Chapter Three

The Theory of Demand for Money

3.1. Classical theories of money demand

3.1.1. Quantity Theory of Money

The quantity theory of money is a theory that discusses how the nominal value of aggregate income is
determined. It is also a theory of money demand since it tells how much money is hold for a given
amount of aggregate income. The theory is based on the concept of velocity of money.

Velocity of Money: Is the rate of turnover of money. It is the average number of times that a unit of
currency is spent in buying the total amount of goods and services produced in the economy. It provides
the link between money supply and nominal income. Mathematically, it can be given as follows.

We first start from an identity which equates total spending with nominal income or nominal value of
goods and services. The identity is holds true by definition.

MV = PY.................................................................... (1)

Where: V= is velocity of money

M= is money supply

P= is average price level

Y =is real level of income or volume of transaction and

PY =is nominal income

From the above identity we derive the equation for velocity of money as follows:

V = PY / M....................................................................... (2)

According to classicalists, velocity of money depends on institutional and technological factors related to
the paying behavior of people. It is therefore assumed to be constant in the short run since institutions
and technologies do not change in the short-run. This implies that any change in money supply (M) will
be reflected in the nominal income (PY) i.e., if money supply doubles so will, nominal income.
Classicalists also assume that the aggregate real income (Y) will remain constant at the equilibrium level
in the short-run since prices and wages are completely flexible. Thus, changes in money supply will lead
to changes in price only. In other words, an increase in the supply of money leads to an increase in
average price level, but everything else (real income, velocity of money etc) will not be affected. For
example, if V and Y are fixed at 4 and 100 respectively, a supply of money (M) which equals 25 implies
that the average price level (P) should be 1. And if M doubles to 50 P will also double to 2 while
everything else will be remain unchanged. This is called the quantity theory of money which implies that
money is neutral with respect to the real sector of the economy and movements in the price level
results solely from changes in the quantity of money.

From the formula of velocity of money given above we can derive the formula for money holdings or
money supply (M) as follows:

1
M= . PY .............................................................................. (3)
v

In equilibrium, the amount of money that people hold (M) will be equal with the quantity of money
people demand (quantity of money demand). Thus, we can substitute money demand for money supply
in the equation for money supply and then derive the function for money demand. In effect, the
quantity theory of money tells us how much money is people hold for a given amount of aggregate
income and is a theory of demand for money.

1
Md= . PY
v

= kPY................................................................................... (4)

Where Md is quantity of money demanded and k is the reciprocal of velocity while the other symbols are
defined as above.

This suggests that money demand is purely a function of nominal income and is not affected by interest
rate. Thus, the classicalists’ theory of money demand shows that money demand is not a function of
interest rate and this is backed by the assumption that people demand money only for transaction
purpose. For classicalists, money demanded for transaction purpose only depends on the volume of
transaction and does not depend on interest rate. The demand function also tells us that quantity of
money demanded is a constant function of nominal income, i.e, people hold a fraction of their nominal
income in the form of money.

3.1.2. The Cambridge Approach to money Demand

The Cambridge school followed a different approach though they arrived at a similar money demand
equation which is implies that the quantity of money demanded is given by some proportion of the
nominal income. They did not take money demand to be solely affected by volume of transactions or
nominal income and velocity. They allow for flexibility in people’s decision about money holding instead
of being completely bound by institutional and technological factors. As such, it did not rule out the
effect of interest rate on the demand for money.

For them, people demand money because it serves as a medium of exchange (transaction motive) and
as a store of value. To the extent that money serves as a medium of exchange, demand for money is a
positive function of the volume of transactions like in the case of the classicalists’ quantity theory of
demand. But, money also serves as a store of value and this part of the demand for money according to
the Cambridge economists depends on wealth and the relative expected return of money. But, they say
that wealth in nominal terms is proportional to nominal income and this suggests that, the part of
money demanded as a store value is also proportional to nominal income. But, when people demand
money as store of value they are also affected by the relative expected return of money in addition to
their wealth (and hence income). They considered bond as an alternative to money which can be hold as
a store of value and if the return of bond (interest on bond) changes the demand for money will fall
since people will resort to bond. More specifically, if interest rate on bonds increases, less money will be
demanded as a store of value and the whole quantity of demand for money will decrease though
quantity of money demanded for transaction purposes will not be affected by interest rates.

To conclude, the quantity theory of money and the Cambridge economists developed a classical theory
of money demand in which the demand for money is proportional to nominal income. However, the two
theories are different in that the first one emphasized technological and institutional factors and ruled
out any possible effect of interest rates on the demand for money in the short-run while the Cambridge
economists emphasizes individual choice and allows interest rate to affect the demand for money by
affecting people’s decision to hold money.

3.1.3 Keynes's Liquidity Preference Theory

Keynes developed a theory of demand that emphasized the importance of interest rates like the
Cambridge economists. But, his approach is more detailed to the extent that he identified the different
motives why people demand money and showed the effect of interest rate on the demand for money in
a more explicit way. According to his theory, there are three motives for demanding money namely:
transaction motive, precautionary motive and speculative motive. We will fist see the three motives
briefly and then the function of demand for money.

Transaction Motive:

This motive of demanding for money refers to the act of demanding money for the purpose of
transaction. People demand money to fulfill their current consumption demand of goods and services
i.e., they demand money as a medium of exchange. This part of the demand for money is determined by
the amount of current consumption which according to Keynes is proportional to income; it is purely a
function of income and interest rate does not affect it.

Precautionary Motive:

Like the transaction motive this motive also refers to demand for money for the purpose of transaction.
But, unlike the first motive, here money is not demanded for current transactions and it is rather
demanded a cushion against unexpected transactions in the future. People could not predict their future
volume of transactions and hence their future demand for money and they hold some amount money as
a precaution for future unexpected demand for money and this what Keynes called the precautionary
motive for money demand. People for example, may not be sure about their future health expense and
may hold some money for fear they may face some health problem unexpectedly and need money for
treatment. Another example could be expectation about price changes; they may suspect that the prices
for some commodities may fall in the future and this will make them hold money so that they will
purchase these commodities at better price. For Keynes, this part of the demand for money is primarily
dependent on the volume of future expected transactions which in turn is proportional to income like
the transaction motive, i.e. as income increases, people will hold more money for both purposes-current
transaction and future expected transactions.

Speculative Motive:

Keynes agreed with the Cambridge economists that money is also demanded as a store of value (wealth)
and he called this motive of holding money the speculative motive. Though this motive is affected by
wealth which in turn is believed to be closely related with income Keynes also identified interest rate to
be an important determinant of thispart of money demand. To put it differently, people hold their
wealth in different assets and money is one alternative of holding wealth. Therefore, as their wealth
increases people will hold more of different assets including money but for the same wealth people may
make a substitutions between assets based on the relative desirable properties of the assets like
expected return. Keynes considered money and bond as the two alternative assets of holding money
and hence people can hold their wealth either in the form of money or bond and since money does not
earn interest people will choose to hold bond if they expect a positive return from holding bond.
Therefore, the speculative motive is inversely affected by interest rate, i.e., as interest rate from bonds
increases the return from bonds will increase and people will shift from money to bonds (they will hold
less money and more money). Though Keynes considered only bond as an alternative asset to money in
terms of storing wealth the conclusion can be generalized to the case where there many alternative
assets of storing wealth including different physical assets and financial assets other than bond. This part
of the demand for money is therefore affected by interest rate and since the total demand for money is
according to Keynes a function of the three motives it will also be affected by interest rate.

Keynes’ demand function for money:

Keynes identified the three motives for demanding money as a foundation for the money demand
function. He also argued that people worry about real money balances since what matters in terms of
their motives is how much they can buy using their money holding. He therefore chose to put his
demand function for money in real terms and as is discussed above income is a very important
determinant of demand for money whichever the motive might be. More specifically, demand for
money is positively related with income; people demand more money as their income be it for
transaction purpose, as a precaution for future transactions or as a store of value. What is more, interest
rate also affects demand for money through the speculative motive. The first two motives, as discussed
earlier are not affected by interest rate, according to Keynes while the third motive is inversely affected
by interest rate. Thus, to the extent that the speculative motive is part of the total demand for money,
interest rate will be a determinant for the latter. The strength of the effect of interest rate on demand
for money will depend on the importance of the speculative motive in deriving the total demand for
money.

Keynes’ demand function for money can be put mathematically as follows:

Md/p=f(i_,Y+)……………………………………………………(5)
 Where: i =is interest rate, y =is real income, Md = is demand for nominal money
d
balances, P = is price level and M /P= is demand for real money balances

The function shows that the read demand for money is a function of both interest rate and real income
and the signs under each of the factors show the direction of relationship. Thus, real money demand is
inversely affected by interest rate and positively affected by real income or transaction.

The fact that money demand is affected by interest rate implies that velocity of money is no more
constant and it is rather volatile. This is so because money holding changes even without change in
nominal income if interest rate changes. This can be showed mathematically by first deriving the
formula for velocity of money from the real demand for money given above.

By taking the reciprocal of both sides we will get the following:

P 1
d=
… … … … … … … … … … … … … … … … … … … … … … .. 6
M f (i , y)

And multiplying both sides by ’y’ will give us the following:

Py y
d=
… … … … … … … … … … … … … … … … … … … … … … … … … … … .7
M f (i , y)

But, money demand (Md) and money supply (M) are equal in equilibrium and hence we can substitute
one by the other, thus:

Py y
d=
=v … … … … … … … … … … … … … … … … … … … … … … … 8
M f (i , y)

This shows that velocity of money is not constant even in the short run and this is reflected on the read
demand for money equation which is part of the above velocity function. As is shown above, velocity of
money is inversely affected by the read demand for money which in turn is inversely affected by interest
rate. Thus, we can conclude that the velocity of money under the Keynesian framework is positively
affected by interest rate, i.e., as interest rate increases the velocity of money will rise. This can also be
shown by taking the first order derivative of the velocity function with respect to interest rate. The
institution behind is that, as interest rate increases people will hold less money since money will become
less attractive as a store of wealth and hence people will resort to other asset like bond. And, as the
money hold by the public falls, taking the real transaction level constant (y), the velocity of money has to
increase i.e., money should circulate faster that before in order for the money hold by people to be
enough for all the transactions.

Further Developments in the Keynesian Approach:

After Keynes developed his liquidity preference theory of demand for money more sophisticated
theories of demand for money have been developed with in the frame work of the Keynesian approach.
These recent developments give due emphasis on the importance of interest rate as a determinant of
the demand for money. The two famous economists known in this regard are William Baumol and
James Tobin.

The assumptions of the model are

1. An individual receives a fixed income at the beginning of every period

2. An individual spends his income at a constant rate, and so at the end of the period he has spent all his
income

3. There are only two assets-cash and bonds. Cash earns a nominal return of zero, bonds earn an
interest rate r

4. Every time an individual buys or sells bonds to raise cash he incurs at a fixed brokerage fee.

Transactions Demand:

Boumol and Tobin independently developed similar demand for money models which shows that the
transaction component of the demand for money is also dependent on interest rate i.e., they developed
a theory of demand for money along side Keynes’s liquidity preference theory but modified his theory
by allowing the transaction motive for money to be affected by interest rate while Keynes argued that
the transaction motive form demanding money is solely affected by income.

Assuming that money is demanded only for transaction purposes, people will hold some amount of
money taking in to consideration their volume of transaction which in turn is proportional to their
income. But, when we say a transaction motive, it does not necessarily mean that the whole money will
be spent on the spot or over night. What it all means is that people will hold some money for the
purchase of some goods and services in the near future, say a month. If someone holds some amount of
money for his current budget period, which will be assumed to be a month for our purpose, he will be
loosing some return on his money since he will not use the whole money today. Rather, part of his
money balance will stay over the course of the month and hence he could have invested it in an interest
bearing asset, for example a saving account.

Therefore, holding money for transaction purposes has an opportunity cost which is measured in terms
of the return on an alternative asset-interest on the saving account. But, it also has also an advantage in
terms of avoidance of transaction cost. If the individual holds all of his budget in the form of money he
can use it any time in the budget period and there is not need of converting the money (this is so
because moneyis absolutely liquid) but if he puts a fraction of him budget in a saving account knowing
that it is not until latter period in the budget time that he will need this part of the money, when the
time reaches, he has to withdraw it from the bank and this entails atransaction cost in terms of time,
transportation cost, inconvenience and the like. Thelarger balance he puts in the bank, the more
frequently he will have to go to the bankand withdraw some money and hence the more the transaction
cost will be and in factthe more the interest income will also be. The same will be true if he put part of
themoney in another asset like bond since he has to sell the bond before he could use the money. Thus,
there will be a tradeoff between return (interest) and transaction cost andthe person will make his
decision of holding money ( and other assets) based on the costand benefit of the interest bearing asset.
By implication, if interest rate on savingaccounts increases, while transaction cost remains constant, the
demand for money willfall as people will decrease their money balance and increase their saving
accountbalance. Velocity will also increase as interest rate increases since a fall in money demand
keeping income constant means money should circulate faster than before. To conclude, the transaction
component of the demand for money is negatively related to the level of interest rates.

Precautionary Demand

Models that explore the precautionary motive of the demand for money have been developed along
lines similar to the Baumol-Tobin framework. Like the transactions demand, the precautionary demand
is also affected by interest rate since the trade-off between return and transaction cost also applies
here. If a person holds some amount of money as a precaution for future need of money he will be
loosing some return but if he puts the money (or part of it) in some interest bearing asset like the saving
account he will be getting a positive return but he will have also to incur a transaction cost whenever he
needs the money since he cannot use his saving account balance as it is. Thus,the higher the interest
rate, the lager money balance he will put in the form of saving account. The precautionary demand for
money is also inversely related to interest rate.

Speculative Demand

Keynes’ analysis of the speculative demand for money was open to serious criticisms and we will
consider the criticism forwarded and the improvement made by Tobin. In his analysis of the speculative
demand for money Keynes indicated that people hold an asset as a store of wealth if it has higher
expected return relative to other alternative assets. For example, if a bond has a positive expected
return people will hold only bond since money does not earn interest. This implies that when people
decide as to which asset to hold as a store of value, they only consider expected return and do not worry
about the risk the asset. A related implication is that people will hold just one asset and will not hold a
diversified portfolio of assets there by distributing risk and minimizing the overall risk. For Tobin this is
not the case; people do care about risk and more specifically are risk averse. The also diversify their
holding of assets instead of holding just one asset. They will choose to hold an asset if it can contribute
more to expected return than to risk. Therefore, though money does not earn interest, it has a desirable
property since it is riskless (its value does not vary with market conditions unlike other assets like bond
whose value may rise or fall). In deciding which asset to hold, there will be a trade-off between risk and
return and people will choose to hold a portfolio of assets with the best risk-return structure.

In conclusion, the recent developments on the Keynesian theory of demand for money imply that all the
three motives for money demand are affected by interest rate and hence interest rate is very important
in determination the demand for money. But, it should be noted that the effect of interest rate is the
strongest in the speculative motive. Another development is that risk of an asset is also an important
consideration and money has an advantage over other assets in this regard since it is risk less.

3.1.4. Friedman’s Modern Quantity Theory of Money:

In 1956, Milton Friedman developed a theory of the demand for money in a famous article, “The
Quantity Theory of Money: A Restatement.” His analysis is closer to that of Keynes and the Cambridge
economists than to Fisher’s quantity theory of money though his article seems about quantity theory of
demand. Though, Friedman, like his predecessors, pursued the question of why people choose to hold
money, he did not however, deal with the specific motives for holding money, as Keynes did. He simply
applied the general theory of portfolio choice to money. He said that the demand for money is affected
by the same factors that affect the demand for any other asset. Accordingly, the demand for any asset is
affected by the relative return of its substitute assets in addition to the total wealth of the individual.
More specifically, he claimed that the demand for money is affected by the resources available to the
individual (wealth) and the expected returns of on other assets (which can serve as substitute for
money) relative to the expected return on money. He identified bonds, equities (stocks) and real goods
as substitutes for money and hence their relative return will affect the demand for money. Like Keynes,
he recognized that people want to hold a certain amount of real money balance, i.e., he put his demand
function for money in real terms and included wealth and the relative returns of bond, stock and real
goods as factors. His demand function is given below:
d
M
=f(Yp,rb-rm,re-rm,Πe-rm)…………………………………………………………………………………9
P
d
M
where , =demand for real money balances
P

YP=Friedman's measure of wealth, known as permanent income(technically, the present discounted

value of all expected future income, butmore easily described as expected average long-run income)

rm= Expected return on money

rb= Expected return on bonds

re=Expected return on equity (common stocks)

e
Π= Expected inflation rate

Let us look in more detail at the variables in Friedman's money demand function and what they imply
for the demand for money.

Because the demand for an asset is positively related to wealth, money demand is positively related to
Friedman's wealth concept, permanent income (indicated by the plus sign beneath it). Unlike our usual
concept of income, permanent income (which can be thought of as expected average long-run income)
has much smaller short run fluctuations because many movements of income are transitory (short-
lived), For example, in a business cycle expansion, income increases rapidly, but because some of this
increase is temporary, average long-run income does not change very much. Hence in a boom,
permanent income rises much less than income. During a recession, much of the income decline is
transitory, and average long-run income (hence permanent income) falls less than income. One
implication of Friedman's use of the concept of permanent income as a determinant of the demand for
money is that the demand for money will not fluctuate much with business cycle movements.

An individual can hold wealth in several forms besides money; Friedman categorized them in to three
types of assets: bonds, equity (common stocks), and goods. The incentives for holding these assets
rather than money are represented by the expected return on each of these assets relative to the
expected represented by the expected return on each of these assets relative to the expected return on
money, the last three terms in the money demand function.

The expected return on money rm, which appears in all three terms, is influenced by two factors:

1. The services provided by banks on deposits included in the money supply, such as provision of
receipts in the form of canceled checks or the automatic paying of bills. When these services are
increased, the expected return for holding money rises.

2. The interest payments on money balances. Now accounts and other deposits that are included in the
money supply currently pay interest. As these interest payments rise, the expected return on money
rises.

The terms rb –rm and re – rm represent the expected return on bonds and equity relative to money; as
they rise, the relative expected return on money falls, and the demand for money falls. The final term,
Пe– rm, represents the expected return ongoods relative to money. The expected return from holding
goods is the expectedrate of capital gains that occurs when their prices rise and hence is equal to the
expected inflation rate Пe. If the expected inflation rate is 10 percent, for example,then goods' prices are
expected to rise at a 10 percent rate, and their expected returnis 10 percent. When П e– rm rises, the
expected return on goods relative to moneyrises, and the demand for money falls.