Unit 3

Theories of Money Demand

 Theories of Money Demand

Transaction Approach

Cash Balance Approach

Keynesian Theory of Money demand

Baumol’s Square Root Approach

Tobin’s Portfolio Approach

 Theories of Money Demand

Fisher’s Transactions Approach

 Theories of Money Demand
Fisher’s Transactions Approach
In his theory of demand for money, Fisher attached emphasis on
the use of money as a medium of exchange. In other words,
money is demanded for transaction purposes.

 In a given time period, total money expenditure is equal to

the total value of goods traded in the economy. In other
words, national expenditure, i.e., the value of money, must be
identically equal to national income or total value of the goods
for which money is exchanged, i.e.,

MV = PT or P = MV/T (Equation of Exchange)

 Theories of Money Demand

Fisher’s Transactions Approach

Suppose in a country there is only one good, wheat, which is to be
exchanged. The total output of wheat is 2,000 quintals in a year.
Further suppose that the government has issued money equal to
Rs. 25,000. We further assume that one rupee is used four times
in a year for exchange of wheat.
 Theories of Money Demand
Fisher’s Transactions Approach
That is, velocity of circulation of money is 4. Under these
circumstances, 2,000 quintals of wheat are to be exchanged for
Rs. 1, 00,000 (25,000 x 4 = 1, 00,000 = MV).
The price of wheat will be (MV=PT or P=MV/T) 1, 00,000/2,000 =
Rs. 50 per quintal.
Suppose the quantity of money is doubled to Rs. 50,000, while
the output of wheat remains at 2,000 quintals. As a result of this
increase in the quantity of money, the price of wheat will rise to
2, 00,000/2,000 = Rs. 100 per quintal.
Theories of Money Demand
 Theories of Money Demand

Cambridge Cash Balance Approach

 Value of a commodity is determined by demand for and supply of it
and likewise, according to them, the value of money. As studied in
cash-balance approach to demand for money, Cambridge economists
laid stress on the store of value function of money in sharp contrast
to the medium of exchange.

 According to Cash Balance Approach, the public likes to hold a

proportion of nominal income in the form of money (i.e., cash
balances). Let us call this proportion of nominal income that people
want to hold in money as k.
Md =kPY
 Theories of Money Demand
Cambridge Cash Balance Approach
Md =kPY
Y = real national income (i.e., aggregate output)
P = the price level PY = nominal national income
k = the proportion of nominal income that people want to hold in money
Md = the amount of money which public want to hold
Money-market equilibrium, demand for money must equal worth the supply
of money which we denote by M. It is important to note that the supply of
money M is exogenously given and is determined by the monetary policies of
the central bank of a country. Thus, for equilibrium in the money market.
M = Md
As Md =kPY
Therefore, in equilibrium M = Md = kPY
 Theories of Money Demand

Keynesian
Approach
to Money
Demand
 Theories of Money Demand
Keynesian Approach to Money Demand
Keynes an individual’s total wealth consisted of money and bonds.
Keynes used the term ‘bonds’ to refer to all risky assets other than
money.
Money holding was the only alternative to holding bonds. And the
only determinant of an individual’s portfolio choice was the interest
rate on bonds.
This would affect an individual’s decision to divide his portfolio
into money and bonds. To Keynes, the rate of interest is the
opportunity cost of holding money. At high rates of interest an
individual loses a large sum by holding money or by not holding
bonds.
 Theories of Money Demand
Keynesian Approach to Money Demand
Another factor affecting an individual’s portfolio choice was
expected change in the rates of interest which would give rise to
capital gain or loss.

According to Keynes when the interest rate was high relative to its
normal level people would expect it to fall in near future. A fall in
the rate of interest would imply a Capital gain on bonds. According
to Keynes at a high rate of interest there would be low demand for
money as a store of value (wealth).
 Theories of Money Demand
Keynesian Approach to Money Demand
There are two reasons for low Md when interest is high:
(i) At high rate of interest the opportunity cost of money holding (in
terms of forgone interest) is high.

(i) At a high rate of interest, future capital gain on bonds is likely

due to a fall in the rate of interest in future. It is because there is
an inverse relation between the rate of interest and the price of
old bonds. Thus if the present rate of interest is high, people will
expect it to fall in near future, in which case they will expect to
make capital gain.
 Theories of Money Demand
Keynesian Approach to Money Demand

Keynes also considered transactions and precautionary demand

for money whose primary determinant was income. Such demand
would increase proportionately with increase in income.

Since the demand for money would fall at high rates of interest, and
increase at low rates of interest, there is an inverse relation between
the asset (speculative) demand for money and the rate of interest.
 Theories of Money Demand
Keynesian Approach to Money Demand
Suppose the current interest rate is denoted as i

Expected interest rate is ie

Capital gain or loss is denoted as g = i/ie -1

If i > ie, anticipated capital gain. If i < ie, anticipated capital gain.

i + g = 0, Critical interest rate.

i + g > 0, above Critical interest rate, speculative balances will go

into bond (only Bond), Otherwise.
 Theories of Money Demand
Keynesian Approach to Money Demand
 Theories of Money Demand
Keynesian Approach to Money Demand
 Theories of Money Demand
Keynesian Approach to Money Demand
 Theories of Money Demand
Keynesian Approach to Money Demand

Effects of increase
in Money Supply

M2 by the community with total M2 as a function of i

 Theories of Money Demand
Keynesian Approach to Money Demand

So Keynes’ demand function for money can be expressed as

Md = L(Y, i)
+ -
Thus, M = Md = M1 + M2 = L1 (Y) + L2 (i)

where Y is income and i is nominal interest rate and L stands for

liquidity preference.
Baumol’s Inventory Theoretic
Approach to Money Demand
 Theories of Money Demand
Baumol’s Inventory Theoretic Approach to Money Demand

William Baumol has made an important addition to the Keynesian

transactions demand for money. Keynes regarded transactions
demand for money as a function of the level of income.

Baumol shows that the changes in income lead to less than

proportionate changes in the transactions demand for money.
Keynes considered transactions demand as primarily interest
inelastic. But Baumol analyses the interest elasticity of the
transactions demand for money.
 Theories of Money Demand
Baumol’s Inventory Theoretic Approach to Money Demand

William Baumol’s analysis is based on the holding of an optimum

inventory of money for transactions purposes.

Cash balances are held because income and expenditure do not

take place simultaneously. “But it is expensive to tie up large
amounts of capital in the form of cash balances. For that money
could otherwise be used profitably elsewhere in the firm or it could
be invested profitably in securities.”
 Theories of Money Demand
Baumol’s Inventory Theoretic Approach to Money Demand

Individuals have to keep optimum inventory of money for

transaction purposes. Individuals also incur cost when they hold
inventories of money for transactions purposes.

Interest income forgone is the cost of holding money for

transactions purposes. In this way Baumol and Tobin emphasised
that transaction demand for money is not independent of the rate
of interest.
 Theories of Money Demand
Baumol’s Inventory Theoretic Approach to Money Demand

It may be noted that by money we mean currency and demand

deposits which are quite safe and riskless but carry no interest.
On the other hand, bonds yield interest or return but are risky and
may involve capital loss if wealth holders invest in them.

However, saving deposits in banks, according to Baumol, are quite

free from risk and also yield some interest. Therefore, Baumol asks
the question why an individual holds money (i.e. currency and
demand deposits) instead of keeping his wealth in saving deposits
which are quite safe and earn some interest as well.
 Theories of Money Demand
Baumol’s Inventory Theoretic Approach to Money Demand

Unlike Keynes both Baumol and Tobin argue that transactions

demand for money depends on the rate of interest.

Individuals compare the costs and benefits of funds in the form of

money with the interest- bearing saving deposits. According to
Baumol, the cost which people incur when they hold funds in
money is the opportunity cost of these funds, that is, interest
income forgone by not putting them in saving deposits.
Similarly, there is a transaction cost for withdrawal of cash or
brokerage fee.
 Theories of Money Demand
Baumol’s Inventory Theoretic Approach to Money Demand

Baumol analysis explained the transactions demand for money of

an individual who receives income at a specified interval, say
every month, and spends it gradually at a steady rate.

For example; It is assumed that the individual is paid Rs. 12000

salary in the form of cheque on the first day of each month.
 Theories of Money Demand
Baumol’s Inventory Theoretic Approach to Money Demand

Suppose he gets it cashed (i.e. converted into money) on the very first
day and gradually spends it daily throughout the month. (Rs. 400
per day) so that at the end of the month he is left with no money. It
can be easily seen that his average money holding in the month will
be Rs. = 12000/2 = Rs. 6,000 (before 15th of a month he will be
having more than Rs. 6,000 and after 15th day he will have less than
Rs. 6000).

Average holding of money equal to Rs. 6,000 has been shown by the
dotted line. Now, the question arises whether it is the optimal
strategy of managing money or what is called optimal cash
management?
 Theories of Money Demand
Baumol’s Inventory Theoretic Approach to Money Demand
The greater N is, the less money the individual holds on average
and the less interest he forgoes. (N = no of trips)
Cost of going to bank is F amount. F means anything, OC of Time,
money, other expense and so on.
So the optimal choice of N determines money demand.
For any N, the avg amount of money held is Y/2N. So the forgone
interest is iY/2N. F is the cost to bank trip, so total cost of bank trip
is FN.
Now the total Cost is TC = iY/2N + FN (TC=forgone interest +cost of trips)
The larger the N, smaller the forgone interest and larger the
cost of going to Bank.
 Theories of Money Demand
Baumol’s Inventory Theoretic Approach to Money Demand
The optimal value of N denoted as N*

𝑖𝑌
N* = √
2𝐹
𝑌𝐹
So the average money holding is Y/(2N*) = √
2𝑖
Meaning that, the individual holds more money if F is higher, if
expenditure Y is higher or the i is lower.
Therefore, LT is –ve function of i and +ve function of income.
The Square Root Result shows that the Md rises less than
proportion to the volume of transactions.
 Theories of Money Demand
Baumol’s Inventory Theoretic Approach to Money Demand
optimal strategy of managing money

Avg = Y/4
Avg = Y/2

Square Root rule that optimum money holding for transactions will
increase less than proportionately to the increase in income.
 Theories of Money Demand
Baumol’s Inventory Theoretic Approach to Money Demand
 Theories of Money Demand
Baumol’s Inventory Theoretic Approach to Money Demand
Conclusion
Higher broker’s fee will raise the money holdings (decrease bond
purchase) as it will discourage the individuals to make more trips to
the bank. 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. That is, at a higher rate of interest transactions
demand for money holdings will decline.
Tobin Approach to Money
Demand
 Theories of Money Demand
Tobin Approach to Money Demand

The main drawback of Keynes’ speculative demand for money

is that it visualises that the people hold their assets in either all
money or all bonds.
This gave rise to portfolio approach to demand for money put
forward by Tobin, Baumol and Freidman.
The portfolio of wealth consists of money, interest-bearing
bonds, shares, physical assets etc.
According to Keynes’ theory, demand for money for
transaction purposes is insensitive to interest rate (Inelastic).
Tobin show that money held for transaction purposes is
interest elastic.
 Theories of Money Demand
Tobin Approach to Money Demand

In his important contribution explained rational behaviour on the

part of the individuals is that they should keep a portfolio of assets
which consists of both bonds and money.
# Idle cash is safe (no risk), but earns zero income or interest.
# Bonds earn interest, but they are risky.
In his analysis he makes a valid assumption that people prefer
more wealth to less.
Individuals diversify their portfolio by holding a balanced
combination of safe and risky assets.
Depends on the individual’s attitude to Risk.
 Theories of Money Demand
Tobin Approach to Money Demand

According to Tobin, individual’s behaviour shows “Risk

Aversion.”

They prefer less risk to more risk at a given rate of return.

Individuals are uncertain about future rate of interest.

Tobin argues that a risk averter will not opt for risky assets with
all risky bonds or a greater proportion of them.
 Theories of Money Demand
Tobin Approach to Money Demand

But holding cash is unproductive, as it earns no income.

So they have to choose a combination or portfolio of assets

#some less risky (safe) but less productive.
#some more risky but more productive.

The portfolio of assets depends on the nature of the individual.

 Theories of Money Demand
Tobin Approach to Money Demand

At a higher rate of interest, individual demand for holding money

(i.e., liquidity) will be less and therefore they will hold more
bonds in their portfolio.

On the other hand, at a lower rate of interest they will hold more
money and less bonds in their portfolio.
 Theories of Money Demand
Tobin Approach to Money Demand

So the Asset Demand for Money is inversely related to interest

rate.
 Theories of Money Demand
Tobin Approach to Money Demand

Tobin Money Demand Function is expressed as;

Other than Wealth, All are inversely related to Money Demand

 Theories of Money Demand
Tobin Approach to Money Demand
Conclusion
In economics, demand of money is the desired holding of financial
assets in the form of money.
The Portfolio Demand for Money is that, Money is just one of
many financial instruments that we can hold in our investment
portfolios.
In this approach, the demand for money is viewed as a joint
demand for all liquid assets. Holding of money is preferred by the
people because it enables them to maintain cash disbursements
and carry on transactions when there is lack of synchronization
between timings or receipts of income and payments.