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Bond prices and the rate of interest are inversely related to each other. The way in which these factors affect money demand is usually explained in terms of the three motives for demanding money: the transactions, the precautionary, and the speculative motives. The line or is the budget line of the risk averter. 600. They accept risk of loss in exchange for the income they accept from bonds. The Expected Rates of Return on Money and Other Assets: These rates of return are the counterparts of the prices of a commodity and its substitutes and complements in the theory of consumer demand. 100 each at the market price of Rs. This demand for money curve relates to the speculative demand for money and not to the aggregate demand for money. Speculative demand for money occupies a strategic position in Keynesian theory of demand for money. Thus the demand for money in Fisher’s approach is a constant proportion of the level of transactions, which in turn, bears a constant relationship to the level of national income. Thus, according to Friedman, income is a surrogate of wealth. But the other factors are important. According to Keynes, it relates to “the need of cash for the current transactions of personal and business exchange.” It is further divided into income and business motives. Panel (B) shows the speculative demand for money at various rates of interest. 200 each when the rate of interest falls (to 2 per cent). In this respect, Tobin regards his theory as a logically more satisfactory foundation for liquidity preference than the Keynesian theory. This relationship between an individual asset holder’s demand for money and the current rate of interest gives the discontinuous step demand for money curve LMSW. for converting cash into bonds, and vice versa. 1. Third, the policy of a general wage cut cannot be efficacious in the face of a perfectly elastic liquidity preference curve, such as Ls in Figure 5. Equation (2) shows that if the brokerage fee increases, the number of withdrawals will decrease. 2. They are prepared to bear some additional risk only if they expect to receive some additional return on bonds, provided every increase in risk borne brings with it greater increase in returns. Empirical evidence suggests that the income elasticity of demand for money is greater than unity which means that income velocity is falling over the long run. One of the primary research areas for this branch of economics is the quantity theory of money. •Thus, from the view point of yield and risks of holding money, M2 is more appropriate. Demand for money 1. The figure shows that at a very high rate of interest r12, the speculative demand for money is zero and businessmen invest their cash holdings in bonds because they believe that the interest rate cannot rise further. The holding of cash balances consists of interest cost and non-interest costs. Report a Violation 11. James Tobin in his famous article “Liquidity Preference as Behaviour Towards Risk,” formulated the risk aversion theory of liquidity preference based on portfolio selection. For example, at r rate of interest, the total demand for money is OD which is the sum of transactions and precautionary demand OT plus the speculative demand TD, OD=OT+TD, where TD = OS. Baumol analyses the transactions demand for real balances thereby emphasizing the absence of money illusion. Theories of Demand for Money - Free download as Word Doc (.doc), PDF File (.pdf), Text File (.txt) or read online for free. Points on I2 curve are preferred to those on I1 curve. Quantity Theory of Money Demand When market for money is in equilibrium, we have MD =MS Substitute this into the theory equation, and get Money demand is proportional to nominal income (V– constant) Interest rates have no effect on demand for money Underlying the theory is the belief that people hold money only for transactions purposes. Since Baumol takes the income elasticity of demand for money to be one-half (1/2), the demand for money will not increase in the same proportion as the increase in income. It also yields real return in the form of convenience, security, etc. Conversely, if the current rate of interest happens to be below the critical rate, businessmen expect it to rise and bond prices to fall. But the post-Keynesian economists believe that like transactions demand, it is inversely related to high interest rates. The income motive is meant “to bridge the interval between the receipt of income and its disbursement.” Similarly, the business motive is meant “to bridge the interval between the time of incurring business costs and that of the receipt of the sale proceeds.”. Out of this, it keeps $ 400 in cash for transactions purposes and buys bonds with the remaining amount of $800. It can refer to the demand for money narrowly defined as M1 (directly spendable holdings), or for money in the broader sense of M2 or M3. It is possible to “put funds to work for a matter of days, weeks, or months in interest-bearing securities such as U.S. Treasury bills or commercial paper and other short-term money market instruments. 50 each when the rate of interest is high (8 per cent), and sell them again when they are dearer (Rs. By income, Friedman means “permanent income” which is the average expected yield on wealth during its life time. The Keynesian Theory of Demand for Money Keynes’ theory of demand for money is known as ‘Liquidity Preference Theory’. The demand function for business is roughly similar, although the division of total wealth and human wealth is not very useful since a firm can buy and sell in the market place and hire its human wealth at will. For instance, at r. rate of interest it is OS and as the rate of interest falls to r2, the Ls curve becomes perfectly elastic. It shows how the money demand function fits intostatic and dynamic macroeconomic analyses and discusses the problem ofthe definition (aggregation) of money. This approach includes time and saving deposits and other convertible funds in the demand for money. The demand for money curve can thus be drawn on the basis of figure 9. The theories are: (1) Fisher’s Transactions Approach, (2) Keynes’ Theory, (3) Tobin Portfolio Approach, (4) Boumol’s Inventory Approach, and (5) Friedman’s Theory. It is a smooth curve which slopes downward from left to right, as shown in Figure 5. Keynes visualised conditions in which the speculative demand for money would be highly or even totally elastic so that changes in the quantity of money would be fully absorbed into speculative balances. What is known as the Keynesian theory of the demand for money was first formulated by Keynes in his well-known book, The Genera’ Theory of Employment, Interest and Money (1936). The Demand for Money: Theoretical and Empirical Approaches. Content Guidelines 2. Further, in the Keynesian analysis the speculative demand for money is analysed in relation to uncertainty in the market. With a further fall in the interest rate to r6, it rises to OS1 But at a very low rate of interest r2, the Ls curve becomes perfectly elastic. Changes in the transactions balances are the result of movements along a line like kY rather than changes in the slope of the line. Bonds, treasury bills or treasury certificates are not included in the theory of the demand for money. 13.2.1 Classical approach to demand for money 13.2.2. StudentShare. Instead, income may serve as an index of wealth. Uploader Agreement. Baumol-Tobin Money Demand Model(s) These are further developments on the Keynesian theory Variations in each type of money demand: transactions demand is also affected by interest rates so is precautionary demand speculative demand is affected not only by interest rates but also by relative riskiness of available assets Bottom line: demand for money is still positively Nonetheless, with the cost per purchase and sale given, there is clearly some rate of interest at which it becomes profitable to switch what otherwise would be transactions balances into interest-bearing securities, even if the period for which these funds may be spared from transactions needs is measured only in weeks. These are Rm, the yield on money; Rb, the yield on bonds; Re, the yield on securities; gp, the yield on physical assets; and u referring to other variables. A Meta-Theory of the Demand for Money and the Theory of Utility1 Michael Ellwood 0044 7881 998649 email@example.com www.economictheoriespro.com Abstract This theory postulates that the demand for any good or service is derived from an underlying need. Discover everything Scribd has to offer, including books and audiobooks from major publishers. When the rate of interest is râ€ž they hold OB, bonds and B1 W money. Prohibited Content 3. Keynes theory is also called a demand-for-money theory. Fifth, according to David Laidler, the real importance of the portfolio theory lies in “not what it tells directly about the aggregate economy, but rather it represents an interesting approach to the problem of relating demand for money to the existence of uncertainty, an approach that probably has scope for considerable development in the future.”. For ultimate wealth holders, the demand for money, in real terms, may be expected to be a function primarily of the following variables: The total wealth is the analogue of the budget constraint. Money held for speculative purposes is a liquid store of value which can be invested at an opportune moment in interest-bearing bonds or securities. Further, according to Keynes, “a long-term rate of interest of 2 per cent leaves more to fear than to hope, and offers, at the same time, a running yield which is only sufficient to offset a very small measure of fear.” This makes the Ls curve “virtually absolute in the sense that almost everybody prefers cash to holding a debt which yields so low a rate of interest.”, Prof. Modigliani believes that an infinitely elastic Ls curve is possible in a period of great uncertainty when price reductions are anticipated and the tendency to invest in bonds decreases, or if there prevails “a real scarcity of investment outlets that are profitable at rates of interest higher than the institutional minimum.”. This is because the total wealth in the portfolio consists of bonds plus money. But people also hold money for other reasons, such as to earn interest and to provide against unforeseen events. The former consist of transactions and precautionary motives, and the latter consist of the speculative motive for holding money. Thus there is no effect on income. For them, money performed a neutral role in the economy. The demand for money is the amount of money individuals in an economy wish to hold at a particular point in time. If the current rate of interest (r) is above the “critical” rate of interest, businessmen expect it to fall and bond prices to rise. One, Keynes’s liquidity preference function depends on the inelasticity of expectations of future interest rates; and two, individuals hold either money or bonds. It is OP of bonds shown as B, and PW of money shown as M in the figure. The modern view is that the transactions demand for money is a function of both income and interest rates which can be expressed as. If the market rate of interest falls to 2 per cent, the value of the bond will rise to Rs. Economics, Monetary Economics, Money, Demand, Demand for Money. As the rate of interest falls to say, r8 the speculative demand for money is OS. where V is the current market value of a bond, R is the annual return on the bond, and r is the rate of return currently earned or the market rate of interest. When a firm or an individual purchases large number of bonds, it is left with small transactions balances and vice versa. Suppose the firm has $ 1,200 which it has to spend every quarter at a constant rate over the year. Another weakness of the quantity theory of money is that it concentrates on the supply of money and assumes the demand for money to be constant. Demand is simply the quantity of a good or service that consumers are willing and able to buy at a given price in a given time period. If g is the expected capital gain or loss, it is assumed that the investor bases his actions on his estimate of its probability distribution. The way in which these factors affect money demand is usually explained in terms of the three motives for demanding money: the transactions, the precautionary, and the speculative motives. Interest cost is in the nature of opportunity cost because when a firm holds cash balances for transactions purposes it forgoes interest income. 300. There is a fixed cost in exchanging bonds for cash and vice versa. The present discounted value of these expected income flows from these five forms of wealth constitutes the current value of wealth which can be expressed as: where W is the current value of total wealth, y is the total flow of expected income from the five forms of wealth, and r is the interest rate. Content Filtration 6. They will, therefore, sell bonds in the present if they have any, and the speculative demand for money would increase. Permanent income is the amount a wealth holder can consume while maintaining his wealth intact. which the purchaser has to pay. Objectives: After studying this lesson, you will be able to understood, • • • 13.1 The defination of demand for money The different approaches to …, 77% found this document useful (13 votes), 77% found this document useful, Mark this document as useful, 23% found this document not useful, Mark this document as not useful, Save Theories of Demand for Money For Later. Second, Friedman postulates a demand for money function quite different from that of Keynes. They will either put all their wealth into bonds or will keep it in cash. For ultimate wealth holders, the demand for money, in real terms, may be expected to be a function primarily of the following variables: 1. 3. Income can change without any change in the quantity of money. The demand for money is affected by several factors, including the level of income, interest rates, and inflation as well as uncertainty about the future. According to him, money is held for a variety of different purposes which determine the total volume of assets held such as money, physical assets, total wealth, human wealth, and general preferences, tastes and anticipations. “When the price of bonds has been bid up so high that the rate of interest is, say, only 2 per cent or less, a very small decline in the price of bonds will wipe out the yield entirely and a slightly further decline would result in loss of the part of the principal.” Thus the lower the interest rate, the smaller the earnings from bonds. People will not buy bonds so long as the interest rate remains at the low level and they will be waiting for the rate of interest to return to the “normal” level and bond prices to fall. 11 3. It is CD in Figure 10. This means that the long-run demand for money function is stable and is relatively interest inelastic, as shown in Fig. “Thus we conclude that the chief determinant of changes in the actual amount of the transactions balances held is changes in income. This theory removes two major defects of the Keynesian theory of liquidity preference. But it does not explain fully why people hold money. ‘Liquidity preference’, a term that was coined by John Maynard Keynes in his masterpiece ‘The General Theory of Employment, Interest and Money’(1936), denotes people’s desire to hold money rather than securities or long-term interest-bearing investments. Baumol’s theory is based on the following assumptions: 1. “On a $ 1000 bond purchase, minimum brokerage fees can be costly. Theory 1# Fisher’s Transactions Approach to Demand for Money: In his theory of demand for money Fisher and other classical […] The income to which cash balances (M/P) are adjusted is the expected long-term level of income rather than current income being received. When the money involved in transactions is larger, the smaller will be the brokerage costs. An investor can bear this risk if he is compensated by an adequate return from bonds. The problem here is that there is a cost involved in buying and selling. Thus Y/K is the number of withdrawals that occur over the year. 1000 and 1200crores, transactions balances would be Rs. Since the average cash withdrawal are K/2, the interest cost of holding cash balances is rK/2. In the lower portion of the figure, the length of the vertical axis shows the wealth held by the risk averter in his portfolio consisting of money and bonds. Transaction demand for money. What are the determinants of liquidity preference? Money in the Utility Function Thus money is luxury good. This also means that the demand for money falls by smaller amounts, as the rate of interest increases. The Demand for Money Portfolio Theories of Money Demand •Portfolio theories are applicable when we consider broad money. Copyright 10. Bonds, treasury bills or treasury certificates are not included in the theory of the demand for money. When r falls below rc, the individual expects more capital losses on bonds as against the interest yield. The Cambridge Equation & the Debate of Money Demand. In this case, changes in the quantity of money have no effects at all on prices or income. The have also pointed out that the relationship between transactions demand for money and income is not linear and proportional. The most important thing about money in Fisher’s theory is that it is transferable. Last, if new money is created, it instantly goes into speculative balances and is put into bank vaults or cash boxes instead of being invested. Bonds are defined as claim to a time stream of payments that are fixed in nominal units. It depends on both prices and quantities of goods traded. Consequently, the Ls curve will become perfectly elastic. The higher the rate of interest, the larger the expenses which a firm can absorb in making bond purchases. It shows the combinations of risk and expected return on the basis of which he arranges his portfolio of wealth consisting of money and bonds and l2 are indifference curves. The higher the rate of interest, the lower the speculative demand for money, and the lower the rate of interest, the higher the speculative demand for money. Keynes in his General Theory used a new term “liquidity preference” for the demand for money. In fact, an individual spreads his expenditure evenly over the month. Equation (3) shows that the demand for real transactions balances “is proportional to the square root of the volume of transactions and inversely proportional to the square root of the rate of interest.” It means that the relationship between changes in the price level and the transactions demand for money is direct and proportional. Thus monetary changes have a weak effect on economic activity under conditions of absolute liquidity preference. The demand for money theory is the main element of the monetary economics theory and an essential part in the macroeconomic theory. He treats money as an asset or capital good capable of serving as a temporary abode of purchasing power. b.Brokerage fees decline, making bond transactions cheaper. The purpose is speculation. At the same clip, each state ‘s authorities, policy shaper and economic expert takes it earnestly on economic control. This is depicted in Figure 10 as the Ls curve. Variables other than income may affect the utility attached to the services of money which determine liquidity proper. Broadly, total wealth includes all sources of income or consumable services. where LT is the transactions demand for money, k is the proportion of income which is kept for transactions purposes, and Y is the income. Then the total cost of making transactions, C, may be written in equation form as: The optimal value of K is that which minimizes the total inventory cost C. By differentiating C with respect to K, setting the derivative dC/dK equal to zero, and solving for C, we obtain. In the Keynesian theory, the demand for money as an asset is confined to just bonds where interest rates are the relevant cost of holding money. Since precautionary demand, like transactions demand is a function of income and interest rates, the demand for money for these two purposes is expressed in the single equation LT = f (Y,r).9 Thus the precautionary demand for money can also be explained diagrammatically in terms of Figures 2 and 3. Theories of the demand for money that emphasize the role of money as a store of value are called asset or portfolio theories. "The Demand for Money: Theoretical and EmpiricalApproaches" provides an account of the existing literature on thedemand for money. 1600 crores, the transactions demand also increases to Rs 400 crores, given k=1/4. All theories of demand for money give a different answer to the basic question: If bonds earn interest and money does not why should a person hold money? Thus the shape of the Ls curve shows that as the interest rate rises, the speculative demand for money declines, and with the fall in the interest rate, it increases. The transactions and precautionary demand for money will be unstable, particularly if the economy is not at full employment level and transactions are, therefore, less than the maximum, and are liable to fluctuate up or down. At the same time, each country’s government, policy maker and economist takes it seriously on economic control. Consequently, the transactions demand curve shifts to Y2 The transactions demand curves Y1 and Y2 are interest-inelastic so long as the rate of interest does not rise above r8 per cent. Therefore, “money held under the precautionary motive is rather like water kept in reserve in a water tank.” The precautionary demand for money depends upon the level of income, business activities, opportunities for unexpected profitable deals, availability of cash, the cost of holding liquid assets in bank reserves, etc. At such times; the speculative demand for money would fall. If the transactions demand falls due to a change in the institutional and structural conditions of the economy, the value of k is reduced to say, 1/5, and the new transactions demand curve is k’Y. Friedman calls the ratio of non-human to human wealth or the ratio of wealth to income as w. 3. Keynes held that the precautionary demand for money, like transactions demand, was a function of the level of income. Assuming k= 1/4 and income Rs1000crores, the demand for transactions balances would be Rs. In the following section, we will see the theory of demand … c.The stock market crashes. Baumol shows that the relation between transactions demand and income is neither linear nor proportional. Our website is a unique platform where students can share their papers in a matter of giving an example of the work to be done. Second, the rate of interest cannot fall to zero. 2 nd Edition. Tobin has removed both the defects. It shows how the money demand function fits into static and dynamic macroeconomic analyses and discusses the problem of the definition (aggregation) of money. Demand for money represents the wealth people hold in the form of money. Panel (A) of the Figure shows OT, the transactions and precautionary demand for money at Y level of income and different rates of interest. The classicists emphasized only the medium of exchange function of money which simply acted as a go-between to facilitate buying and selling. Thus point E on this line drawn as perpendicular from point T determines the portfolio mix of money and bonds. THEORIES OF DEMAND FOR MONEY This transactions demand for money, in turn, is determined by the level of full employment income. The amount of cash held for transactions purposes by the individual during each week is shown in saw-tooth pattern in Panel (B), and the bond holdings in each week are shown in blocks in Panel (C) of Figure 2. Now the problem is how to hold assets by a firm, “given that there exist interest-yielding bonds that can be owned as well as cash, and given that there is a fixed cost involved in exchanging bonds for cash.”. Monetary economics is a branch of economics that studies different theories of money. Thus the total demand for money can be derived by the lateral summation of the demand function for transactions and precautionary purposes and the demand function for speculative purposes, as illustrated in Figure 6 (A), (B) and (C). They will, therefore, diversify their portfolios, and hold both money and bonds. Moreover, it explains that an individual’s portfolio holds both money and bonds rather than only one at a time. The Post-Keynesian Approaches. On the other hand, the Keynesian definition of money consists of demand deposits and non-interest bearing debt of the government. Wealth can be held in five different forms: money, bonds, equities, physical goods, and human capital. Thus each form of wealth has a unique characteristic of its own and a different yield either explicitly in the form of interest, dividends, labour income, etc., or implicitly in the form of services of money measured in terms of P, and inventories. But the majority of investors belong to the third category. brokerage fees are lower. It is the interaction of this need with the functions of the good or THEORIES OF DEMAND FOR MONEY 2. At a very low rate of interest, such as r2, in Figure 5, the Ls curve becomes perfectly elastic and the speculative demand for money is infinitely elastic. If the income level rises to Rs. Theories of demand and supply for money. The slope of the budget line increases with the increase in the interest rate. I Liquidity preference theory of money demand posits that the demand for real money balances, m t = M t P t, is an increasing function of output, Y t, but a decreasing function of the nominal interest rate, i t: M t P t = L(i t,Y t +) I But then velocity: V t = P tY t M t = Y t L(i t,Y t) 21/37. This is shown by the budget line r1 rotating upward to r2 and r3 Consequently, returns increase in relation to risk with increase in the interest rate, and the budget line touches higher indifferences curves. A firm would always try to keep minimum transactions balances in order to earn maximum interest from its assets. The demand for money is a function of prices and income (assuming the velocity of circulation is stable.) Thus the Keynesian speculative demand for money function is highly volatile, depending upon the behaviour of interest rates. Given these assumptions, Baumol’s analysis is based on the holding of an optimum inventory of money for transactions purposes by a firm or an individual. But Baumol analyses the interest elasticity of the transactions demand for money. It has developed further by other economists of Keynesian persuasion. The demand for money is affected by several factors, including the level of income, interest rates, and inflation as well as uncertainty about the future. 6. The higher the interest rate on bonds, the lesser the transactions balances which a firm holds. He will, therefore, convert this idle money into interest-bearing bonds, as illustrated in Panel (B) and (C) of Figure 2. Prof. Baumol has analysed the interest elasticity of the transactions demand for money on the basis of his inventory theoretical approach. If the time between the incurring of expenditure and receipt of income is small, less cash will be held by the people for current transactions, and vice versa. No doubt it is true the transactions demand increases with increase in income but it increases less than proportionately because of the economies of scale in cash management. It refers to people’s preference for holding assets in liquid form at a given rate of interest.