Demand of Money

A Presentation by
Sahil Mir
 Introduction
 Money is at the centre of every economic transaction and plays a significant role in all economies.
 Money is a means of payment / medium of exchange; or an instrument used for transferring
purchase power of consumer.
 The usefulness of money makes people demand money. Money is either used for goods and services
or to hold idle cash.
 For this purpose, its important to know bout its demand and how is it measured and what are the
components affecting money’s demand.

The Demand of Money.

• Having understood the role of functions of money and it’s importance, the concept of
money demand becomes easy. If people desire to hold money, we can say there is demand
for money. Also, the demand for money is of derived nature as it is demanded for
purchasing power. Basically, it is demanded because people wish to have more command
over real goods and services with the use of goods.
• Income, rate of interest, general price level, real GDP are some of the factors influencing
demand for money.
There are two kinds of theories for the concept of MONEY DEMAND.
They are as follows:
• Pre-Keynesian Theory

• Post-Keynesian Theory

Pre-Keynesian Theories
There are three approach under the pre-Keynesian theory :-
1. Classical approach
2. Neo- classical approach
3. Keynesian theory

For the purpose of this chapter, we will focus mainly on classical approach and
Keynesian theory.
 Classical Approach

 Classical approach was propounded by IRVING FISHER (of Yale university) in his book “THE
PURCHASING POWER OF MONEY” in the year 1911.
 This approach demonstrate that there is a strong relationship between money and price
level. The quantity of money is the main determinant of the price level and the value of
money.
 This approach is also know as “The Quantity Theory of Money” or “Equation of Exchange”
or “Transition Approach”.
MV=PT
Where, M= The total amount of money in circulation.
V= Velocity of money circulation.
P= Average price level
T= The total number of transactions.
 Classical Approach
 Here, considering the equilibrium, supply of money is equal to demand of supply. MV
represents the supply of money and hence the demand too. According to Say’s Law, here,
income and employment are the main determinants(Assumed).
 In the given equation, demand of money is shown by “PV”. Based on the above assumption,
keeping T constant, demand will change directly and proportionally top change in Income.
So is the velocity i.e. “”V”, is having inverse effect on demand for money.
Md = PT/V
Where, Md = Demand of Money.

 Assumptions:-
1. Money is demanded for transactions as means of payments.
2. Demand of money depends on volume of transaction and price level.
3. A change in velocity of money circulation changes the quantity of money demanded.
 Keynesian Approach
 Keynes approach of demand for money is known as ‘Liquidity Preference Theory’; Liquidity
Preference is a term given by J.M. Keynes in his book “The General Theory Of Employment, Interest
and Money”(1936), denotes people’s desire to hold money rather than securities or long term
Interest bearing investments.
 According to Keynes , People hold money in cash for three motives:

Precautionary
Motive Sp The Two important function of this theory:-
o n ec
i u
act e Mo lati 1) Medium of Exchange 2) Store of Value
n s iv tiv vAlso,
r a ot e e this theory was explained by raising two
T M
fundamental questions:-
1) Why is money demanded?
2) What are the determinants of demand for
money?
 Transaction Motive
 The transaction motive for holding cash relates to the need for cash for current transactions
for personal and business exchange. The need for holding money arises because there is lack
of synchronization between receipts and expenses. For example: there is a time gap
between successive income receipts and expenses carried on by a wage worker.
 There are two kinds of transaction motive: 1) Income Motive 2) Business Motive
 Keynes did not consider the transaction balances as being affected by interest rates. The
transaction demand for money is directly related to the level of income. The transactions
demand for money is a direct proportional and positive function of level of income.

Lr = kY
Here, Lr = transaction demand for money,
k= ratio of earnings which is kept for transaction purpose,
Y= earnings
 Transaction Motive
 Income motive: It refers to the transactions demand for money by the wage and salary
earners. They receive their income once in a month or in few case weekly or daily. Money is
required for these people to carry out transaction.

 Business motive: Business firms require to hold money to meet their day to day expenses.
The income interval of the firms may be a month or two or even longer; as there is always
time gap between production and realisation.
 Keynes agreed that aggregate demand for money for transaction purposes as the sum of
individual demand and therefore, the aggregate demand for money is a function of national
income.
 The amount of money held for transaction motive depends on the level of income, time
interval, price level, and volume of employment.

Income Transaction Lr
Increase Increase Increase
Decrease Decrease Decrease
 Precautionary Motive
 Many unforeseen and unpredictable contingencies involving money payments occur in our
day to day life; individuals as well as businesses keep am portion of their returns to finance
such unanticipated expenditures. Hence in this approach too , The demand for money is
influenced by Income level as well as the personalities of a individual such as being
optimistic and pessimistic and certain political and economic condition .
 Here also, it is assumed that this motive is insensitive to interest.
 The demand for transaction and pre-cautionary motive is expressed as L1 = f(y).
Here,L1 = demand for money for transactions and precautionary motive; y= Income
 Demand for money held under transactions and precautionary motives is knows as “Active
Cash Balances”.
 Speculative Motive
 The speculative motive reflects people’s desire to hold cash in order to be equipped to
exploit any attractive investment opportunity requiring cash expenditure. According to
Keynes, people demand to hold money balances too take advantage of the future changes in
the interest rate, which is the same as future changes in bond prices.
 It is implicit in Keynes theory, that the rate of interest is really then return on bonds. We
can say that speculative demand is ‘Interest Elastic.’ Keynes assumed that the expected
return on money is zero, while the expected returns om bonds are of two type:
1) The interest Payment (current interest rate)
2)The expected rate of capital gain (Critical interest)
 The market value of the bond and the market rate of interest are inversely related. A rise in
the market rate of interest leads to decrease in the market value of bond and vice versa

Interest Value Bond Value Investment Lr

Increase Decrease Increase Decrease
Decrease Increase Decrease Increase
 Speculative Motive
 Here, The change in market rate of interest and security price can be expressed in the form of an
equation.
P= R/m*N
Here, P= Market Price of security,
R= Return on securities,
m= Market rate of interest,
N= Original price of security.
 People usually don’t hold cash when rate of interest is high, since;
1) The opportunity cost of holding cash is high
2) Security prices at that time, being low investors are included to purchase them.
 Demand for money held under the speculative motive is referred to as the demand for “idle cash
balance”.
L2= f(r)
Here, L2= demand for speculative motive, r=rate of interest
L2 and r are inversely related.
 Liquidity Trap
• The Inverse relation between the rate of interest and speculative demand for money
transforms into a different form of relationship at a very low rate of interest.
• The speculative demand for money will be perfectly elastic.
• The Speculative demand for money, its inverse relationship with the interest rate and
liquidity trap is shown in the figure below.
• The horizontal part of the curve shows the liquidity trap which explains the perfectly
elastic demand for money for speculative motive.
• People prefer to hold cash instead of bonds due to the fear of an
imminent decline in the prices. At such a lower rate people do
not prefer to hold any other asset or debt.
• This concept has a lot of significance for monetary policy.
 Total Demand for money
 The aggregate demand consists of Transaction Motive and Precautionary Motive which is
income based and interest inelastic as well as speculative motive which is influenced by
interest. Hence the Total demand for money Is expressed as
Md = L1 (y) + L2 (r)

 The transaction and precautionary demand is considered as active balance and is the
function of income. It is positively related to the level of income .
 The speculative demand is a demand for idle balance and is inversely related to the rate of
interest.
THANK YOU