Chapter 3

The Demand for Money and

Other Assets
 Introduction 2
• As we have discussed in previous sessions, money is an asset
to be held by the public
• As such, it has its demand, supply and also a market
• The demand for money refers to how much assets individuals
wish to hold in the form of money (as opposed to other
illiquid assets)
• It is a demand for real cash balances because people hold
money for the purpose of buying goods and services, and in
effect, it is sometimes referred to as liquidity preference
• It can refer to the demand for money, the money which is
narrowly defined as M1 (directly spendable holdings i.e.
currency and demand deposits)
• The demand for money (money in the sense of M1) arises
from two important functions of money; money as a medium
of exchange (which provides liquidity) and money as a store
of value by interest-bearing assets
 ……Continued 3
• This creates a trade-off between the liquidity advantage
of holding money for near-future expenditure and the
interest advantage of temporarily holding other assets
• The demand for M1 is a result of this trade-off regarding
the form in which a person's funds to be spent should be
held
• Thus, individuals and businesses wish to hold money
partly in cash and partly in the form of other assets
• What explains changes in the demand for money?
• A change in the demand for money is interconnected
with income, interest rates, the level of inflation, etc.
• The demand for money is directly related to the income
level
 ……Continued 4
• The higher the income level, the greater will be the
demand for money, and vice versa
• Demand for money can also depend on the relative
attractiveness of assets that can be substituted for money
• When alternative assets like bonds become unattractive
due to fall in interest rates, people prefer to keep their
assets in cash, and the demand for money increases
• With regard to inflation; the higher the price level, the
more money balances a person has to hold in order to
purchase a given quantity of goods
Theories of Money Demand
• The theory of demand for money is the main element of
the monetary economics theory
• There are several theories of demand for money
 3.1. Quantity Theory of Money 5
• According to this theory, the general price level of goods and
services is proportional to the money supply in an economy
• Accordingly, the quantity theory of money seeks to explain
the value of money in terms of changes in its quantity
• Double the quantity of money, and other things being equal,
prices will be twice as high as before, and the value of money
one-half
• Similarly, halve the quantity of money, and other things
being equal, prices will be one-half of what they were before
and the value of money double
• There are two versions of the Quantity Theory of Money: (1)
The Fisherian Transaction Approach and (2) The Cambridge’s
Cash Balance Approach
3.1.1. The Fisherian Transaction Approach
• It stresses on money as a medium of exchange, i.e. money as
a means of buying goods and services
 …...Continued 6
• According to Irving fisher, the demand for money refers to
the amount of money people have to hold to undertake a
given volume of transaction over a given period of time
• Fisher’s transaction approach to the Quantity Theory of
Money begins with an identity equation known as ‘equation
of exchange’
MV = PT
• Where M is the total quantity of money, V is its velocity of
circulation (the average number of times a unit of money is
used for transactions), P is the price level, and T is the volume
of transactions
• The equation of exchange claims that, in an economy, the
total value of all goods sold during any period (PT) must be
equal to the total quantity of money spent during that period
(MV)
 …...Continued 7
• Another way of saying it is that if an accounting identity
(namely value paid must equal value received) is to occur,
value of goods, services and assets sold must be equal to the
value of money paid for them
• Thus, in any given period, the value of all goods, services or
assets sold must equal to the number of transactions made
multiplied by the average price of these transactions (= PT)
• On the other hand, because value paid is identically equal to
the value of money flow used for buying goods, services and
assets, the value of money flow is equal to the nominal
quantity of money supply (M) multiplied by the average
number of times the quantity of money in circulation is used
or exchanged for transaction purposes (V) (= MV)
• Fisher transformed the above identity (PT = MV) into a
theory of demand for money
 …...Continued 8
• To move towards the quantity theory of demand for money,
Fisher made two important assumptions; (1) full
employment, and (2) V is constant
• Fisher, like his contemporary classical economists, believed
that flexible prices and wages guarantee output (Y) to be at
its full employment and constant
• He also viewed V as constant because velocity is affected by
technology and institutional arrangements which change
slowly over time
• Putting these two assumptions together, if both Y and V are
constant, then changes in M must cause changes in P to
preserve the equality between MV and PY
• This is the quantity theory of money which illustrates a
change in money supply results in a proportional change in
the price level
• We can further modify this r/ship by dividing both sides by V
 …...Continued 9
• Md = PT/V = kPT; Where k = 1/V
• Thus, according to Fisher’s transactions approach, demand
for money depends on the following three factors, which are
(1) The number/volume of transactions (T), (2) The average
price of transactions (P), and (3) The transaction velocity of
circulation of money (V)
• Example: Assume V is 5 in a year , T is 1,000,000 units and P
is 20 per unit. Calculate money demand (Md).
• Md = PT/V = 20,000,000/5 = 4,000,000
• Another example: Suppose the nominal GDP (P x T) of a
hypothetical country is $10 Billion and quantity of money
(M) $4 Billion. Then, (1) Calculate the velocity of money,
and (2) Interpret the result ?
(1) From the equation of exchange, we have MV= PT
V = PT/M = 10,000,000,000/4,000,000,000 = 2.5
• V= 2.5, meaning the average $ is spent 2.5 times in
purchasing goods and services per year
 …...Continued 10
• The demand for money is

Demand for Money

directly related to the
Md = kPT
value of transaction (PT)
• The slope of Md curve is k
or 1/v ; and since k is
assumed to be constant the
Md curve is a straight line,
as shown in the figure PT
• It slopes upward • In sum, according to this
indicating a direct and theory, since the volume of
proportional relationship transactions (T)and the
between the demand for velocity of circulation (V)
money & the value of are assumed to remain
transactions constant, the demand for
money will increase if the
average price (P) increases
 …...Continued 11
3.1.2. The Cambridge (Cash Balance) Approach
• Cambridge or Cash Balance theory of demand for
money was put forward by Cambridge economists,
Marshall and Pigou
• According to them, the value of a commodity is
determined by demand for and supply of it, and
likewise, the value of money (i.e., its purchasing power)
is determined by the demand for and supply of money
• Cash Balance theory of demand for money differs from
Fisher’s transactions 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
• Money is the most liquid form of wealth, so it serves as
an excellent store of value
 …...Continued 12
• Marshall and Pigou focused their analysis on the factors that
determine individual demand for holding cash balances
• Although they recognized that current interest rate, wealth
owned by the individuals, expectations of future prices and
future rate of interest can all be determinants of the demand
for money, they believed that changes in these factors remain
constant or they are proportional to changes in individuals’
income
• In their approach, these other factors determine the
proportionality factor k, that is, the proportion of money
income that people want to hold in the form of money, i.e.
cash balances
• 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)
 …...Continued 13
• Thus, according to cash balance approach, the public
likes to hold a proportion of their nominal income in the
form of money (i.e., cash balances)
• With this proportion of nominal income (k) that people
want to hold in money; the cash balance approach can
be written as:
Md = kPY
• Where Y = national 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 the public want to hold
• Cambridge Cash balance approach to demand for
money is illustrated in the following figure; where, on
the X-axis, we measure nominal national income (PY);
and on the Y-axis, the demand for money (Md)
 ……Continued 14
• From the graph, it is Md
clear that demand for
money (Md) in the Md = kPY
Cambridge Cash Balance
Approach is a linear
function of nominal
income (PY)
• This is the money
demand function Nominal Income (PY)
• It is a straight line
through the origin
• Here k may be • Now, for the achievement of
interpreted as the average money-market equilibrium,
propensity to hold money demand for money must equal
and thus the slope of the with the supply of money
money demand function S
which we denote by M
 ……Continued 15
Price Level (P)
• It is important to note
that the supply of MS
money MS is Md = kPY
exogenously given and
P*
is determined by the
monetary policies of
the central bank of a
country Quantity of Money
• Thus, equilibrium in
the money market is • The Cambridge economists
achieved when: assumed that k remains constant
• With k and Y remaining constant,
Md = MS the price level (P) is determined
• Since Md = kPY, at by the quantity of money (MS)
equilibrium, • This means that a certain change
MS = kPY in MS will lead to an exact
proportional change in P
 …...Continued 16
Comparison with Fisher’s Transactions Approach:
• There is one similarity between Cambridge cash balance
approach and Fisher’s transactions approach
• Since k = 1/V or V = 1/k, the cash balance approach’s
equation can be rewritten as:
M = 1/V PY or MV = PY
• In fact, Fisher’s transactions approach and Cambridge cash
balance approach are similar in that both seek to explain the
direct and proportional relation between M and P
• In other words, like Fisher’s equation, cash balance equation
is also an accounting identity
• Both consider the possibility of substitution between money
and goods
• Thus, when a greater proportion of nominal income is held
in the form of money (i.e., when k is higher), V falls
• On the other hand, when less proportion of nominal income
is held in money (i.e., when k is lower), V rises
 …...Continued 17
Superiority of the Cash Balance Approach:
• The cash balance approach is superior to the
transactions approach for the following reasons
1. As to the analytical technique, the cash balance
approach fits in easily with the general demand-supply
analysis as applied to the money market
This feature is not available in the transaction approach
2. According to the transaction approach, the change in P
is caused by change in MS only
In the Cash Balance approach, P may change even
without a change in MS if k undergoes a change
Thus k, according to the cash balance approach, is a more
important determinant of P than M as stressed by the
transaction approach
 3.2. Liquidity Preference Theory 18
• Keynes, who was at Cambridge when he wrote his book,
naturally enough, followed the approach developed by his
Cambridge predecessors
• It is an extension of Cambridge theory of demand for money
and stresses on asset role or store of value function of money
• Keynes also asked the question “why do individuals hold
money?” and analyzed the motives that lead people to hold
money with more care than his classical predecessors, Fisher
and the Cambridge economists
• The peculiar characteristic of money as an asset, emphasized
by Fisher and the Cambridge economists alike, was that
money is universally acceptable as a means of exchange
• Keynes too listed the “transaction motive” as an important
(but by no means the only) factor underlying the demand for
money
 …...Continued 19
• According to Keynes people hold money because (1) they
need cash balances to make day-to-day transactions, (2) it is
important to have money balances on hand to meet
unforeseen contingencies, and (3) they prefer to hold money
balances as an asset in preference to or in the combination
with other forms of assets
• Thus in his theory of the demand for money, which is called
The Liquidity Preference Theory, Keynes postulated that
there are three motives behind the demand for money: (1)
the transaction motive, (2) the precautionary motive, and (3)
the speculative motive
• For Keynes, the nominal and real money balances people
desire to satisfy their transaction and precautionary motives
is a constant proportion (k) of income
Md = kPY
• Where, P is aggregate price level, Y is the level of real output
and k is the factor of proportionality
 …...Continued 20
• Expressed in real terms the demand for real cash balance is
proportional to real income
d
• That is, M  kY
P
• He confined the use of the terms transaction and
precautionary demand for money to describing the necessity
of holding cash to bridge the gap between receipts and planned
regular payments
• Keynes did not end his theory with the transaction and
precautionary motives
• He agreed with the Cambridge economists that money is a
store of wealth and called this motive for holding money the
speculative motive
• Money held under the speculative motive serves as a store of
value; just as money held under the precautionary motive or
the classical Cambridge economists’ assertion that tied
money held as a store of value with income
 …...Continued 21
• But it is a store of money meant for a different purpose i.e.,
the cash held under this motive is used to make speculative
gains by dealing in interest-bearing assets like bonds
• Therefore, the speculative component of demand for money
d
can be expressed as: M  f (r )
P
• He also argued from this equation that at some low level of
interest rate, everyone in the economy will expect the rate to
rise rapidly enough to make them unwilling to hold bonds,
preferring money instead of bonds
• At this point the demand for money in the aggregate becomes
perfectly elastic with respect to the rate of interest
• This is what he refers to as Liquidity trap
• This hypothesis implies when such circumstances arise,
monetary policy is ineffective and fiscal policy gets to be the
only means of economic control
 …...Continued 22
• Thus, according to liquidity preference theory, total
demand for money is an additive demand function with two
separate components
• The first component, the transactions demand for money
arising out of transactions and precautionary motives, is an
increasing function of the level of money income (and also
proportional to income)
• The second component, the speculative demand for money
which depends upon rate of interest, is a decreasing
function of the rate of interest
• Thus, total demand for money can be expressed as:
Md  kY  f (r )
P
• In general, Keynes’ analysis of the demand for money
arrives at conclusions completely opposite to those of the
QTM economists in a sense that, according to Keynes,
interest rates were important to money demand
3.3. Post Keynesian Developments in Monetary Theory 23
3.3.1. Baumol’s Inventory Approach to Transactions
Demand for Money
• Keynes assumed transaction and precautionary demand
for money depend only on income, so changes in interest
rate have no impact on them
• But Prof. William Baumol showed that the rate of
interest also affects transaction motive for holding
money:
• Holding cash in hand gives high liquidity
• But there is loss of interest as the money is not
deposited in banks
• Thus, interest rate also affects transaction demand for
money
• Baumol’s model describes money demand in terms of a
trade-off between liquidity and rate of return
 …...Continued 24
• Baumol asserts that individuals hold money (inventory of
money) for the transaction purposes by a firm or an
individual
• Cash balances are held because income and expenditure do
not take place simultaneously
• He claims that 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
• Thus, the alternative to holding cash balances is bonds which
earn interest
• A firm would always try to keep minimum transactions
balances in order to earn maximum interest from its assets
• The higher the interest rate on bonds, the lesser the
transactions balances which a firm holds
• The same can be said about individuals
 …...Continued 25
• Assume that a consumer can keep his income in the
form of either cash or in savings account
• The savings account pays interest, and interest is the
opportunity cost of holding money
• The consumer has to decide between keeping cash
(liquidity) with no interest; or putting it in savings
account and earn interest with less liquidity
• If he keeps the money in deposits, he must spend time
and money to go to the bank to withdraw cash, and this
is the opportunity cost of keeping money in deposits
• So according to him, the total cost of money
management is expressed as:
TC = cost of withdrawal (N*C) + cost of interest foregone
for holding cash (i*M)
 …...Continued 26
• Where N = the number of trips the consumer has to make to
the bank to withdraw money from his savings account; C =
cost of one trip to the bank; i = the nominal interest rate on
the deposits; and M = the amount of cash held by the
consumer
• All of these variables seem to be fixed except for N which
becomes the only endogenous variable that affects the
average money holdings, and it has to be minimized
• If N=1, then the consumer is keeping all his income in the
form of cash
• He spends it gradually throughout a given time period
• His expenditure becomes constant over the time period,
which means the cash in hand falls at a constant rate, till it
becomes zero at the end of the given time period
• How does the consumer determine the optimal cash balance?
 …...Continued 27
• Assume that the consumer Y
keeps all his income in the N=1

Holdings (M)
form of cash, then he goes

Money
to the bank only once to Average = Y/2
withdraw all of his cash
• In one year, his average
money holdings is Y/2
• By keeping all of his 1 Year Time
income as cash, he loses all
the interest
Y/2
N=2
Holdings (M)
• Supposing he keeps half of Money
his income in savings Average = Y/4
account, then he has to
make 2 trips to withdraw
money
• So on average, he has Y/4 6 months 1 Year Time
cash in hand
 …...Continued 28
• By the same token, if N = 3, then 3 trips to the bank, and
the average cash holdings becomes Y/6 and so on
• In general,
• Average money holdings = Y/2N
• Foregone interest = i*(Y/2N)
• Cost of N trips to the bank = C*N
 Y 
• Thus,Total _ Cost  i *  C*N
 2N 
• Given Y, i, and C, the consumer chooses the optimal level
of N to minimize the total cost
• To minimize it, take the derivative of total cost with
respect to N, and set it equal to zero
iY iY iY iY
 2
C  0C  2
N 
2
N
2N 2N 2C 2C
 …...Continued 29
• Suppose the income of Mr. X is 8000 birr per month, and
he wants to spend that income optimally throughout the
month. The annual interest rate is 12% compounded per
month; and cost of a trip is 10 birr. (1) Find the number
of trips Mr. X has to make to the bank to hold optimal
cash balance. And (2) find the average money holdings
in the month iY
1N  
(0.01)(8000)

80
 4 2
2C 2(10) 20
(2) The average money holdings = Y/2N
Thus, Y/2N = 8000/4 = 2000
• Baumol’s real demand for money is expressed as:


M
P

d
 f (i, Y , C ) 
YC
2i
• See the derivation below
 …...Continued 30
• We know the average money holdings = Y/2N, and at
equilibrium, N = √(iY/2C)


M
P

d

Y

Y
2 N 2 iY
2C
Squaring...both...sides,

 
2 2 2
 M   Y d 2CY CY
 P  4 iY  2C
 
4iY

2i
Taking...the...squareroot,


M
P

d

CY
2i
 …...Continued 31
• According to him, demand for money depends positively on
income (Y) and the cost of travelling to and from the bank
(C), and negatively on interest rate (i)
• Thus, in effect, he concluded that transaction demand for
money depends not only on income but also on the interest
rate
• Baumol’s inventory approach to the transactions demand for
money is an improvement over the classical and Keynesian
approaches because:
1. The cash balances quantity theory of money assumed the
relationship between the transactions demand and the level of
income as linear and proportional
• Baumol has shown that this relationship is not accurate
• No doubt it is true the transactions demand increases with
increase in income but it increases less than proportionately
 …...Continued 32
2. 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
3. Baumol’s inventory 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
4. Baumol’s theory removes the dichotomy between
transactions and speculative demand for money of the
Keynesian approach
5. His analysis is the analysis of demand for real balances, and
hence, money illusion is absent
• Money illusion is a name for people’s tendency (human
cognitive bias) to view their wealth and income in nominal
terms, rather than in real terms, ignoring the effect of
inflation
 …...Continued 33
3.3.2. Tobin’s Portfolio Approach to Demand for Money
• Portfolio theories like Tobin’s emphasize the role of money as
a store of value
• According to these theories, people hold money as part of
their portfolio of assets
• The reason for this is that money offers a different
combination of risk and return than other assets which are
less liquid than money–such as bonds
• The main problem with Keynesian approach to the demand
for money is that it suggests that individuals should, at any
given time, hold all their liquid assets either in money or in
bonds, but not some of each
• Tobin’s model of liquidity preference deals with this problem
by showing that if the return on bonds is uncertain i.e., bonds
are risky, then the investor worrying about both risk and
return is likely to do best by holding both bonds and money
 …...Continued 34
• In his analysis, James Tobin makes a valid assumption that
people prefer more wealth to less
• According to him, an investor is faced with a problem of
what proportion of his portfolio of financial assets he should
keep in the form of money (which earns no interest) and
interest-bearing bonds
• The portfolio of individuals may also consist of more risky
assets such as shares
• Thus, faced with various safe and risky assets, individuals
diversify their portfolio by holding a balanced combination
of safe and risky assets
• The choice of the balanced portfolio of assets depends on an
individual’s attitude towards risk
• A risk-averse person will hold more money and less bonds in
his asset portfolio, as money neither brings any return nor
imposes any risk
 …...Continued 35
• But a risk-taker will do just the opposite
• He will hold very little money in his portfolio and the
maximum number of bonds
• All in all, this theory claims that the demand for money
depends on the risk and return associated with money as also
on various other assets households can hold instead of money
• According to Tobin, the majority of investors belong to the
first category — they are risk–averse
• They are prepared to bear some additional risk only if they
expect to receive some additional returns
• So for a risk–averse, every increase in risk born should bring
with it greater increase in returns
• They will, therefore, diversify their portfolios, and hold both
money and bonds
• 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
 ……Continued 36

• This is illustrated in the

Expected Return (R)

following figure where N
the horizontal axis
measures risk (σ) and the
vertical axis measures U3
the expected returns (R) U2
• The line ON is the budget U1
line of the risk averter Zero bond holding
• It shows the O
combinations of risk and Risk (σ)
expected return on the • If an individual holds all his
basis of which he wealth (W) in money (M)
arranges his portfolio of and none in bonds (B), both
wealth consisting of return (R) and risk (σ) will
money and bonds
be zero, as shown by the
• U1,U2, and U3 are
indifference curves
origin (point O)
 ……Continued 37

• With an increase in

Expected Return (R)

the proportion of N
bonds, R and σ will
both rise
• The opportunity line
ON is a locus of
points showing the
terms on which the O Risk (σ)
individual investor
can increase R at the • A movement along ON from
cost of increasing σ left to right shows that the
investor increases his bond
holding only by reducing his
money holding
 ……Continued 38

• The lower part of the

Expected Return (R)

figure shows
N
alternative portfolio
allocations, resulting
U3
in different
combinations of R and U2
σ U1
Zero bond holding
• The vertical axis
measures bond O Risk (σ)
holding
• The amount of wealth
Bonds (B)

(W) held in bonds (B)

increases as the
investor moves down
the vertical axis
 ……Continued 39

• The difference between W

Expected Return (R)

and B is the asset demand N
for money (M); (W=B+M)
• The line OK in the lower U3
part of the diagram shows
U2
the relationship between
U1
σ and B Zero bond holding
• As the proportion of
O Risk (σ)
bonds (B) in the wealth
portfolio (W) increases,
Bonds (B)

the total risk (σ) of the

wealth portfolio increases,
too
• So, where is the optimal K
portfolio allocation?
 …...Continued 40
• The optimal portfolio allocation depends on the
preferences of the investor
• The risk–averse wants the best of both worlds—a high
return on the portfolio by reducing risk
• Each indifference curve shows the risk–return trade-off,
i.e., the terms on which the investor is desirous of taking
more risk if he is compensated by a higher expected
return
• All the points on any such indifference curve yield the
same fixed level of utility
• Any movement from U1 to U2 and from U2 to U3 implies
higher level of utility, i.e., higher levels of R and the same
or even lower levels of σ
• The indifference curves are upward sloping because the
investor is risk-averse
 …...Continued 41
• He will take more risk only if he is compensated by a
proportionately higher return
• Moreover, the curves become steeper as the investor moves
farther to the right, implying increasing risk aversion
• If we make this assumption, then the more risk the
individual has already taken, the greater will be the increase
in expected return required for the investor to be exposed to
a greater degree of risk
• We may now determine the optimal portfolio allocation of a
risk-averse investor
• A risk–averse investor will move to that point along the line
ON which enables him to reach the highest attainable
indifference curve
• At that point he ends up choosing that portfolio which he
intends to choose, and thus, maximizes his utility
 ……Continued 42
• At the tangency point

Expected Return (R)

E, with R = R* and
σ = σ*, the terms on N
which the investor is
able to increase U3 E
expected return on the R*
U2
portfolio by taking U1
more risk, as shown Zero bond holding
by the slope of the line
ON, is the same as O σ* Risk (σ)
terms on which he is
willing to make the
Bonds (B)

trade-off, as is
measured by the slope
of the indifference
curve K
 ……Continued 43

• From the lower part, we

Expected Return (R)

see that the risk–return
combination is achieved N
by holding an amount
of bonds equal to B*, U3 E
and by holding the R*
U2
remainder of wealth, i.e. U1
(W – B* = M*) in the Zero bond holding
form of money
• The demand for money
O σ* Risk (σ)
thus shows the
Bonds (B)

investor’s behavior
towards risk, i.e., the B*
result of seeking to M*
reduce risk below what 𝑾
it would be if W = B and σ* K
M=0
 ……Continued 44
• In the graph, such an all-

Expected Return (R)

bonds portfolio would be
associated with risk of σ F N
and the expected return of R
R, as shown by point F U3 E
• This portfolio yields a R*
lower level of utility than U2
that represented by bond U1
holding of B* and money Zero bond holding
holding of M* O
• The reason is that as the
σ* σ Risk (σ)
investor moves to the right
Bonds (B)

of point E along the line Zero money

ON, the additional return B* holding
expected from the portfolio M*
by holding more bonds 𝑾
(and less money) is not σ* σ K
adequate to compensate
him for the additional risk
 ……Continued 45
N2
• In other words, the

Expected Return (R)

slope of the line ON is E2
less than that of the R1* F N
indifference curve U2 R
U3
• The movement to point E
R*
F takes the investor to U2
a lower indifference U1
curve U1 Zero bond holding
• If the rate of interest O
rises, the opportunity σ* σ Risk (σ)
curves for the investor
Bonds (B)

shifts to ON2 Zero money

B* holding
• The equilibrium is at
B1* M* M1*
point E2, where a
greater proportion of 𝑾 σ* σ1* σ K
assets will be in the
form of bonds (OB1*)
 …...Continued 46
• In other words, as the interest rate increases, the
increase in the wealth holder's welfare, which has been
shown by the movement on to the higher indifference
curves, is accomplished by an increase in the amount of
bonds from OB* to OB1* (or decrease in the amount of
money held from M* to M1*) and also by the increase in
the portfolio risk from OR* to OR1*
• That is, from the lower part of graph, when the rate of
interest increases, a risk–averter holds successive units
of more bonds (rise from OB* to OB1*) and less money
(reduction from M* to M1*) in their portfolio
• Thus, Tobin again, like Keynes, proves the negative
relationship between the speculative demand for money
and the rate of interest
• This means that the demand for money falls as the rate
of interest increases
 …...Continued 47
Superiority of Tobin’s Theory over Keynes’
1. Tobin’s approach generates a smooth and continuous
liquidity preference function
• In addition, Tobin postulates quite realistically, that
liquidity preference shows people’s behavior towards risk
instead of expected return since it is not possible to know
whether the rate of interest will rise or fall in the future
• In doing so, Tobin discussed the possibility of perfect
elasticity of demand for money at a very low rate of
interest (look at the shape of the indifference curves close
to the origin)
2. From Tobin’s portfolio theory, we can look at the
money demand function (M/P)d = f(Y, i) as a useful
simplification
• The theory uses real income Y as a proxy for wealth W
3.4. Friedman’s Modern Quantity Theory of Money 48
• In 1956, Milton Friedman, the leader of Chicago
(monetarist) school presented a new type of money demand
function on the basis of which he made a restatement of the
classical Quantity Theory of Money
• In his view, the money demand function is fairly stable
• He treats money as just one type of asset in which people
hold a certain portion of their wealth
• Business firms view money as a capital good or a factor of
production which they combine with the services of other
productive assets or inputs to produce goods and services
• Thus, according to Friedman, individuals hold money for the
services it provides to them
• It may be noted that the service rendered by money is that it
serves as a general purchasing power so that it can be
conveniently used for buying goods and services
 …...Continued 49
• 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
• Friedman considers the demand for money merely as an
application of a general theory of demand for capital assets
• Like other capital assets, money also yields return and
provides services
• He analyzes the various factors that determine the demand
for money and from this analysis derives demand for money
function
• Note that the value of goods and services which money can
buy represents the real yield on money
• Obviously, this real yield of money in terms of goods and
services which it can purchase will depend on the price level
of goods and services
 …...Continued 50
• Beside money, bond is another type of asset in which people
can hold their wealth
• Bonds are securities which yield a stream of interest income,
fixed in nominal terms
• Yield on bond is the rate of interest and also anticipated
capital gain or loss due to expected changes in the market
rate of interest
• Equities or Shares are another form of asset in which wealth
can be held
• The yield from equity is determined by the dividend rate,
expected capital gain or loss and expected changes in the
price level
• The fourth form in which people can hold their wealth is the
stock of producer and durable consumer commodities
• These commodities also yield a stream of income but in kind
rather than in money
 …...Continued 51
• Thus, the basic yield from commodities is implicit one
• However, Friedman also considers an explicit yield from
commodities in the form of expected rate of change in their
price per unit of time
• Friedman’s demand for real money balances (M/P)d can be
written as:
(M/P)d = f (W, h, rm, rb, re, P, π, U)
• Where, (M/P)d stands for demand for real money balances;
W stands for wealth of the individuals, h for the proportion
of human wealth to the total wealth held by the individuals,
rm for rate of return or interest on money, rb for rate of
interest on bonds, re for rate of return on equities, P for the
price level, π for expected rate of inflation [expected change
in price level calculated as (ΔP/P)] , and U for the institutional
factors over which wealth–holders have no control
• These factors may now be explained one by one:
 …...Continued 52
1. Wealth; and Proportion of Human Wealth to Total Wealth:
• An individual’s total stock of wealth is the most important
determinant of his demand for money
• The greater the wealth of an individual, the more money he
will demand for transaction and other purposes
• For the same reason, as a country continues to grow, the total
demand for money for all purposes will also increase, though
not proportionately
• Wealth has two main components—non-human and human
• Non-human wealth consists of financial assets such as bonds,
shares and money
• Human wealth refers to the sum of an individual’s present
and future earnings or his permanent income
• There are two main differences between non-human and
human wealth
• Non-human wealth can easily be converted into money
 …...Continued 53
• So such wealth is highly liquid
• But human wealth (such as an individual’s knowledge, skill
and superior ability to perform a certain task) is not liquid
• It cannot be used as security to borrow money
• So the proportion of human wealth to total wealth is
included as an independent variable in the money demand
function
• Friedman argues that as the proportion of human (illiquid)
wealth to total wealth increases, the demand for money will
increase to offset the illiquidity of human wealth
2. The Relative Rates of Return (rm; rb; re):
• rm is the rate of interest on savings and fixed deposits
• People compare all the three rates of interest while taking
decision on how much wealth to hold in the form of money
 …...Continued 54
• If rates of return on bonds (rb) and equities (re) increase, the
opportunity cost of money holding will increase
• This will reduce the demand for money [i.e., the desire to
hold money either in liquid form (currency)] or in the form
of demand deposits on which no interest is paid
• In short, the demand function for money varies inversely
with the rate of interest (or return) on bonds and equities
3. The Price Level (P):
• If the price level rises, people require more nominal balance
to keep their real balance intact so that they can buy the
same amount of goods and services
• This means that as the price level goes up (down) the
demand for money will increase (fall)
4. Expected Rate of Inflation (π):
• If people expect a higher rate of inflation, they will reduce
their money holding, since inflation will reduce the value
(purchasing power) of their money holding; and vice-verse
 …...Continued 55
• If the rate of inflation exceeds the nominal rate of interest,
the real rate of interest will be negative
• Therefore, when people expect a higher rate of inflation, they
become eager to convert their money holdings into goods or
real assets (like houses or land) which act as inflation hedges
5. Institutional Factors (U):
• Various institutional factors such as the method of wage
payment and payment of bills affect the demand for money
• If, for example, checks are used in all types of transactions,
the demand for money will fall
• But if there is a wave of credit card fraud, the demand for
money will increase since credit cards will not be widely
accepted
• If people anticipate a major war or revolution, they will try
to buy more goods, the prices of which are likely to rise
sharply due to acute scarcity raising the demand for money
 …...Continued 56
• Similarly, a major global financial crisis will increase the
demand for money and reduce the demand for bonds and
equities
• All these institutional factors are included in the variable U
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
• To overcome this difficulty, Friedman takes the present value
of wealth which is YP/rm as a proxy variable for wealth
• Where Yp is the permanent income and rm is the rate of
interest on money
• So his money demand function becomes;
Md = f (Yp, h, rm, rb, re, P, π, U)
 …...Continued 57
• If we assume reasonable price level stability and constancy of
institutional factors as also the ratio of non-human to human
wealth and a uniform rate of interest (r) as returns on money,
bonds and equities, then the demand function for money
becomes
Md = f ( Yp, r)
• Once again, we find that the demand for money Md is a
function of two key variables, namely permanent income (Yp)
and rate of interest (r)
Superiority of Friedman’s Theory over Keynes’ theory
1. Friedman uses a broader definition of money than that of
Keynes in order to explain his demand for money function
• He treats money as an asset or capital good capable of
serving as a temporary abode/habitate of purchasing power
• It is held for the stream of income or consumable services
which it renders
 …...Continued 58
2. Friedman postulates a demand for money function quite
different from that of Keynes
• As per Friedman, the demand for money on the part of
wealth holders is a function of many variables
• In the Keynesian theory, on the other hand, the demand for
money as an asset is confined to just bonds where interest
rates are the relevant cost of holding money
3. 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
• According to Keynes, monetary changes affect economic
activity indirectly through bond prices and interest rates
• The monetary authorities increase the money supply by
purchasing bonds which raises their prices and reduces the
yield on them
• Lower yield on bonds induces people to put their money
elsewhere, such as investment in new productive capital that
will increase output and income
 …...Continued 59
• On the other hand, in Friedman’s theory, monetary
disturbances will directly affect prices and production of all
types of goods since people will buy or sell any asset held by
them
• Friedman emphasizes that the market interest rates play
only a small part of the total spectrum of rates that are
relevant
4. There is also a difference between the two approaches with
regard to the motives for holding money balances
• Keynes divides money balances into “active” and “idle”
categories
• The former consists of transactions and precautionary
motives, and the latter consists of the speculative motive for
holding money
• On the other hand, Friedman makes no such division of
money balances
 …...Continued 60
• According to him, money is held for a variety of
different purposes which determine the total volume of
assets held such as money, physical assets, total wealth,
human wealth, and general preferences, tastes and
anticipations
5. In his analysis, Friedman introduces permanent income
and nominal income to explain his theory
• Permanent income is the amount a wealth holder can
consume while maintaining his wealth intact
• Nominal income is measured in the prevailing units of
currency
• It depends on both prices and quantities of goods traded
• Keynes, on the other hand, does not make such a
distinction