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theories of demand for money

If the-price level doubles, the money value of the firm’s transactions will also double. He will, therefore, convert this idle money into interest-bearing bonds, as illustrated in Panel (B) and (C) of Figure 2. An indifference curve shows that he is indifferent between all pairs of expected return and risk that lie on I1 curve. At the same time, each country’s government, policy maker and economist takes it seriously on economic control. Terms of Service Privacy Policy Contact Us, Cash Balances Approach and Transactions Approach | Money, The Classical Theory of Interest (With Criticisms), Keynesianism versus Monetarism: How Changes in Money Supply Affect the Economic Activity, Keynesian Theory of Employment: Introduction, Features, Summary and Criticisms, Keynes Principle of Effective Demand: Meaning, Determinants, Importance and Criticisms, Classical Theory of Employment: Assumptions, Equation Model and Criticisms, Classical Theory of Employment (Say’s Law): Assumptions, Equation & Criticisms. Physical goods or non-human goods are inventories of producer and consumer durables. This is illustrated in Figure 8 where the horizontal axis measures risk (sR) and the vertical axis the expected returns (smR). Individuals hold some cash to provide for illness, accidents, unemployment and other unforeseen contingencies. It is the total that must be divided among various forms of assets. But the conversion of human wealth into non- human wealth or the reverse is subject to institutional constraints. An investor can bear this risk if he is compensated by an adequate return from bonds. “On a $ 1000 bond purchase, minimum brokerage fees can be costly. Medium of exchange 2. Baumol’s analysis points toward another important fact about the behaviour of demand for transactions balances. 100 each at the market price of Rs. However, income from bonds is uncertain because it involves a risk of capital losses or gains. They emphasized the transactions demand for money in terms of the velocity of circulation of money. The higher the interest rate, the lower the demand for money, and the higher the incentive to hold more bonds. Interest cost is in the nature of opportunity cost because when a firm holds cash balances for transactions purposes it forgoes interest income. Baumol’s theory also has the merit of demonstrating the interest elasticity of the transactions demand for money as against the Keynesian view that it is interest inelastic. It refers to people’s preference for holding assets in liquid form at a given rate of interest. Friedman in his latest empirical study Monetary Trends in the United States and the United Kingdom (1982) gives the following demand function for money for an individual wealth holder with slightly different notations from his original study of 1956 as: where M is the total stock of money demanded; P is the price level; Y is the real income; W is the fraction of wealth in non-human form; Rm is the expected nominal rate of return on money; Rb is the expected rate of return on bonds, including expected changes in their prices; Re is the expected nominal rate of return on equities, including expected changes in their prices; gp =(1 /P) (dP/dt) is the expected rate of change of prices of goods and hence the expected nominal rate of return on physical assets; and u stands for variables other than income that u may affect the utility attached to the services of money. 1. The structure of cash for holdings and bond holdings by a firm is shown in Figure 7. Thus its underlying assumption is that people hold money to buy goods. The bond market is perfect where there is easy conversion of bonds into cash and vice versa. His theory argued there was a relationship between interest rates and the demand for money. 50 each when the rate of interest is high (8 per cent), and sell them again when they are dearer (Rs. Baumol’s inventory theoretic approach is superior to both the classical and Keynesian approaches because it integrates the transactions demand for money with the capital-theory approach by taking assets and their interest and non-interest costs into account. Keynes expounded his theory of demand for money. But the other factors are important. Speculative demand for money occupies a strategic position in Keynesian theory of demand for money. 1. Account Disable 12. 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.”. Hence, not in the case of M1 = CC + DD, which earn either zero or very low interest rates. 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. 200 and 240 crores at points C and D respectively in the figure. Panel (C) shows the total demand curve for money L which is a lateral summation of LT and Ls curves: L=LT+LS. If the income level rises to Rs. Changes in the transactions balances are the result of movements along a line like kY rather than changes in the slope of the line. 2. In his General Theory of Employment, Interest and Money (1936), J.M. Theories of the demand for money that emphasize the role of money as a store of value are called asset or portfolio theories. It implies that at higher levels of income, the average cost of transactions i.e. This is the famous Keynesian liquidity trap. 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. But the post-Keynesian economists believe that like transactions demand, it is inversely related to high interest rates. 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 first category is of risk lovers who enjoy putting all their wealth into bonds to maximise risk. Hence, not in the case of M1 = CC + DD, which earn either zero or very low interest rates. Theories of Demand for Money - Free download as Word Doc (.doc), PDF File (.pdf), Text File (.txt) or read online for free. to the holder which is measured in terms of the general price level (P). The greater the investment in bonds, the greater is the risk of capital loss from them. Besides liquidity, variables are the tastes and preferences of wealth holders. where MD is the demand for money and P is the price level. LESSON 13: In order to find out risk averter’s preference between risk and expected return, Tobin uses indifference curves having positive slopes indicating that the risk averter demands more expected returns in order to take more risk. It depends on both prices and quantities of goods traded. This also means that the demand for money falls by smaller amounts, as the rate of interest increases. Further, in the Keynesian analysis the speculative demand for money is analysed in relation to uncertainty in the market. Why do people prefer liquidity? For instance, if a bond of the value of Rs. One of the primary research areas for this branch of economics is the quantity theory of money. So he has Rs900 idle money in the first week, Rs600 in the second week, and Rs300 in the third week. Tobin starts his portfolio selection model of liquidity preference with this presumption that an individual asset holder has a portfolio of money and bonds. When all prices double, brokerage fee (b) will also double “so that larger cash balances will become desirable in order to avoid investments and withdrawals and the brokerage costs which they incur.” Thus the increase in the money value of transactions and in brokerage fees leads to a rise in the optimal demand for money in exactly the same proportion as the change in the price level. The Keynesian Theory of Demand for Money Keynes’ theory of demand for money is known as ‘Liquidity Preference Theory’. Transaction demand for money. 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. 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 demand for money is a function of prices and income (assuming the velocity of circulation is stable.) 2 nd Edition. In this case, changes in the quantity of money have no effects at all on prices or income. Theories of Demand for Money - Free download as Word Doc (.doc), PDF File (.pdf), Text File (.txt) or read online for free. THEORIES OF DEMAND FOR MONEY Second, this theory is superior to Keynes’s theory in that it explains that individuals hold diversified portfolios of bonds and money rather than either bonds or money. The purpose is speculation. It was the Cambridge cash balances approach which raised a further question: Why do people actually want to hold their assets in the form of money? 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. Rather, changes in income lead to less than proportionate changes in the transactions demand for money. Theories of the demand for money that emphasize the role of money as a store of value are called asset or portfolio theories. The non-interest costs such as brokerage fee, mailing expenses, etc. Given these assumptions, the firm buys bonds with 2/3K ($800) of its income at time f=0 and keeps 1/3K ($400) in cash, as shown in the figure. One of its major criticisms arises from the neglect of store of value function of money. This means that the long-run demand for money function is stable and is relatively interest inelastic, as shown in Fig. 1200crores, the transactions demand would be Rs300crores at point B on the curve kY. •Thus, from the view point of yield and risks of holding money, M2 is more appropriate. They emphasized the transactions demand for money in terms of the velocity of circulation of money. This is because money acts as a medium of exchange and facilitates the exchange of goods and services. 300. The demand for money theory is the main element of the monetary economics theory and an essential part in the macroeconomic theory. Third, there is also the difference between the monetary mechanisms of Keynes and Friedman as to how changes in the quantity of money affect economic activity. Broadly, total wealth includes all sources of income or consumable services. 2. Money is taken in the broadest sense to include currency, demand deposits and time deposits which yield interest on deposits. Similarly, businessmen keep cash in reserve to tide over unfavourable conditions or to gain from unexpected deals. Plagiarism Prevention 5. 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. In other words, the optimal cash balance will increase because the firm will invest less in bonds. The purpose is speculation. The Post-Keynesian Approaches. This demand for money curve relates to the speculative demand for money and not to the aggregate demand for money. If the current rate of interest (r) is above the “critical” rate of interest, businessmen expect it to fall and bond prices to rise. Keynes suggested three motives which led to the demand for money in an economy: The transactions demand for money arises from the medium of exchange function of money in making regular payments for goods and services. are also fixed over the year. Lower yield on bonds induces people to put their money elsewhere, such as investment in new productive capital that will increase output and income. They depend upon the level of income, the interest rate, the business turnover, the normal period between the receipt and disbursement of income, etc. On the other hand, the Keynesian definition of money consists of demand deposits and non-interest bearing debt of the government. Thus money is luxury good. 1600 crores, the transactions demand would decline to Rs. 3. When r falls below rc, the individual expects more capital losses on bonds as against the interest yield. But the risk averter will achieve an equilibrium position between expected return and risk where his budget line is tangent to the indifference curve. The Cambridge Equation & the Debate of Money Demand. Such variables are noted as u by Friedman. However, the risk averter possesses an intrinsic preference for liquidity which can be only offset by higher interest rates. Points on I2 curve are preferred to those on I1 curve. It shows that for income of Rs. b.Brokerage fees decline, making bond transactions cheaper. This is illustrated by the LM portion of the vertical axis. Accordingly, his transactions demand for money in each week is Rs. One must weigh the financial cost and inconvenience of frequent entry to and exit from the market for securities against the apparent advantage of holding interest-bearing securities in place of idle transactions balances. 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. On the other hand, Friedman makes no such division of money balances. A firm would always try to keep minimum transactions balances in order to earn maximum interest from its assets. 1600 crores, the transactions demand also increases to Rs 400 crores, given k=1/4. According to Keynes, theories of interest have little meaning if speculative demand for money is overlooked. The demand for money on the part of wealth holders is a function of many variables. It is held for the stream of income or consumable services which it renders. The precautionary motive relates to “the desire to provide for contingencies requiring sudden expenditures and for unforeseen opportunities of advantageous purchases.” Both individuals and businessmen keep cash in reserve to meet unexpected needs. The line or is the budget line of the risk averter. But it does not explain fully why people hold money. 4. This is because of the economies of scale that encourage larger investment in bonds when the amount of money involved in transactions is larger due to increase in income. Keynes held that the precautionary demand for money, like transactions demand, was a function of the level of income. The income to which cash balances (M/P) are adjusted is the expected long-term level of income rather than current income being received. A more important factor which determines this decision is the amount of money involved in transactions because brokerage fees of buying and selling bonds are relatively fixed and do not change much in relation to the former. Bond prices and the rate of interest are inversely related to each other. They will, therefore, diversify their portfolios, and hold both money and bonds. The most important thing about money in Fisher’s theory is that it is transferable. Assuming k= 1/4 and income Rs1000crores, the demand for transactions balances would be Rs. 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. 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. Money - Money - Monetary theory: The relation between money and what it will buy has always been a central issue of monetary theory. 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. Explain how the following events will affect the demand for money according to the portfolio theories of money demand: a.The economy experiences a business cycle contraction. Given these factors, the transactions demand for money is a direct proportional and positive function of the level of income, and is expressed as L=kY. It is capitalized income. Explain how the following events will affect the demand for money according to the portfolio theories of money demand: a.The economy experiences a business cycle contraction. In Figure 9, budget lines r1 r2 and r3are tangents to I1, I2 and I3 curves at points T1, T2 and T, respectively. By income, Friedman means “permanent income” which is the average expected yield on wealth during its life time. The Demand for Money Portfolio Theories of Money Demand •Portfolio theories are applicable when we consider broad money. 5. The demand for. 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. 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. Half the bonds purchased carry maturity of 1 /3t (4 months) and the other (half) bonds carry maturity of 2/31 (8 months). Thus Y/K is the number of withdrawals that occur over the year. At time 2/3f, the remaining bonds mature which the firm sells for transactions purposes until time t1 At time t1 when the year is over, the cash balance is zero and the firm is again ready for fresh receipts in the new year. 5. “However, he did not stress the role of the rate of interest in this part of his analysis, and many of his popularizes ignored it altogether.” Two post-Keynesian economists William J. Baumol and James Tobin have shown that the rate of interest is an important determinant of transactions demand for money. 1000 and 1200crores, transactions balances would be Rs. Fourth, Tobin is more realistic than Keynes in not discussing the perfect elasticity of demand for money (the liquidity trap) at very low rates of interest. This is because the classicists believed in Say’s Law whereby supply created its own demand, assuming the full employment level of income. The line OC shows risk as proportional to the share of the total portfolio held in bonds. It is a smooth curve which slopes downward from left to right, as shown in Figure 5. 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 classicists emphasized only the medium of exchange function of money which simply acted as a go-between to facilitate buying and selling. 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.”. The curve shows that when the rate of interest falls from a higher level, there is a smaller increase in the demand for money. Variables other than income may affect the utility attached to the services of money which determine liquidity proper. 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