In monetary economics, the quantity theory of money (QTM) states that the general price level of goods and services is directly proportional to the amount of money in circulation, or money supply.For example, if the amount of money in an economy doubles, QTM predicts that price levels will also double. This perfectly elastic portion of liquidity preference curve indicates the position of absolute liquidity preference of the people. The above function implies that money held under the transactions and precautionary motives is a function of income. In fact, the demand for money is the quantity of money that people want to hold. If income is taken as a proxy for total wealth then even speculative demand for money will depend upon the size of income, apart from the rate of interest. Keynes theory is also called a demand-for-money theory. There are different concepts of the demand for money. Therefore, at higher interest rates people tend to hold less money for transaction purposes. On the other hand, a rich man will tend to hold more money for transactions motive as his expenditure will be relatively greater. John Maynard Keynes created the Liquidity Preference Theory in to explain the role of the interest rate by the supply and demand for money. He shows how a theory of the stable demand for money becomes a theory of prices and output. We can write this in a functional form as follows: where Y stands for income, L1 for demand function, and M1 for money demanded or held under the transactions and precautionary motives. According to Keynes, the transactions demand for money depends only on the real income and is not influenced by the rate of interest. Besides, price elasticity of demand is also not necessarily equal to unity. On the other hand, if people expect a fall in the price level, their demand for money holdings will increase. Now, which scheme will he decide to adopt? It may be noted that money is not demanded for its own sake but because it can be used to purchase economic goods and services. The reason for this inverse correlation between money held for speculative motive and the prevailing rate of interest is that at a lower rate of interest less is lost by not lending money or investing it, that is, by holding on to money, while at a higher current rate of interest holders of cash balance would lose more by not lending or investing. Several other factors which influence the overall economic environment affect the demand for money. Given the other rates of interest or return, the higher the own rate of interest, the greater the demand for money. This means, like Keynes’ speculative demand for money, in Tobin’s portfolio approach demand function for money as an asset (i.e. Aggregate demand for money consists of two large parts - the demand for money as a medium of circulation and the demand for money as a special asset. In this video clip I explain the demand for money in terms of the liquidity preference theory of Keynes. purchases) of goods and services. Speculative demand for money occupies a strategic position in Keynesian theory of demand for money. This theory was developed by James Tobin. Thus. How much of his income or resources will a person hold in the form of ready money (cash or non-interest-paying bank deposits) and how much will he part with or lend depends upon what Keynes calls his “liquidity preference.” Liquidity preference means the demand for money to hold or the desire of the public to hold cash. However, Baumol and Tobin have shown that transactions demand for money is sensitive to rate of interest. Bonds, treasury bills or treasury certificates are not included in the theory of the demand for money. But the demand for money to satisfy the speculative motive does not depend so much upon what the current rate of interest is, as on expectations about changes in the rate of interest. His approach to demand for money does not consider any motives for holding money, nor does it distinguish between speculative and transactions demand for money. A) 5. American economist James Tobin, in his important contribution, explained that rational behaviour on the part of the individuals is that they should keep a portfolio of assets which consists of both bonds and money. demand for money holdings through the portfolio motive. If the individual is optimistic, he will take risks and purchase fewer bonds and shares. The asset motive states that people demand money as a way to hold wealth. Therefore, at a higher rate of interest people will try to economies the use of money and will demand less money for transactions. Aggregate demand for money consists of two large parts - the demand for money as a medium of circulation and the demand for money as a special asset. In fact, the equation (iii) is the money demand function, another way of interpreting Fisher’s equation of exchange. 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. Therefore, the higher the level of income, the greater the transactions demand for money at a given rate of interest. They do not deny the important relation between demand for money and the level of income. Share Your PPT File. In his well-known book, Keynes propounded a theory of demand for money which occupies an important place in his monetary theory. The major factor determining the demand for money is the wealth of the individual (W). Quantity Theory of Money. 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 Demand for Money: Theoretical and EmpiricalApproaches" provides an account of the existing literature on thedemand for money. A certain amount of ready money, therefore, is kept in hand to make current payments. He postulated that there are three motives behind the demand for money: the transactions motive, the precautionary motive, and the speculative motive. It will be seen that his money holdings of Rs. The Liquidity Preference Theory was introduced was economist John Keynes. This means that most of the people in the economy have liquidity preference function similar to the one shown by curve Md in Fig. Since these institutional and technological factors do not vary much in the short run, the transactions velocity of circulation of money (V) was assumed to be constant. The second problem which is faced in Fisher’s approach is that it is difficult to define and determine a general price level that covers not only goods and services currently produced but also capital assets just mentioned above. The Demand for Money Synopsis of Theory of Money Demand –Here people hold money when they expect bond prices to fall, that is, interest rates to rise, and thus expect that they would take a loss if they were to hold bonds. This is why the quantity theory of money is the theory of money demand. Tobin derived his liquidity preference function depicting relationship between rate of interest and demand for money (that is, preference for holding wealth in money form which is a safe and “riskless” asset. By introducing speculative demand for money, Keynes made a significant departure from the classical theory of money demand which emphasized only the transactions demand for money. Thus, it is proportional function of both price level (P) and real income (Y). For ultimate wealth holders, the demand for money, in real terms, may be expected to be a function primarily of the following variables: 1. A merit of this formulation is that it makes the relation between demand for money and income as behavioural in sharp contrast to Fisher’s approach in which demand for money was related to total transactions in a mechanical manner. 3# Tobin’s Portfolio Approach to Demand for Money: 4# Baumol’s Inventory Approach to Transactions Demand for Money: 5# Friedman’s Theory of Demand for Money: Money Supply: Importance, Concepts, Determinants and Everything Else. Thus the demand for money balances is demand for real rather than nominal balances. 6,000 in saving account which gives him interest of 5 per cent, his expenditure per day remaining constant at Rs. According to Fisher, MV = PT. For ultimate wealth holders, the demand for money, in real terms, may be expected to be a function primarily of the following variables: 1. The higher the interest rate, the greater the opportunity cost of holding money rather than non-money assets. The liquidity preference curve LP is downward sloping towards the right signifying that the higher the rate of interest, the lower the demand for money for speculative For this rule, it follows that a higher broker’s fee will raise the money holdings as it will discourage the individuals to make more trips to the bank. In other words, the interest rate is the ‘price’ for money. 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. In view of the desire of individuals to have both safety and reasonable return, they strike a balance between them and hold a mixed and balanced portfolio consisting of money (which is a safe and riskless asset) and risky assets such as bonds and shares though this balance or mix varies between various individuals depending on their attitude towards risk and hence their trade-off between risk and return. It is the interaction of this need with the functions of the good or Thus the speculative demand for money constitutes the main … On the other hand, when the rates of interest are low, opportunity cost of holding money will be less and, as a consequence, people will hold more money for transactions. Before publishing your Articles on this site, please read the following pages: 1. If the price level doubles, then the individual has to keep twice the amount of money balances in order to be able to buy the same quantity of goods. The demand for money is related to income, interest rates and whether people prefer to hold cash(money) or illiquid assets like money. Nor is there any empirical evidence supporting unitary income elasticity of demand for money. Simplifying Friedman’s Demand for Money Function: A major problem faced in using Friedman’s demand for money function has been that due to the non-existence of reliable data about the value of wealth (W), it is difficult to estimate the demand for money. THEORIES OF MONEY DEMAND First: Quantity Theory of Money • Quantity theory of money is a classical theory that related the amount of money in the economy to nominal income. The quantity theory of money is a framework to understand price changes in relation to the supply of money in an economy. Thus, the total value of transactions made is equal to PT. Why people hold money? The inverse relationship between the price of bonds and bond yields. 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. These include. According to him, it is for convenience and capability of it being easily used for transactions of goods that people hold money with them in preference to the saving deposits. Factors Which Increase the Demand for Money . These other influences remain in the background of the theory. PT) and Md as PT represents the total amount of work to be done by money as a medium of exchange. Therefore, Baumol asks the question why an individual holds money (i.e. That is, they prefer less risk to more risk at a given rate of return. Rates of Interest or Return (rm, rb, re):. 6000 (before 15th of a month he will be having more than Rs. The speculative motive of the people relates to the desire to hold one’s resources in liquid form in order to take advantage of market movements regarding the future changes in the rate of interest (or bond prices). Thus, individual faces a trade-off problem; the greater the amount of pay cheque he withdraws in cash, less the cost on account of broker’s fee but the greater the opportunity cost of forgoing interest income. People demand … This is shown in Fig. Money - Money - Monetary theory: The relation between money and what it will buy has always been a central issue of monetary theory. The average number of times a unit of money is used for transactions of goods, services and assets is called transactions velocity of circulation and is denoted by V. Symbolically, Fisher’s equation of exchange is written as under: Where, M = the quantity of money in circulation. Our site uses cookies so that we can remember you, understand how you use our site and serve you relevant adverts and content. Modern Monetary Theory or Modern Money Theory (MMT) is a heterodox macroeconomic theory that describes currency as a public monopoly and unemployment as evidence that a currency monopolist is overly restricting the supply of the financial assets needed to pay taxes and satisfy savings desires.. MMT is an alternative to mainstream macroeconomic theory. 400. 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. The demand for … The higher the rate of interest, the greater the opportunity cost of holding money (i.e. In fact, changes in the price level may cause non-proportional changes in the demand for money. The opportunity cost of holding money is the interest or return given up by not holding these other forms of assets. The fourth form in which people can hold their wealth is the stock of producer and durable consumer commodities. At a lower interest rate on bonds, saving and fixed deposits, the opportunity cost of holding money will be less which will prompt people to hold more money for transactions. Increasing the money supply doesn’t reduce interest rates and the impact of increasing the money supply is ineffective in boosting demand. Thus, demand for money under this motive is a decreasing function of the rate of interest. Understanding Demand Theory . Thus, Tobin’s approach, according to which individuals simultaneously hold both money and bonds but in different proportion at different rates of interest, yields a continuous liquidity preference curve. Keynes thought that transactions demand for money was independent of rate of interest. People hold money for transaction purposes “to bridge the gap between the receipt of income and its spending.” As interest rate on saving deposits goes up people will tend to shift a part of their money holdings to the interest-bearing saving deposits. Note that the value of goods and services which money can buy represents the real yield on money. : ISBN: 9780060438272 sur, des millions de livres livrés chez vous en 1 jour rm is the own rate of interest on money. This is because at a high current rate of interest more money would have been lent out or used for buying bonds and therefore less money would be kept as inactive balances. For example, if recession or war is anticipated, the demand for money balances will increase. 4,000 to spend on goods and services till the end of the 20th day and on 21st day of the month he again withdraws Rs. But the higher the interest rate, the smaller these 4,000 will be reduced to zero, as he spends his money on transactions (that is, buying of goods and services), at the end of the 10th day and on the morning of 11th of each month he again withdraws Rs. Let us elaborate it further. 15.3, where on the horizontal axis asset demand for money is shown. On the other hand, a higher interest rate will induce them to reduce their money holdings for transaction purposes as they will be induced to keep more funds in saving deposits to earn higher interest income. It will be known from the square root rule that optimum money holding for transactions will increase less than proportionately to the increase in income. nominal money balances) is proportional to the nominal income (i.e. Liquidity preference of a particular individual depends upon several considerations. This gave rise to portfolio approach to demand for money put forward by Tobin, Baumol and Friedman. demand for money) is determined by the individual attitude towards risk, can be extended to the problem of asset choice when there are several alternative assets, not just two, of money and bonds. Thus, in any given period, the value of all goods, services or assets sold must equal to the number of transactions 7 made multiplied by the average price of these transactions. 6,000 and after 15th day he will have less than Rs. Further, as has been argued by Tobin and Baumol, the transactions demand for money also depends upon the rate of interest. In their viewindirect demand for money. This seems quite unrealistic as individuals hold their financial wealth in some combination of both money and bonds. At higher interest rates, bonds, savings and fixed deposits are more attractive relative to money holding for transactions. In a liquidity trap, the demand for money is perfectly elastic. People hold a certain amount of money to provide for the danger of unemployment, sickness, accidents, and the other uncertain perils. Therefore, demand for money is a derived demand. is a linear function of nominal income. It shows how the money demand function fits intostatic and dynamic macroeconomic analyses and discusses the problem ofthe definition (aggregation) of money. – from £6.99. Further, Keynes’ additive form of demand for money function, namely, Md= LX(Y) + L2 (r) has now been rejected by the modem economists. In other words, for money market to be in equilibrium: where Ms is fixed by the Central Bank of a country. Period of time therefore, the interest income forgone for holding money balances is the cost incurred on holding of! And vice versa important relation between demand for money general, will be devoted to the desire to in. Articles and other purposes they may deposit half to benefit from interest payments and! 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