02 - Theories of the

Demand for Money

3 primary functions of money

1. Medium of Exchange
• It’s the most liquid part of wealth. Which can be most readily exchanged for
goods & services. An item that buyers give to sellers when they purchase goods
and services (i.e., facilitate transaction).
2. Unit of Account
• Money has a agreed value, to evaluate cost of goods & services, assest & liabilities. An
agreed 3.

3. Store of Value
• its 1 form of assets that can store value over time. Land & gold are also used to store
wealth. Money can also be saved & retrieved it holds its value over time.

Fisher’s Quantity theory of money

Money demand refers to the desire for holding financial assets in the form of money.
If you hold your wealth in the form of money it gives you the advantage of liquidity.
However, holding money gives you no interest (dis-adv), also its loses purchasing power
during inflation (Dis-adv). This indicates that there is a trade-off between liquidity advantage &
interest advantage.

Fisher’s quantity theory of money stresses the connection between changers in the economy’s
money stop. & Changers in the general price level.

M*V=P*T

Quantity of money Velocity → avg time a $ is General

Aggregate out of the
(economy’s money stop) spend per year Price level
economy (GDP)
The important concept in the Fisher’s theory is the velocity of money. It is calculated by

V = total spending / quantity of money

Or

The theory assumed that the:

01. velocity is fairly constant in the short run.
→ Velocity is affected by the technology (rapidity of transportation of goods & services &
nature of banking system). Which changers very slowly over time.

02. Transactions/aggregate income is also constant in the short-run

→Here we assume that the output will be at full employment level

Since both V & T are constant, if money supply doubles, price levels must also double. Therefore,
quantity of money is proportionate to the change of price level.

Due to this money demand becomes a function of income.

Activity

i. What was the motive that informed Fisher’s money demand?

ii. What was the main factor influencing money demand?
iii. What is the role of interest rates under Fisher?
iv. What does Fisher say about the velocity of money?

1. Motive the theory in this case is transaction demand for money

2. Income
3. It has not discussed about the interest rate
4. According to the theory, its assumed fairly constant in the short run

Under the velocity its no longer constant therefore the fisher’s theory in no longer valid.
Keynes’ Liquidity Preference Theory

• Keynes (1936) developed his theory of money demand:

– abandoned classical view that velocity was constant
– identified a link between money and interest rates.

• Individuals hold money for three motives:

– Transactions Motive
– Precautionary Motive
– Speculative Motive

(i) Transactions Motive (income)

• Individuals are assumed to hold money because it is a medium of exchange.
• Demand for money is determined primarily by the level of people’s transactions.
• Transactions were proportional to income:
– As income rises, people undertake more transactions and will hold more money.

(ii) Precautionary Motive (income)

• Individuals also hold money for unexpected needs and emergencies (i.e. different type
of transaction).
• Hence, demand for precautionary money balances is proportional to income.
– As income rises, people hold more money for potential emergency transactions.

(iii) Speculative Motive (interest)

• This motive is the money demand for investment purposes.
• Most important contribution of Kayne’s to the theory of money Demand
• Accordingly, Kayne’s assumed 2 assets where people can store wealth such as
• Money (expected return is zero)
• Bonds (expected return through interest & there is risk associated
with it)

Q.
What is relationship between interest rate & bond prices?

Case1 :
Assume you have a bond which has a price $1000 & the current interest rate is 10% per annum.
Calculate the expected return at the end of 1sy year (yield)

$1000*10% = $100

Assume the interest is increased to 15% your return or loss when selling the bond
X*15% = $100
X = $100/15%
X = $666.67

A capital loss of = $1000 - $666.67 = $333.33

Interest rate increases : Bond Price decreases → (-) relationship

Therefore, speculative demand for money will decrease

There is a (-) relationships between interest rate & speculative demand for money

Velocity under Kayne’s Theory

Starting from a position of equilibrium in the money & bonds markets & anticipated increase in
the supply of money, causes interest rate to fall & money demand to increase. Therefore, when
interest rate increases people will hold low real money balances at a given level of income, then
velocity increases because people convert more bonds to cash.

(+) relationship, as interest rate increases there’s a capital loss. To avoid the capital loss people,
sell the bonds, as a result more money circulating in the economy.
Micro Theory of Keynes’s LPF (Liquidity Preference theory)

To decide whether to keep or hold bonds convert to cash agents must compare
the interest rate payable on bonds with the risk of capital loss of holding them.
This requires a decision regarding likely future bond price.

Keynes assumed that every person at any time holds a view of the likely interest rate in the.
Economy that is the interest rate he or she regarded as “normal interest rate”.

If the current interest rate is < normal If the current interest rate is > normal
interest. Rate interest. Rate
Agents would anticipate a RISE in the Agents would anticipate a FALL in the
interest rate. Therefore, at a LOWER interest interest rate. Therefore, at a HIGHER interest
rate, bond prices will fall and people will rate, bond prices will INCREASES people will
switch from bonds to money & money switch from MONEY to BONDS & money
demand will increase. (People will sell bonds) demand will DECREASE. (People will buy
bonds)

Therefore normal interest rate will show the interest of people switching between bonds &
cash
Criticisms of LPT
• Keynes assumed that if the interest rate is likely to rise (and the bonds processes fall)
causes a switch between bonds to cash entirely & visa versa. It is clearly unrealistic at
 micro level because the rational level dictated a portfolio of diversification & the holding
of a mixture of bonds & cash.

Baumol-Tobin (B-T) Transaction demand / Inventory theoretic model

In this model they’ve considered that the balances set aside for transaction
purposes are held temporary in the form of securities & it can be converted easily
into money when needed to purchase goods & services. However, in this
conversion processes bonds to money & money to bonds there is a “transaction
cost” (fees, commission, transportation etc…) which also affected money
demand. When transaction cost is high it reduces the demand for bonds or
securities, this will increase the demand for money.

In Keynes LPF the opportunity cost of holding money for transaction purposes aren’t
recognised. Here it says that when keeping money for transaction purposes when the interest
increases therefore holding money for te transaction purposes will decrease. Therefore, the
transaction demand for money inversely related to the interest rate.

As a summary BT transaction model means holding money for transaction purposes is positively
related to the transaction cost & negatively related to Interest rate.

B-T Precautionary Demand

Here it says that there is an opportunity cost of holding money for precautionary purposes.
When interest rate is high then opportunity cost of holding money for precautionary purposes
will be high & therefore money demand for precautionary purpose will be low.

As a summary for precautionary purpose the money demand will negatively related to the
interest rate.

B-T Speculative Demand

Hence limit its speculative demand to only money and bonds, but B-T model assume a portfolio
a portfolio approach. This means that individuals have a mix of assets in the portfolio & their
choice between money & bonds is depends on expected return trade-off & the degree of risk
associated with the total portfolio of bonds & money.

Money = 0 return & 0 Risk

Bond = high risk & high return

Therefore, in portfolio approach of money & bonds its possible to reduce risk by having low risk
low return assets or high risk high return assets. Individuals can choose a mix of theses 2 types
of assets based on risk & expected return trade off.

Freidman’s modern quantity theory of money

Freidman (1956) applied the “assets demand theory” to identify factors influencing money
demand. He didn’t specify as Keynes did any particular motive for holding money. He viewed
money as a durable good yielding a flow of non-observable services. He also assumed that
money competes with other assets, such as bonds, stocks & physical goods.
(Money is considered as a durable product)

It where money has to compete with these assets in individual’s portfolio. Therefore, the
demand for money should be a function of
1. The resources available for individuals (their wealth)
2. Expected return of other assets relative to expected return on money