rate of interest, in particular, is not ited Serene hase in the determination of demand for money due to a number of reasons: ® cae ed cla esol ‘market; (b) the institutional pegging of interest rates; (c) limited array nani 5 legree of substitution between money and financial assets. Empirial Evidence Empirical research on money-demand function in the und it i __Empiries jerdeveloped countries in general and in India in particular lead to the following broad conclusions :1 : * () Stable demand for money functions for the underdeveloped countries can be estimated on the same lines as for the developed countries. (ii) Expected price changes rather than interest rates tend to be important determinant of money demand. (ii) Some measure of income remains the major determinant of real money holdings. (iv) The effects of different levels of monetary developments are also reflected in the studies which have investigated the variability of income velocity. (©) The almost universal use of annual rather than quarterly data has been a constraining factor, particularly in the investigation of lag in adjustment of money markets towards equilibrium. (vi) Changes in the distribution of income between the agricultural sector and the rest of the economy as represented by variations of the ratio of agricultural income (0 net national income have been found to affect negatively the demand for money. 153-0 Baumol, W.J.: “The Transactions Demand for Cash ~An Inventory Theoretic Approach’, Quarterly Journal ‘of Economics, Nov.1952, PP. 545-56. Cathcart, C.D. : Money, Credit, and ‘Economic Activity, Chap. 5. Friedman M. ; "The Demand for Money: Some Theoretical and Empirical Results’, Journal of Political Economy, Aug. 1959. Friedman, M: ‘The Quantity Theory of Money ‘Money, edited by M. Friedman (1956) Ghatak, S.; Monetary Economics in Developing Hansen, AH.: A Guide to Keyn hap. 6. Keynes, JM. The General Theory of ‘Employment Interest and Money.chaps.13 and. 15. Laden D.: The Demand for Money: Theories and Evidence, 1977. 2y a and inerest Rates: AN Introduction to Monetary, Theory 1978, _ A Restatement’, in Studies in the Quantity Theory of Countries, 1981, Chap. 2 Makinen. G.E.: Money the price loping Countries, PP.28-33; S.B. Gupta (1983) : Monetary 1 See Subvata Ghatak (1981) : Monetary Economics Esonomice Insitutions, Theory and Polly, PP4 26.