Supply of and Demand for Money and the Rate of Interest
According to classical theory, rate of interest is determined by the interaction of supply of
savings and demand for investment. Conversely, according to Keynesian theory, rate of interest
is determined by the interaction of supply of money and demand for money. Moreover, though
Keynes accepted that ‘investment is a function of interest rate’; one part of classical theory,
however, another part of the classical theory, ‘savings as a direct function of interest rate was
rejected by Keynes.
In Keynesian theory, savings is a positive function of income, and, contrary to classical view, it
is held that interest rate may influence savings, but that is of minor importance. Moreover, in
Keynesian theory, the interest rate depends on the supply of money and demand for money. It is,
clear then, that Keynesian theory of interest sharply differs from classical theory, where interest
rate depends on real factors like supply of savings and demand for investment. Although the
above mentioned real factors indirectly enter into the determination of the interest rate, in
Keynesian theory, the monetary factors are at the forefront of the theory. In this sense, Keynesian
theory of interest is a departure from the classical one.
Supply of Money
Regarding supply of money, there are several possible measures. Here, for the sake of simplicity,
the narrowest measure of money supply has been considered; which limits money to the public
holding of currency and demand deposits at commercial banks.
Demand for Money
According to classical theory, money is a medium of exchange. Hence, it is hold for transaction
purposes only. Contrarily, Keynesian theory is of the view that money is not merely a medium of
exchange, but more than that. People hold money not only for transaction purposes but also for
speculative and precautionary purposes. Break-down of the demand for money into transaction
demand, speculative demand and precautionary demand plays a vital role in the Keynesian
theory of interest rate determination. This point is considered as another significant departure of
Keynesian theory of interest rate determination from the classical one.
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Transaction Demand for Money
Everyone needs to hold some money to carry out ordinary day-to-day transactions. However, the
closer the synchronization between the timing of one’s receipts and the timing of payments, the
smaller will be the average money balance one must hold for this purpose. If the amount that a
person received at each point in time equated the amount that he/she paid out at each point in
time, no balance at all would be required for transactions. In practice, of course, no person or
firm even approaches this limiting case, despite the ability of each to exercise some control over
the timing of what comes in and what goes out. If, there is an even distribution of payments over
the month, a person whose receipts for the month, all come in on the first day of the month will
require a larger average money balance over the month than would be the case if these same total
receipts cane in ant intervals during the month.
As a general rule, the average money balance a person or a firm must hold over time for
transactions purpose decreases as the frequency of receipts rises. On the other hand, the average
money balances a person or firm must hold in order to mediate transaction, increases
proportionally with the volume of transactions. So, it is clear that, the average level of money
balance held by the individuals and firms are influenced by two forces in two opposite directions.
While a closer degree of synchronization between receipts and payments shrinks it, a higher
level of transaction over time tends to increase it. In reality, the strength of the latter force far
outweigh the former to give us an almost uninterrupted increases year after year in the amount of
money balances that all persons and firms find it necessary to hold in order to mediate the total
volume of transactions.
Transaction Demand for Money (Mt) as a Function of Income
Growth in total volume of transaction is generally accompanied by growth in the size of GDP. If
the relationship between these is fairly stable, then Mt (transactions demand for money) directly
depends on the level of income/output.
That is, Mt = f (PY), where, PY is money value of total output; or, Mt = kPY where, k is the
fraction of money income over which the public wishes to hold command in the form of
transaction balances. Size of ‘k’ depends on institutional and structural conditions within the
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economy, like, speed of movement of money, time required for payments originating in one
location of the economy to become receipts in another location of the economy, degree of
synchronization between receipts and payments for each person, and, integration system between
firms regarding intra-firm receipts and payments, etc. Graphically, transaction demand for
money can be presented as follows.
Mt k/ ˃ k
k/Y
kY
O Y
Transaction Demand for Money (Mt) as a Function of Interest
Transactions demand for money may also vary with rate of interest at very high level of the latter
(though this level of interest rate is unspecified). In practice, at least some people, under some
conditions may have more alternatives than the simple choice between holding money and
holding long term bonds. As for example, instead of keeping money idle for transaction
purposes, he can use them to buy interest bearing bonds. But in that case, he will be incurring
some costs (transactions cost, banking cost and cost in the form of creation of hazards). He will
then, compare his interest earnings with these costs. Whatever high these costs may be, they can
be compensated for by the high interest rate. As a result, Mt becomes interest-elastic at high
levels of interest rate, and, thus, bends backwards. Graphically,
i
Mt= f(i)
i ………..
O Mt
Speculative Demand for Money (Msp)
Speculative Demand for Money, a systematic part of the demand for money in Keynesian theory,
represents another distinct break from the classical theory. Classical theory holds that a person
would hold no money in excess of the amount needed to meet his transactions (including
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precautionary) requirements. According to this theory, to do otherwise would be to forgo the
interest rate that could be earned by putting that money into a bond.
Classical theorists reasoned that, even if the rate of interest were very low, it would be better to
get some return than none at all. Keynes, however, pointed out that, one who buys a bond is
speculating that the interest rate will not rise appreciably during the period in which he intends to
hold the bond. If he believes that it will rise, he would be wise to hold non-interest bearing
money. This uncertainty, regarding the future rate of interest causes people to hold money for
speculative purposes. If the future rate of interest were known with certainty, there would have
been no speculative demand for money, and, hence, no objection to the classical theory of
demand for money. Graphical presentation of speculative demand for money (Msp)
i
imax
………………………………
imin Msp(i)
O Msp
Security Price and Interest rate
To understand Msp, it is needed to examine the relationship between interest rate and the market
price of a security. If, for eg., market rate of interest is ‘r’ and the amount lent is P 0. Then, at the
end of one year the lender will get back: P1 = P0 + P0 r = P0 (1 + r). If he lends this P1 amount for
the second year, at the end of that year, he will get back:
P2 = P1+ P1 r = P1 (1 + r) =P0 (1 + r)(1 + r) = P0 (1 + r)2
In like manner, a sum of P0, lent at a rate of interest rate ‘r’ for ‘n’ years will grow to:
Pn = P0 (1 + r)n
The process of finding the present value of a future sum is the reverse of the process of
P1
accumulation. As, P1 = P0 (1 + r) ; P0 = ; Accordingly, present value (PV) of an amount
1+r
P2
receivable two years from now is, P0 =
(1+r)2
. In general, we can find the PV of the series of
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future sums generated by any bond by discounting each portion of that series back to the present
by the appropriate rate of interest. Using PV for present value, R1 , R2 ,…… Rn , for each part of
the stream of interest income, and A for the face value of the principal amount to be paid in year
‘n’, we have:
R1 R2 R3 Rn A
PV= + + + ……… + +
1+r (1+r)2 (1+r)3 (1+r)n (1+r)n
Let a bond is issued in 1965, has a face value of $1000, is to be matured in 1990, an income
stream at a rate of 5% of the face value of the bond is realizable per year, and market interest rate
of 8%; then the price of the bond in 1985 will be calculated as follows: PV of the bond will be
calculated for 5 years income stream and the principal amount to be got on 1990.
50 50 50 50 50 1000
PV= + 2 + + + + = 4880.21
(1+0.08)1 (1+0.08) (1+0.08)3 (1+0.08)4 (1+0.08)5 (1+0.08)5
If the interest rate had been higher than 8%, the PV would have been smaller or the discount
would have been larger. That is there exists an inverse relationship between security prices and
the current rate of interest.
Total Demand for Money (MD)
Total demand for money may be designated as: MD = Mt + Msp = f(Y) + f(i)
Hence, total demand for money curve becomes:
Mt Mt i i
M/t ……… ……………. Msp ………………. MD= Mt + Msp
O Y Y O Msp O M/t MD
Determination of Equilibrium Interest Rate
Equilibrium interest rate is determined at the interaction point of demand for money (MD) and
supply of money (Msp) curves (figure below).
5
i MS
i*…………….… E
MD=Mt +Msp
O MD, MS
Change in Equilibrium Interest Rate Due to Change in Money Supply
Equilibrium interest rate changes due to change in money supply. With the increase in money
supply, there is fall in the rate of interest and vice versa (figure below).
i Ms M/s M//s M///s M////s
i1 …………… E1
i2 ………………………….. E2
imin ………………………………………. E3 E4 E5
MD
O MD, MS
Concept of Liquidity Trap
An important concept of Keynesian Economics, used to justify application of fiscal policy
instead of monetary policy to combat depression. According to Keynes, during depression period
the economy got trapped in this region. Hence, it is named, liquidity trap.
Change in Equilibrium Interest Rate Due to Change in Transaction Demand for Money
MS
/
i MD MD
i2 ........................E2
i1 ………………. E1
MD
O MD, MS
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Equilibrium interest rate may also change due to change in transaction demand for money. With
the increase in transaction demand for money, there is also increase in the rate of interest and
vice versa (figure above).
Expectation and interest rate
Anyone who buys a long term bond unavoidably speculates to some extent on future changes in
the interest rate and, thus, must face the possibility of either financial gain or loss that is
supposed to come with such changes. Persons who switch at any time from money to bonds
expect the interest rate to fall and bond prices to rise. That is, they consider the present interest
rate to be high and present bond prices to be low. Conversely, those who switch from bonds to
money hold opposite expectations, that is, they consider the present interest rate to be low and
present bond prices to be high. Clearly, then, anyone who views the current interest rate as high
or low, must have some ‘normal’ rate in his mind against which the current rate is being
compared. This ‘normal’, itself is constantly changing mainly due to change in the inflation rate.
Given the notion of a normal rate, if wealth holders view the current rate as high, they expect the
rate to drop as it returns to the ‘normal’ rate. At this high rate, wealth holders will accordingly
hold bonds rather than money. Thereby, they not only currently enjoy the high rate of return
provided by the bonds, but can expect capital gain as bond prices rise and the interest rate falls to
a normal rate. Conversely, if they view the current interest rate as low, they anticipate a rise in
the rate as it returns to ‘normal’. They, accordingly hold money rather than bonds. The penalty
paid in interest foregone is relatively small when the interest rate is low; the prospective capital
loss is relatively large if the rate should rise as expected from its low to its normal level. Under
such circumstances, holding idle money becomes the financially rational policy.
Quantity Theory of Money
Value of money indicates the purchasing power of money. So, value of money at a specific
period of time is determined by the amount of goods and services bought by that money.
Purchasing power of money can both be internal and external. Economists differ in their views
regarding purchasing power of money. Some highlight its internal purchasing power, some
external, and some both of it. If, general price level increases, then, with the same amount of
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money a lesser amount of goods and services can be bought. Hence, rise in price level leads to
decrease in purchasing power, which again causes decrease in value of money and vice versa.
In other words, there is an inverse relationship between value of money and price of goods and
services. ‘Quantity Theory of Money’ is the most popular among the theories concerned with
determination of value of money. Simply put, the quantity theory of money is the idea that the
supply of money in an economy determines the level of prices and changes in the money supply
result in proportional changes in prices. That is, other things remaining constant price level
increases proportionately with the increase in money supply and value of money decreases with
the same proportion and vice versa. The theory is based on the following two fundamental
assumptions:
i) There is always balance between aggregate demand and aggregate supply of the economy;
ii) The economy is at full employment equilibrium;
Fisher’s Quantity Theory of Money or Cash Transaction Approach
The transactions version of the quantity theory of money was presented by Irving Fisher in his
famous book The Purchasing Power of Money (1911), in the form of an equation of exchange.
The quantity theory of money states that a given percentage changes in the money supply results
in an equivalent level of inflation and deflation. This concept is usually introduced via an
equation relating money and prices to other economic variables.
Equation of Exchange: MV = PT
Where, M = Total quantity of money in circulation; V = Velocity of circulation of money;
P = General price-level; T= Total volume of transactions;
MV = Total supply of money in the economy; PT = Total demand for money;
At equilibrium, MV =PT. Right side of the equation represents the total value of output in an
economy. Since output is purchased using money, PT stands for total demand for money.
Conversely, MV equals to the total amount of money in supply. Hence, according to this version,
value of money is determined by demand for and supply of money. Prof. Fisher's above version
of the quantity theory of money is based on an essential function of money, namely, that money
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is a medium of exchange. Money is not needed for its own sake, but to exchange it for goods and
services. Later, this exposition was modified to include credit money along with legal money.
Hence, it became: M1V1 + M2V2 = PT
Let, M1 = M2 = 100; V1 = V2 = 5; and, T = 500;
Then, P = (M1V1 + M2V2)/T = (500 + 500)/500 = 2
If, now, M1 = M2 = 200; V1 = V2 = 5; and, T = 500;
Then, P = (M1V1 + M2V2)/T = (1000 + 1000)/500 = 4
It is, thus, clear that other factors (V1, V2, and T) remaining constant, P is a positive function of
M. That is, as money supply (M) increases, price level (P) also increases and the increase is
proportionate. This relationship between M and P can be derived as follows:
MV
Given, MV = PT, P= = f (M) (as V and T are constants)
T
dP V
Therefore, = = f /(M) > 0. This implies positive relation between M and P. That is,
dM T
increase in money supply leads to increase in price level.
1
1 T d 1
P
Again, from MV = PT, we get, = . Hence, = f /(M) < 0 .That is, ‘ ’ and ‘M’ are
P MV dM P
inversely related; implying that, increase in money supply leads to decrease in value of money.
P
P = f (M)
P2 E2
P1 E1
O M
𝟏
𝐏
1/P1
1/P2
1/P = f (M)
O M1 M2 M
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Cambridge Equation/Cash Balance Approach
Economists Alfred Marshall, A. C. Pigou, and J. M. Keynes associated with Cambridge
University took a slightly different approach to the quantity theory, focusing on money demand
instead of money supply. They argued that a certain portion of the money supply will not be used
for transactions; instead, it will be held for the convenience and security of having cash on hand.
This portion of cash is commonly represented as k, a portion of nominal income. The Cambridge
equation is thus: M = kPT
In equilibrium, Ms = Md Hence, Ms = Md = kPT
Ms
Or, P = = f (Ms) (as k and T are constants)
kT
dP 1
Therefore, = = f /(Ms) > 0. This implies positive relation between Ms and P. That is,
dMs kT
increase in money supply leads to increase in price level.
Again, from Md = kPT and equilibrium condition, Ms = Md
1
1 kT d
P
Therefore, = Hence, = f /(Ms) <0
P Ms dMs
That is, 1/P and Ms are inversely related. This implies that, increase in money supply leads to
decrease in value of money.
Determination of Value of Money
1/P MS1 MS2 1/P MS
1/P2 E2
1/P1 E1
1/P2 E2 1/P1 E1 MD2
MD MD1
O M1 M2 M O M1 M
It is evident from the graphs that, money demand remaining the same, if, money supply increases
from M1 to M2, then, value of money falls from (1/P1) to (1/P2) . That is, price level rises from P1
to P2 (P1 > P2). Again, money supply remaining the same, if, money demand increases from MD1
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to MD2, then, value of money rises from (1/P1) to (1/P2). As a result, price level falls from P1 to
P2. Hence this version of quantity theory of money shows that both supply of and demand for
money influences the value of money.
Relationship between ‘k’ and ‘v’
Assuming that the economy is at equilibrium (Md= Ms), ‘T’ is exogenous, and ‘k’ is fixed in the
short run, the Cambridge equation is equivalent to the equation of exchange with velocity (v)
1
equal to the inverse of ‘k’ (That is, v = ).
k
PT
From, MV = PT V=
M
M 1 PT
And from, M = kPT k= . Hence, = =v
PT k M
Comparative Analysis of the two versions of Quantity Theory of Money
There is a fundamental difference between the two approaches of simple quantity theory of
money. In case of cash transaction approach concept of demand for money appears implicitly,
whereas in cash balance approach demand for money appears explicitly. As for e.g., if, v = 4 and
k = ¼, then, the former implies that each unit of money is on the average used four times during
the period to purchase goods and services. The latter implies that people want to keep by them,
money equal in value to a certain stock of goods and services.
Both the versions explain the proportional relationship between money supply and price level.
As in case of cash transaction approach, starting from an equilibrium level of Ms = Md, if, there
is an increase in Ms, there will be increased spending which will raise price level (given the
assumption of full employment). A higher price implies a higher PT, which implies a higher M d,
implying higher Ms, that is a higher MV, a higher M (given V is stable in the short run).
In the second version also, starting from an equilibrium situation, when there is an increase in
Ms, people will be holding more money than is needed to hold at the existing price level. They,
therefore, try to get rid of the excess money held, which raises the P (under the assumption of
full employment), until actual money holding equals desired money holdings. With increased
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price, a given output level will be worth of higher PT. Therefore, to have command over it, now
people need to hold more money. In this fashion, new higher money holding equates with higher
level of money supply.
Keynesian version
Like the quantity theorists, Keynes also asserts positive relation between MT and income as
expressed by: MT = P. k(Y). However by adding the speculative demand for money, as,
Msp = P.h(r), Keynes denied that MD = MT. That is, he rejected the proposition that equilibrium
between MS and MD can be stated as MS = P.k(Y). According to Keynes money market
equilibrium thus becomes, MS = P. k (Y) + P. h (r) = MD = P. f (r,Y)
This leads to the proposition that a rise in money supply may be absorbed in part by speculative
demand. As a result, increase in money supply will not lead to a proportionate rise in price level
though there will be an increase in PY. According to Keynes, this increase in PY is initiated by
an increase in Y due to increase in investment spending. This increased investment results from a
lower level of interest rate due to increase in money supply. In short, changes in PY are no
longer determinable from changes in money supply alone, as is true when transaction demand is
the only demand for money.
Though Keynes has asserted that, transaction demand is a function of income only, it has been
found that at very high levels of interest rate transaction demand becomes interest elastic. That is
MT = f (Y, r). Similarly, speculative demand for money is considered to be a function of only
interest rate. But in this case also it is found that, speculative demand for money is a function of
income. So instead of expressing money demand as a combination of transaction demand and
speculative demand, it can be combinedly expressed as a function of income and interest rate
irrespective of the type of demand for money (transaction demand, precautionary demand or
speculative demand). Hence the combined form is: MD = P. f (Y, r).
Modern quantity theory of money (Milton Friedman)
MD
= k (r, Ṗ) Y
P
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Friedman himself sees it as a restatement of the old one, whereas others see it as an elaborate
statement of Keynesian theory. Friedman used the concept of permanent income rather than the
concept of current income. The simple quantity theory was based on the assumption of full-
employment (hence, Y is constant) and also ‘k’ being constant, there exists an exact proportional
relationship between money supply and price level (through the equation MV = PT). This made
the theory a theory of price level.
Like the Keynesian theory, the modern theory recognizes that the output of the economy can be
at below full-employment level that is income is a variable in the short run. It also recognizes ‘k’
as a variable; hence, changes in money supply do not necessarily lead to a proportionate change
in the price level. In that case, PY changes not only due to changes in money supply but also due
to money demand transaction demand interest rate speculative demand for o changes in ‘k’.
Though the modern theory take ‘k’ as a variable; but assumes that ‘k’ is a stable function of a
limited number of other variables. That is, ‘k’ itself is not stable; but the function determining ‘k’
is stable.
Comparison between old and new versions of quantity theory
While, according to old theory, PY may be predicted from money supply alone; modern theory
holds that PY may be predicted from money supply and the several variables that determine ‘k’.
MD
While formulation of old quantity theory is = k (Y); modern quantity theory presents it as,
P
MD
= k (r, Ṗ) Y (where, Ṗ = rate of change of the price level). Friedman assumes that the
P
function, K = k (r, Ṗ) is stable. That is, in Friedman’s version ‘k’ is not stable; but it is a stable
function of interest rate and Ṗ (rate of change of the price level).
In simple quantity theory of money, in the short run, output is constant (as full-employment level
is assumed); hence, there is a proportionate and direct relationship between money supply and
price level. In Friedman’s version, there is no such proportionate relationship between money
supply and price level, as the economy may operate below full-employment level.
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Tobin-Baumol Model
One principal motive for holding money is the need to smooth out the difference between
income and expenditure streams. The alternative to holding money which is the means of
payment and earns no return is bonds, which earns a return but also incurs transaction cost. In
general, higher the interest rate, higher the rate of transaction balances transferred to bonds.
Assumptions of the model
(a) An individual earns a fixed amount of income for a specific time period.
b) He spends this income evenly throughout the period.
(b) He has the option to hold either bond or money.
(c) Bonds yield a given interest rate if held for a specific period.
(d) More transfer from money to bond are made, will yield more interest; but that will incur more
transaction cost. That is, there is trade-off between interest earned and transaction cost.
Calculation of Optimum number of transaction
Let, amount of fixed income = Y ; Time period = T ; Number of transaction = N ;
Interest rate = r ; Unit transaction cost = A ; Total transaction cost = NA
If, N = 1; then initial money holding is Y; which becomes zero at the end of the specific period.
Y+0 Y
Money Hence, average money holding during this period = =
2 2
Holding Y
O 1 Time
Y
If, N = 2; then initial money holding is ; which becomes zero at the end of the specific period.
2
Y/2+0 Y
Money Hence, average money holding during this period = =
2 4
Holding Y/2
O 1/2 1 Time
14
Y
Likewise, if, N = 3; then initial money holding is ; which becomes zero at the end of the
3
specific sub-period.
Y/3+0 Y
Money Hence, average money holding during this period = =
2 6
Holding Y/3
O 1/3 2/3 1 Time
Y
Generalizing, when there are ‘N’ number of transactions, then initial money holding is ; which
N
becomes zero at the end of the specific sub-period. Hence, average money holding during this
Y/N+0 Y Y
sub-period = = . That is for holding money instead of bond forgone interest = r x .
2 2N 2N
As, already mentioned transaction cost = NA
Y rY
Hence total cost (TC) = Forgone interest + transaction cost = r x + NA = + NA
2N 2N
Given Y, r, and A, the individual chooses ‘N’ to minimize total cost.
Following minimization rule, we can write:
∂TC rY rY
=A‒ = 0; Or, N2 =
𝜕N 2N2 2A
rY
Therefore, the cost-minimizing value of N = √
2A
Now, to obtain the money demand function, we put this in the expression for average money
Y
holdings = .
2N
Y Y AY
Hence, average money holding =
2N
= = √ 2r
rY
2√2A
According to Baumol-Tobin model, money demand thus, depends positively on income (Y) and
frequency of transaction (A), and negatively on interest rate (r).
15
