Demand for Money

Under certain circumstances, barter exchange works. The complications associated with the requirements of a double coincidence of wants make the exchange of one good for another inefficient in the modern world. Money was invented to facilitate exchange. Money serves three functions. It is a medium of exchange, a measure of value, and a store of value. Some of the properties that money must have are that it must be durable, portable, divisible, homogeneous, and be relatively scarce. Gold has these characteristics and has long been used as money. Paper money called 'fiat money' works as well, as long as it is universally accepted as the medium of exchange. Money is usually described as a liquid asset because it exchanges easily for other assets.

Demand for Money:

Demand for money is a question of how much wealth individuals wish to hold in the form of money at any point in time. Individuals must decide how to allocate their wealth between different kinds of assets, for example, a house, income-earning securities, a checking account, and cash. The demand for money arises from two important functions of money. The first is that money acts as a medium of exchange and the second is that it is a store of value. Thus individuals and businesses wish to hold money partly in cash and partly in the form of assets. 

Theories of Demand for Money:

The theories of demand for money could be divided into three broad categories:
a) Classical theory of demand for money or the Quantity Theory of Money;
b) Keynesian theory of demand for money; and
c) Friedman’s restatement of the Classical Quantity Theory of Money.

The classical theory of demand for money or the Quantity Theory of Money

According to the Quantity Theory of Money, the value of money depends on the quantity of money in circulation at a given point of time in the economy. Essentially, the quantity theory of money hypothesizes that changes in the general price level are to be explained with reference to changes in the quantity of money in circulation. So, an increase in the quantity of money leads to an increase in the price level, while a contraction in the quantity of money leads to a decline in the general price level. 

The quantity theory of money has two approaches:

1) The Cash-transaction approach or Fisher's version

2) The Cash-balances approach or the Cambridge version.

The Cash Transaction Approach:

Originally propounded by Italian economist, Davnzatti in 1588 and later on accepted and refined by classical economists like David Ricardo, David Hume and J.S. Mill, the Quantity Theory of Money is indeed a very old theory. In 1911 it was made more popular by Irving Fisher with his mathematical equation:

Where M represents the total quantity of money in circulation, V indicates the velocity of circulation of money, P stands for the general price level (or average price per unit) and T represents the total volume of transactions. The left-hand side MV represents the supply of money and the right-hand side PT represents the demand for money. The value of money, according to this theory, varies inversely as the supply of money. In the language of G.S. Mill, “the value of money, other things being the same, varies inversely as its quantity; every increase of quantity lowers the value and every diminution raising it in ratio exactly equivalent”.

Irving Fisher’s equation    can also be expressed as   which implies that V and T remaining constant, the price level varies directly with the quantity of money. In this equation, only primary money is involved. This equation is expanded to include derivative money i.e. credit money.

Where M', V', represent the quantity of credit money and velocity of circulation of credit money. This extended version of Fisher implies that the price level is directly related to M, V, M' and V', and inversely related to T. Here Fisher considers M' V, V' and T as constant. Thus according to Fisher, there is a direct proportional relationship between P and M. The equation is based on the exchange value of money.

The Cash Balances Approach:

Cambridge economists like Pigou, Marshall, Canhan, Robertson and J.M. Keynes developed their theory based on the function of money as a store of value and it is known as the “cash balance approach”. The basic difference between the American and British economists is with regard to the interpretation of the term “demand for money”. While Fisher interpreted demand for money as a “medium of exchange”, Cambridge economists treated demand for money as a “store of value” due to liquidity preference. The Cambridge economists believe that the value of money at any time comes to be settled at a level at which the demand for money is equal to its supply. An increase in demand for money implies a fall in demand for goods and services and a consequent fall in price level when the value of money rises. A fall in demand for money implies larger demand for goods and services and the price level will rise; decreasing the value of money. 

Many cash balance equations have been formed by Cambridge economists in the process of attempting to establish a relationship between the supply of and demand for money. Some of them are discussed below briefly:

1. Pigou’s Equation: 

Where,

P = Purchasing power of money or value of money 

R = Aggregate real income 

K = Portion of R held by the public as cash balance 

M = Total money stock or cash held by community 

Pigou further extends the equation to include bank deposits as given below: 

Where,

c = the portion of money which is held by the public as legal tender 

h = the portion of cash reserve to deposits held by the banks 

1 - c = the proportion of total money which is held by the people as a bank deposit 

K declines during the period of inflation and K rises in the period of deflation. Pigou overlooked the changes in saving and investment. He ignored money as a medium of exchange. 

2. Marshall’s Equation:

 Where,

M = Total supply of money 

Y = aggregate real income 

K = Fraction of real income which the public desires to hold. 

We can derive the purchasing power of the value of money from this equation as: 

Therefore, according to Marshall the value of money is not only influenced by a change in M but also by a change in K. 

3. Robertson’s Equation:

Where,

P = Price level 

M = Supply of money 

T = Total amount of goods and services to be brought during a year 

K = that proportion of T which the people desire to hold in the form of cash 

Therefore, P varies directly as M and inversely as K or T. There is a similarity between Robertson’s and Fisher’s equation. In both equations P, M, T are synonymous and  . The only difference being Fisher interprets money as a medium of exchange whereas Robertson treats money as a store of value.

4. Keynes’ Equation:

The equation put forward by Keynes is known as “The real balance quantity equation”. It can be expressed as:

Where

n = the total supply of money in circulation

p = the general price level of prices of consumption goods

k = real balance i.e. the total quantity of consumption units which the people decide to keep in the term of cash.

Keynes’ Liquidity Preference Theory

In his famous 1936 book The General Theory of Employment, Interest, and Money, Keynes developed a theory of money demand which he called liquidity preference theory. Keynes abandoned the classical view that velocity was a constant, emphasized the importance of interest rates. He postulated that there are three motives behind the demand for money: the transactions motive, the precautionary motive, and the speculative motive.

Transactions motive: 

Keynes emphasized that this component of the demand for money is determined primarily by the level of people’s transactions. The transactions demand for money arises from the lack of synchronization of receipts and disbursements. In other words, people aren’t likely to get paid at the exact instant you need to make a payment, so between paychecks, people keep some money around in order to buy stuff. Keynes believed that these transactions were proportional to income, like the classical economists, he considered the transactions component of the demand for money to be proportional to income.

Precautionary motive: 

Keynes also recognized people hold money not only to carry out current transactions but also as a cushion against an unexpected need. Because people are uncertain about the payments they might want, or have, to make. If people do not have money with which to pay, they will incur a loss. When you are holding precautionary money balances, you can take advantage of the sale. Keynes believed that the amount of precautionary money balances people want to hold is determined primarily by the level of transactions that they expected to make in the future and that these transactions are proportional to income. So he considered the demand for precautionary money balances to be proportional to income.

Speculative motive: 

The transactions motive and the precautionary motive for money emphasized the medium–of-exchange function of money, for each refers to the need to have money on hand to make payments. Keynes agreed with the classical Cambridge economists that money is a store of wealth and called this reason for holding money the speculative motive. He also considered that wealth is tied to closely to income, the speculative component of money demand would be related to income. Keynes believed that interest rates have an important role to play in influencing the decisions regarding how much money to hold as a store of wealth. Keynes divided the assets that can be used to store wealth into two categories: money and bonds. He also asked why individuals would decide to hold their wealth in the form of money rather than bonds. Keynes assumed that the expected return on money was zero in his time, unlike today. For bonds, there are two components of the expected return: the interest payment and the expected rate of capital gains. As we know, when interest rates rise, the price of a bond falls. If you expected interest rates to rise, you expect the price of the bond to fall and suffer negative capital gains. In this case, people would want to store their wealth as money because its expected return is higher; it's zero return exceeds the negative return on the bond. Keynes assumed that individuals believe that interest rates gravitate to some normal value. When interest rates are below the normal value, people expect the interest rate on bonds to rise in the future and so expect to suffer a capital loss on them. Therefore, people will be more likely to hold their wealth as money rather than bonds, and the demand for money will be high. And contrariwise, they will be more likely to hold bonds than money, and the demand for money will be quite low. Therefore, money demand is negatively related to the level of interest rates. Keynes carefully distinguished between nominal quantities and real quantities. He reasoned that people want to hold a certain amount of real money balances (an amount that the three motives indicated would be related to real income Y and to interest rates i. 

Keynes developed the following demand for money equation, known as the liquidity preference function, which says that the demand for real money balances Md/P is a function of i and Y:

Where the minus sign below i in the liquidity preference function means that the demand for real money balances is negatively related to the interest rate, and plus sign below Y means that the demand for real money balances and real income Y are positively related. Keynes thought that the demand for money is related not only to income but also to interest rates. 

Because the transactions motive and precautionary motive demand for money are positively related to real income Y, speculative motive demand for money is negatively related to interest rate i, the demand for real money balances Md/P can be rewritten as:

 

Where    means the transactions demand for money;  means the speculative demand for money. By deriving the liquidity preference function for velocity  , we can see that Keynes’s theory of the demand for money implies that velocity is not constant but instead fluctuates with movements in interest rates. The liquidity preference equation can be rewritten as:

      

Multiplying both sides of this equation by Y and recognizing that  can be replaced by M because they must be equal in money market equilibrium, we solve for velocity:

    

Keynes’ liquidity preference theory of the demand for money indicates that velocity has substantial fluctuations as well. 

Additional notes:

The classical theory of demand for money, popularly known as the Quantity Theory of Money (QTM), is basically is a theory of the price level. However, under the influence of Keynes, the theory of demand for money became a theory of the rate of interest, output and employment. Friedman later tried to rescue the quantity theory of money through his restatement. In his version of the theory of demand for money he completely neglected Keynes’ classification of motives for holding money and corresponding components of the demand for money. Instead of motives, he identified the key determinants of the demand for money. 

Reading List: 

1. Jhingan, M.L. (2012), Micro Economic theory (12th edition). Vrinda Publications Pvt. Ltd, Delhi. 

2. Rana, K.C., & Verma, K.N. (2009), Micro Economic theory (8th edition). Vishal Publishing co, India

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