SEBI Gr A 2020

Economics
Phase
1&2
Demand for Money

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Demand for Money

• The demand for money refers to how much assets individuals

wish to hold in the form of money (as opposed to illiquid physical
assets.)
• It is sometimes referred to as liquidity preference.

• Demand for money means demand for holding cash.

• Unlike demand for consumer goods, money is not demanded for its own sake.

• Money performs two important functions:

(i) Medium of exchange
(ii) Store of value

• It is due to these two functions that money is considered as indispensable by the

society. Therefore, demand for money is a derived demand.
• Demand for money is a very crucial concept as the value of money depends on the
demand for money.
There are three approaches to the demand for money:
✓ The Classical approach
✓ The Keynesian approach
✓ The post-Keynesian approach

The Classical Approach:

• The Classical economists viewed that money does not have any inherent utility of
its own but is demanded for transaction motive.
• Money serves as a medium of exchange and facilitates the exchange of goods
and services.

➢ Fisher’s Transaction approach

• Irving Fisher’s version of the quantity theory of money which he developed in
his book “Purchasing Power of Money” is the most famous version and
represents the Classical approach to the analysis of the relationship between the
quantity of money and the price level.
Fisher’s equation of exchange is written as-
MV=PT
Where M = Total quantity of money
V = Velocity of circulation
P = General price level
T = Total amount of goods and services exchanged for money / Total no. of
transactions
• According to Fisher, the nominal quantity of money ‘M’ is fixed by the Central Bank of
a Country and is therefore treated as an exogenous variable which is assumed to be a
given quantity in a particular period of time.

• Further, the number of transactions in a period is a function of national income.

The greater the national income → The larger the number of transactions required
to be made
• Further, since Fisher assumed that full employment of resources prevailed in the
economy, the level of national income is determined by the amount of the fully
employed resources. Thus, with the assumption of full employment of resources,
the volume of transactions T is fixed in the short run.
• According to the classical economists, velocity of circulation (V)
remains constant and is independent of M, P and T.
• Because Determinants of velocity - institutional and technological
factors do not vary much in the short run, that’s why transactions
velocity of circulation of money (V) was assumed to be constant.

• Now, for money market to be in equilibrium, nominal quantity of money supply must
be equal to the nominal quantity of money demand i.e.
Md = M
Where M is fixed by the Central Bank of a country.

• With the above assumptions. Fisher’s equation of exchange can be rewritten as

Md = PT/V

• Thus, according to Fisher’s transactions approach, demand for money depends

on the following three factors:
(1) The number of transactions (T)
(2) The general price level (P)
(3) The transaction velocity of circulation of money
 Limitations of Fisher’s approach

• The quantity theory of money as stated by Prof. Fisher is based on unreal

assumptions like the existence of full employment of resources and stability of
expenditure.

• The theory assumes that other things like V and T remain constant. But in actual
practice a change in M is bound to affect V and T. In a dynamic world, change in
one factor induces changes in other factors.

• The cash transactions equation upholds money because it is a good medium of

exchange. Its great fault is that it completely ignores the significant role of money
which it plays as a store of value.
➢ The Cambridge Cash-balance theory of Demand for Money
• Cambridge Cash-Balance theory of demand for money was put forward
by Cambridge economists, Marshall and Pigou.

• This Cash-Balance theory of demand for money differs from Fisher’s

transaction approach in that it places emphasis on the function of money
as a store of value or wealth instead of Fisher’s emphasis on the use of
money as a medium of exchange.

• Marshall and Pigou focused their analysis on the factors that determine individual
demand for holding cash balances.

• Although, they recognised that current interest rate, wealth owned by the individuals,
expectations of future prices and future rate of interest determine the demand for
money, they however believed that changes in these factors remain constant or they are
proportional to changes in individuals’ income.
Thus, they put forward a view that individual’s demand for Cash-balances
(i.e. nominal money balances) is proportional to the nominal income (i.e.
money income).
Md = kPY
Where Y = real national income
P = average price level of currently produced goods and services
PY = nominal income
k = proportion of nominal income (PY) that people want to hold as cash
balances

• Nominal income is income that is not adjusted for changes in purchasing power.

• Real income is how much money an individual or entity makes after accounting
for inflation.
• It is sometimes called real wage when referring to an individual's income.
• It is calculated by dividing nominal income by the price level.

Real Income (Y) = Nominal Income / Price level (P)

Nominal Income = PY
• It can be seen from that demand for
money (Md) in this Cambridge Cash-
balance approach is a linear function
of nominal income.

• The slope of the function is equal

to k, that is, k = Md/Py.

• Thus important feature of Cash-

balance approach is that it makes
the demand for money as function
of money income alone.

• Thus, it is proportional function of both price level (P) and real income (F).

This implies two things.-

• First, income elasticity of demand for money is unity
• Secondly, price elasticity of demand for money is also equal to unity so that any
change in the price level causes equal proportionate change in the demand for money.
 Limitations of Cambridge
approach

• It has been pointed out by critics that other influences such as rate of interest,
wealth, expectations regarding future prices and rate of interest have not been
formally introduced into the Cambridge theory of the demand for cash-balances.
These other influences remain in the background of the theory.

• Another criticism levelled against this theory is that income elasticity of demand for
money may well be different from unity. Cambridge economists did not provide
any theoretical reason for its being equal to Unity. Nor is there any empirical
evidence supporting unitary income elasticity of demand for money.

• Besides, price elasticity of demand is also not necessarily equal to unity. In

fact, changes in the price level may cause non-proportional changes in the demand
for money.
 Keynes’ Theory of Demand for Money

• Keynesian theory of the demand for money was first formulated by Keynes in his well-
known book- The General Theory of Employment, Interest and Money (1936).

• In understanding Keynes’ theory, we need to understand two concepts-

1. Why is money demanded?
2. What are key determinants of the demand for money?

Why is Money Demanded?

The question is why is money demanded when money does not earn its holders any
income whereas there are competing non-money financial assets in the economy
which yield some income to their holder.

Keynes said that money was demanded due to three main motives:
(1) The transactions motive
(2) The precautionary motive
(3) The speculative motive
The Transactions Demand for Money:
The transactions motive relates to the demand for money or the need for money
balances for the current transactions of individuals and business firms. Individuals hold
cash in order “to bridge the interval between the receipt of income and its expenditure”.

• Most of the people receive their incomes weekly or monthly while the expenditure goes on
day by day.
• A certain amount of ready money, therefore, is kept in hand to make current payments.
This amount will depend upon the-
• Size of the individual’s income
• The interval at which the income is received
• The methods of payments prevailing in the society

• The businessmen and the entrepreneurs also have to keep a proportion of their resources
in money form in order to meet daily needs of various kinds.
• They need money all the time in order to pay for raw materials and transport, to pay wages
and salaries and to meet all other current expenses incurred by any business firm.

According to Keynes, the transactions demand for money depends only on the real
income and is not influenced by the rate of interest.
Precautionary Demand for Money:
• Precautionary motive for holding money refers to the desire of the people to hold
cash balances for unforeseen contingencies.
• People hold a certain amount of money to provide for the danger of unemployment,
sickness, accidents, and the other uncertain perils.

The amount of money demanded for this motive will depend on the psychology of the
individual and the conditions in which he lives.

Speculative Demand for Money:

• 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).
• The notion of holding money for speculative motive was a new and revolutionary
Keynesian idea.
• Money held under the speculative motive serves as a store of value as money held under
the precautionary motive does. But it is a store of money meant for a different purpose.
The cash held under this motive is used to make speculative gains by dealing in
bonds whose prices fluctuate.
• If bond prices are expected to raise i.e. the rate of interest is expected to
fall → Businessmen will buy bonds to sell when their prices actually rise.

• If bond prices are expected to fall i.e. the rate of interest is expected to rise
→ Businessmen will sell bonds to avoid capital losses.

Given the expectations about the changes in the rate of interest in future,
• Less money will be held under the speculative motive → at a higher
current rate of interest
• More money will be held under this motive → at a lower current rate
of interest.
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
• While at a higher current rate of interest -
holders of cash balance would lose more by not
lending or investing.
 Liquidity Trap

• It can be seen that the liquidity preference curve

LP becomes quite flat i.e., perfectly elastic at a very
low rate of interest; it is horizontal line beyond
point E” towards the right.

• This perfectly elastic portion of liquidity

preference curve indicates the position of
absolute liquidity preference of the people.
i.e. at a very low rate of interest people will hold with
them as inactive balances any amount of money they
come to have.
• This portion of liquidity preference curve with absolute liquidity preference is
called liquidity trap by the economists because expansion in money supply gets
trapped in the sphere of liquidity trap and therefore cannot affect rate of interest and
therefore the level of investment.
• According to Keynes, it is because of the existence of liquidity trap that
monetary policy becomes ineffective to tide over economic depression.
• 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.
• If there is a change in the expectations regarding the future rate of
interest, the whole curve of demand for money or liquidity preference for
speculative motive will change accordingly.

Aggregate Demand for Money: Keynes’ View

If the total demand of money is represented by Md it can be written as-
Md = M1 + M2
where M1 = money held for transactions and precautionary motive
M2 = part held for the speculative motive

• According to Keynes, the money held under the transactions and precautionary
motives, i.e., M1 is completely interest-inelastic unless the interest rate is very
high.
• The amount of money held as M1, that is, for transactions and precautionary
motives, is mainly a function of the size of income.
Thus, it can be written as
M1 = L1 (Y) ----- (1)
Where Y = income
L1 = demand function,
M1 = Money demanded or held under the transactions and
precautionary motives

• On the other hand, according to Keynes, money demanded for speculative motive,
i.e., M2, is primarily a function of the rate of interest.
• This can be written as:
M2 = L2 (r) ----- (2)
Where r = rate of interest
L2 = demand function for speculative motive

Since total demand of money Md = M1 + M2, we get from (1) and (2) above
Md = L1 (Y) + L2 (r)
Md = L (Y, r)
According to Keynesian theory, Demand for money is function of Income and
rate of interest.
 Critiques of Keynes’s Theory
The main drawback of Keynes’ speculative demand for money is that it visualizes
that people hold their assets in either all money or all bonds.
• This seems quite unrealistic as individuals hold their financial wealth in some
combination of both money and bonds.
• This gave rise to portfolio approach to demand for money put forward by Tobin,
Baumol and Freidman.

Further, according to Keynes’ theory, demand for money for transaction purposes
is insensitive to interest rate.
• But, modern theories of money demand put forward by Baumol and Tobin show that
money held for transaction purposes is interest elastic.

Further, Keynes additive form of demand for money function, namely, Md = L1(Y) +
L2 (r) has now been rejected by the modern economists.
• There may be more than one motive to hold money but the same units of money can
serve several motives.
• Therefore, the demand for money cannot be divided into two or more different
departments independent of each other.
 Keynes’ Liquidity Preference Theory of Rate
of Interest

• In his book “The General Theory of Employment, Interest and Money”, J.M. Keynes
gave a new view of rate of interest.
• According to him, the rate of interest is a purely monetary phenomenon and is
determined by demand for money and supply of money.
• According to him ”interest is a reward for parting with liquidity for a specified
period.”

• Since people prefer liquidity or want to hold money to meet their various motives,
they need to be paid some reward for surrendering liquidity or money. And this
reward is the rate of interest that must be paid to them in order to induce them to
part with liquidity or money.

• Further, according to Keynes, rate of interest is determined by liquidity preference or

demand for money to hold and the supply of money known as Liquidity Preference
Theory.
In order to explain the demand for money and interest-rate determination,
Keynes assumed a simplified economy where there are two assets which
people can keep in their portfolio balance.
These two assets are:
(1) Money in the form of currency and demand deposits in the banks which
earn no interest,
(2) long term bonds.

• First, the higher the level of nominal income in a two asset economy people would
want to hold more money in their portfolio balance.
• This is because of transactions motive according to which at the higher level of nominal
income, the purchases by the people of goods and services in their daily life will be rela-
tively larger which require more money to be kept for transactions purposes.

• Secondly, if the current rate of interest is higher than what is expected in the
future, the people would like to hold more bonds and less money in their portfolio.
• On the other hand, if the current rate of interest is low (the bond prices are currently
high), the people will be reluctant to hold large- quantity of bonds (and instead they
could hold more money in their portfolio) for the fear that bond prices would fall in the
future causing capital losses to them.
 Determination of Rate of Interest: Equilibrium
in the Money Market
• The rate of interest, according to J.M. Keynes, is determined by demand for
money (Liquidity Preference) and supply of money.
• The factors which determine demand for money has been explained.
• The supply of money, at a given time, is fixed by the monetary authority of the
country.
• MD is the demand curve for money at a given
level of nominal income.
• MS is the money supply curve which is a
vertical straight line which is fixed at 200 crores
rupees.
Now, it can be seen that-
• Quantity demanded of money equals the
given money supply at 10% rate of interest.
i.e. equilibrium at 10% rate of interest

• There will be disequilibrium if rate of interest is

higher or lower than 10%.
 Effect of an Increase in the Money
Supply
MD = demand for money for satisfying various
motives.

To begin with, OM1 is the quantity of money

available. Rate of interest will be determined at
point where the demand for money is equal to the
fixed supply of money.

It is clear that demand for money is equal to

quantity of money at ‘i’ rate of interest.

Now, when the quantity of money increases from

OM1 to OM2, the rate of interest falls from i to i’.
Thus, given the money demand curve or curve of
liquidity preference, an increase in the quantity of
money brings down the rate of interest.
Why rate of interest decreases with increase in money supply?

• When the money supply is expanded, there emerges excess supply of money at the
initial.
• The people would react to this excess quantity of money supplied by buying bonds.
• As a result, the bond prices will go up which implies that the rate of interest will
decline. This is how the increase in money supply leads to the fall in rate of
interest.

Shifts in Money Demand or Liquidity Preference Curve

The position of money demand curve depends upon

two factors:
(1) The level of nominal income
(2) the expectations about the changes in bond prices in
the future which implies changes in rate of interest
in future.
• According to Keynes, demand for money for speculative motive together
with the supply of money determines the rate of interest.

• Moreover, according to him, interest is not a reward for saving or

thriftiness or waiting but for parting with liquidity.
• Keynes asserted that it is not the rate of interest which equalises saving
an investment. But this equality is brought about through changes in
the level of income.
 Critical Appraisal of Keynes’
Liquidity

Keynes ignored the role of real factors in the determination of

interest:
• Firstly, it has been pointed out that rate of interest is not purely a monetary
phenomenon. Real forces like productivity of capital and thriftiness or saving also pay
an important role in the determination of the rate of interest.
• The cash-balances of the businessmen are largely influenced by their demand for
capital investment. This demand for Capital investment depends upon the marginal
revenue productivity of capital.
• Therefore, the rate of interest is not determined independently of the marginal
revenue productivity of capital (marginal efficiency of capital) and investment
demand.

Keynesian theory is also indeterminate:

Keynes’s theory of interest, like the classical and loanable funds theories, is
indeterminate.
• According to Keynes, rate of interest is determined by liquidity
preference (i.e. demand for money) and supply of money.
• However, as we have seen, liquidity preference, especially demand for
money for transactions motive depends on level of income.
• However, we cannot know the level of income unless we first know the
rate of interest.
• This is because rate of interest influences investment which in turn
determines the level of income.
• Thus, Keynes’s theory is indeterminate, that is, we are not able to arrive
at a single determinate rate of interest; rate of interest various as
income varies.

No liquidity without savings:

• According to Keynes, interest is a reward for parting with liquidity and in no way a
compensation and inducement for saving or waiting.
• But without saving how can the funds be available to be kept as liquid and how can
there be the question of surrendering liquidity if one has not already saved money.
• Therefore, the rate of interest is vitally connected with saving which is neglected by
Keynes is the determination of interest.
 Hicks-Hansen Synthesis: IS-LM
Curve Model

• We have noted that both the Classical theory and Keynes’ liquidity preference
theory of interest are indeterminate and quite inadequate.
• Renowned economists, Hicks and Hansen, have brought about a synthesis
between the Classical and Keynes’ theories of interest and have thereby
succeeded in propounding an adequate and determinate theory of interest
through the intersection of what are called IS and LM curves.

Note: IS-LM Model will be covered separately in Chapter 14.

Happy Learning!