THEORY OF DEMAND
FOR MONEY
CLASSICAL APPROACH
Emphasis on transactions demand for money in terms of velocity of circulation of
money
Money is a medium of exchange
Irving Fisher’s Equation of exchange
MV = PT
M = Money supply
V = Transactions velocity of money
P = Price level
T = Transactions
PT represents the demand for money based on the total value of the transactions
in the economy
MV represents supply of money which is given
Assumption of full employment – thus, T is constant
Demand for money changes directly and proportionally with changes in the
price level
Velocity and demand for money are inversely related
Md = PT/V or MV = PT
Md = demand for money
Keynesian approach
Money has two functions: medium of exchange and store of value
People’s desire to hold money in the form of cash or their preference for liquidity is due to
fear and uncertainty regarding the future
Motive for holding money
Transactions motive
Precautionary motive Speculative motive
Transactions motive
People require money to carry out their day to day transactions but most of them
do not receive income daily
Time gap between successive income receipts
1. Income motive: transactions demand for money by wage and salary earners
2. Business motive
Amount of money held for transactions depends on- level of income, time interval,
price level and volume of employment
The precautionary motive
Money held for contingencies requiring sudden expenditure and for unforeseen
opportunities of advantageous purchase
Illness, accidents, emergencies
Business people may demand money to take advantage of favourable market conditions
Demand for money varies directly with income
These two motives are interest inelastic. ( except for a very high rate of interest )
Transactions and Precautionary demand for money
Demand for both these motives is dependent on income and is interest inelastic. It is
unlikely that people may reduce their cash balances to earn additional income offered by
attractive interest rate.
Transaction and precautionary demand for money
Demand for money is unaffected by interest rates. It is also known as demand for “active
cash balances”. It depends upon level of income.
L1 = f(Y)
Speculative demand
Store of value function of money
Asset demand for money
Related to uncertainty
People desire to gain by purchasing financial assets at a low price and selling when their prices
rise
the speculative demand for money is interest elastic.
People do not hold cash when the rate of interest is high because :
a) The Opportunity cost of holding cash is high
b) Security prices at that time being low, people wish to buy them
Besides these reasons, the expectations regarding the market rate of interest and security prices
also play an important role in determining the speculative demand for money
Liquidity trap
The inverse relation between the rate of interest and speculative demand for money at very
low rates of interest is explained by the liquidity trap.
At very low rate of interest, the speculative demand for money becomes perfectly elastic.
i.e. At very low rates of interest people prefer to hold money in cash rather than in the form
of a security and gain from the market.
In the diagram on the right, the liquidity trap is seen as TL2. At such a low rate of interest
people prefer to hold cash ( liquid ) rather than investing in assets.
Speculative demand for money and liquidity trap
Total demand for money
The total demand for money Md is made up of three motives.
Md = L1 (y) + L2 (r )
L1 = Transaction and Precautionary motives. These are an increasing function of level of
income
L2 = Speculative motive is a decreasing ( inverse ) function of rate of interest.
Friedman’s Theory of Demand for Money
According to Friedman, individuals hold money for the services it provides to
them
Like other capital assets, money also yields return and provides services.
The value of goods and services which money can buy represents the real yield
on money
Friedman’s nominal demand function (Md) for money can be written as:
Md stands for nominal demand for money and Md/P for demand for real money balances
W stands for wealth of the individuals
h for the proportion of human wealth to the total wealth held by the individuals
rm for rate of return or interest on money
rb for rate of interest on bonds, re for rate of return on equities
P for the price level
∆P/P for the change in price level (i.e. rate of inflation)
U for the institutional factors.
Wealth:
In wealth Friedman includes not only non-human wealth such as bonds, shares, money
which yield various rates of return but also human wealth or human capital.
Individual’s demand for money directly depends on his total wealth
Since as compared to non- human wealth, human wealth is much less liquid, Friedman has
argued that as the proportion of human wealth in the total wealth increases, there will be a
greater demand for money to make up for the illiquidity of human wealth.
Rates of Interest or Return (rm, rb, re):
money held as saving deposits and fixed deposits earns certain rates of interest and it is this
rate of interest which is designated by r m in the money demand function
higher the own rate of interest, the greater the demand for money
As rates of return on bond (rb) and equities (re) rise, the opportunity cost of holding money
will increase which will reduce the demand for money holdings
Thus, the demand for money is negatively related to the rate of interest (or return) on
bonds, equities and other such non-money assets.
Price Level (P):
A higher price level means people will require a larger nominal money balance in order to
do the same amount of transactions, that is, to purchase the same amount of goods and
services
As the price level goes up, the demand for money will rise and, on the other hand, if price
level falls, the demand for money will decline.
People adjust the nominal money balances (M) to achieve their desired level of real money
balance (M/P).
The Expected Rate of Inflation (∆P/P):
If people expect a higher rate of inflation, they will reduce their demand for money
holdings.
This is because inflation reduces the value of their money balances in terms of its power to
purchase goods and services.
If the rate of inflation exceeds the nominal rate of interest, there will be negative rate of
return on money.
Therefore, when people expect a higher rate of inflation they will tend to convert their
money holdings into goods or other assets which are not affected by inflation.
On the other hand, if people expect a fall in the price level, their demand for money
holdings will increase.
Institutional Factors (U):
Institutional factors such as mode of wage payments and bill payments also affect the
demand for money.
Several other factors which influence the overall economic environment affect the demand
for money.
For example, if recession or war is anticipated, the demand for money balances will
increase.
Besides, instability in capital markets, which erodes the confidence of the people in
making profits from investment in bonds and equity shares, will also raise the demand for
money.
Even political instability in the country influences the demand for money.
To account for these institutional factors Friedman includes the variable U in his demand
for money function.
References-
https://www.economicsdiscussion.net/money/top-5-theories-of-demand-for-money/10465
