CHAPTER –3 (UNIT – 1)

Chapter -3
Unit-1
THE CONCEPT OF MONEY DEMAND :
IMPORTANT THEORIES

1 THE CONCEPT OF MONEY DEMAND

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MONEY

Anything that can serve as a

2M 2S

Medium Measure Standard Store

Of of of of
Exchange Value Deferred Value
Or Payment
People can Unit of People
Buy or sell Account You can can save
Anything with pay any it and
the use of Provide a Defer use it
money common Liability later -
base for easily smoothing
prices with the their
use of purchase
Money. over
time

To put in different way

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 money is something that holds its value over time,

 can be easily translated into prices, and

 is widely accepted.

 Many different things have been used as money over the years—among them, cowry shells,
barley, peppercorns, gold, and silver.

MONEY

For Policy As
Purpose statistical
Concept

Set of Liquid Financial It includes Liquid

Asset, the variation Liabilities of
of stock which particular
could Impact on “Financial intermediaries
Aggregate economic or
Activity. other issuers.

General characteristics
of
Money

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Generally
1 Acceptable

2 Durable

effortlessly
3 Recognizable

Relatively
4 Scarce

5 Portable

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6 Uniform

7 Divisible

Difficult to
8 counterfeit

Types of Money

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1) Commodity Money -
cowry shells,
silver coins
Gold coins etc.

2) Fiat Money -
A Govt. issued currency
which is Not backed by
physical commodity
(Representative Money)

 Fiat money is materially worthless, but has value simply because a nation collectively agrees
to ascribe a value to it.

 In short, money works because people believe that it will.

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How Money is measured

Money in an economy is generally measured

through “broad Money” Which encompasses
everything that provide

Store of Value & Liquidity

people can save the extent to

it and use it which financial
later-smoothing Assets can sold
their purchase at close to full
over time market value at
short Notice.

Narrow Money

includes
Transferable
Currency Deposits

Broad Money

includes

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National Transferable other Securities

currencies Deposits Deposits other than
shares

issued by Tradable certificates

central & commercial papers
government It It
includes includes

Demand Travelers checks Saving Deposits Term Deposits

Deposits
Used for Non Deposit for
Transferable by transactions Transferable a fixed period
check or Money with Residents of a times
order

Deposits Repurchase
Bank checks otherwise Agreement
commonly used
Used as a to Make one party sell a
Medium of Payments security & agree
Exchange to Buy back at
some Foreign fixed price

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Demand for Money

 If people desire to hold money, we say there is demand for money.

 The demand for money is in the nature of derived demand; it is demanded for its purchasing
power.

 The demand for money is a demand for real balances.

 In other words, people demand money because they wish to have command over real goods
and services with the use of money.

 Demand for money is actually demand for liquidity and demand to store value.

 The demand for money is a decision about how much of one’s given stock of wealth should be
held in the form of money rather than as other assets such as bonds.

 Although it gives little or no return, individuals, households as well as firms hold money because
it is liquid and offers the most convenient way to accomplish their day to day transactions.

Determinant

of
Demand for Money

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General Rate of Degree of

Income Financial
Level Interes
Innovation
DM × Y of Price 1
DM × i 1
DM × P DM × 1
FI

Higher the Income Higher Higher Higher the

Higher the level the GPL; the interest level of
of Expd. Higher the Rate; innovations;
 Demand Higher OC; low Demand
Therefore for money low Demand for money
Higher the for money.
Demand
for money

Theories of Demand for Money

The Quantity theory of Money

Classical The oldest Theory
Theory 
propounded by Irving Fisher

Yale University

“The Purchasing Power of Money”

Book Published in 1911

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 Both versions of the QTM demonstrate that there is a strong relationship between money and
price level and the quantity of money is the main determinant of the price level or the value
of money.

 In other words, changes in the general level of commodity prices or changes in the value or
purchasing power of money are determined first and foremost by changes in the quantity of
money in circulation.

Money & Price Level

Fisher’s version, also termed as ‘equation of exchange’ or ‘transaction approach’ is formally
stated as follows:

MV = PT

Total Total No. of

Amount transaction
of Money in
Velocity of Avg. price
Circulation level

Fisher extended this equation

MV + MV = PT

Money Price No. of

Credit level transaction
Money

Velocity of
Circulation Velocity of
Circulation
of
credit

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MV + MV = PT

Supply Demand
of = for
money Money

Demand for Money

CRUX` is for
“Transaction Purpose”.

More the Higher the Demand

No. of transaction for Money

There is an aggregate demand for money for transaction purposes and more the number of
transactions people want, greater will be the demand for money. The total volume of
transactions multiplied by the price level (PT) represents the demand for money.

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Cambridge The Cambridge Approach

Theory or K - MRP
cash Balance Approach

Cambridge Economists
Marshall, Pigou, Robertson & Keynes

Neo classical Approach

For Transaction Motive For Precautionary

M ti

enabling Possibility being A Hedge

of against
split-up of Uncertainties

Sale & Purchase Sale & Purchase

How much money will be demanded?

The answer is:
 it depends partly on income and
 partly on other factors of which important ones are wealth and interest rates.

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The Cambridge money demand function is stated as:

Md = K P Y
Real
income

Demand PY
for Price 
Money Cambridge level of
K Nominal
G&S Income

K= Md
PY

K is proportion of Nominal Income

that
people want to Hold
as “Cash balance”.

. Cash Balance Approach.

The equation above explains that the demand for money (M) equals k proportion of the
total money income.

Both these versions are chiefly concerned with money as a means of transactions or
exchange, and therefore, they present models of the transaction demand for money.

Demand for
CRUX
Transaction Motive Precautionary
i

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Keynesian
Theory The Keynesian Theory of
Demand for Money
or
Liquidity Preference Theory
coined by
John Mayard Kennes EMI
in his masterpiece

Book “General Theory of Employment, Interest & Money (1936)

people hold Money for

Transaction Speculative Precautionar

Motive Motive y Motive

Cash for
Cash for unforeseen &
current Unpredictable
transactions Contingencies

Personal Business
(Income (Trade Personal Business
Motive) Motive)

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It Depends upon –

Lr = KY
Income Etc.

Economic Optimism
condition or
Pessimisiom
Transaction Income of
Demand or Public
for Earning
Money
𝑳𝑳𝑳𝑳
K=
𝒀𝒀

Ratio of earning kept

for transaction Motive

Keynes considered the aggregate demand for money for transaction purposes as the sum of
individual demand and therefore, the aggregate transaction demand for money is a function
of national income.

Keynes regarded the precautionary balances just as balances under transactions motive as
income elastic and by itself not very sensitive to rate of interest.

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Speculative
Motive

Hold cash in order to

Exploit
Any attractive investment
opportunity

As per Keynes theory

expected Return on Expected Return on

Money = 0 Bonds

interest payment expected rate of

capital gain

𝟏𝟏
Market Value ×
of bonds 𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊 𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹

IF i value of bonds 

I  value of bonds 

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Interest Rate

Critical Current
interest interest
rate ( r c ) rate ( r n )

CASE 1 IF rn > rc
eg: 6% > 4%

Purchase Bond

Higher rate Expected

of Capital
interest Gain

At present  i  Bond value  2000/-

Future expectation
i  Bond Value  2500/-

Therefore 2500 – 2000

= ₹ 500 Capital Gain

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If rn = rc
CASE 2 4% < 6%

Hold Liquid cash

loss of interest i at
(in future) present 2500/-
Rate on Bond
rn  rc Return on
8% - 6% Alternative In Future
= 2% Asset 2000/-
Bond

Avoid Capital loss

2500 – 2000 = 5000
+
Opportunity in future to Buy Bonds
in 2000 ₹

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Summing up,
 so long as the current rate of interest is higher than the critical rate of interest, a typical
wealth-holder would hold in his asset portfolio only government bonds, and

 If the current rate of interest is lower than the critical rate of interest, his asset portfolio
would consist wholly of cash.

 When the current rate of interest is equal to the critical rate of interest, a wealth-holder is
different to holding either cash or bonds.

The inference from the above is that the speculative demand for money and interest are
inversely related.

Summing up

IF IF
critical critical
`
current
interest > interest
current
interest < interest
Rate
Rate Rate Rate

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Diagrammatically Presentation

Individual speculative Aggregate speculative

Demand for Money Demand for Money
curve curve

interest
Rate
interest
Rate

Y Y
r
rn Discontinuous
DC
r1
Liquidity
rC r2 Trap

r0
0 x x
Demand M2 M1 M2 Demand M3 M4

If r n > r c ⇒ Purchase Bonds

cash = 0 Demand 𝟏𝟏
for ×
If r n < r c ⇒ No Bond money 𝒓𝒓
cash = full

iR  cash  Bond 
iR  cash  Bond 

According to Keynes, higher the rates of interest, lower the speculative demand for money,
and lower the rate of interest, higher the speculative demand for money.

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Liquidity Trap

or
ineffective Monetary policy

The situation in which Expansionary Monetary

policy does not stimulate economic growth.

In this situation Consumer & Investor

hoard cash Rather than
investing and spending.
Even if interest rate are low.

this is because of Feal of Adverse event.

Like Recession, War, Pandemic etc.

Speculative Demand for money becomes

perfect elastic with espect to
interest rate.

This situation is called “Liquidity Trap”.

The Bank of Japan’s experience is a real-life example of the Keynesian economic theory of a
liquidity trap, in which money printed by a central bank is hoarded in anticipation of further
deflation rather than invested. Japan’s 10-year yield dropped to a record 0.2 percent.

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Post Keynesian Theories

Inventory
Approach Behaviour
to towards
transaction Risk.
Balance

Store Asset
of Function
Value Friedman’s of Money
Restatement
of
Quantity Theory

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Inventory Inventory
Approach Propounded
by Approach
of
Transaction Baymol & Tobin
Balances. (1952) (1956)

As per this theory ‘Money’ or ‘Real cash balances’

was viewed as an

INVENTORY

Which held for transaction purpose.

Two media for storing value

interest bearing
Money Alternative Financial
(cash) Assets
(eg: Deposits, Bonds etc.)

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 Money that people hold

 in the form of currency and demand deposits which are very safe and riskless but pays no
interest.
 While bonds or shares provide returns (interest) but are risky and may also involve capital
loss if people invest in them.

 But saving deposits in banks is quite safe and risk free but also gives some interest.

 So, Baumol questions why people hold money in the form of currency or cash or
demand deposits instead of saving deposits which are quite safe and risk free and
also earn some interest as well.

There is a fixed cost there is a return

of Making transfer on investing
between in Deposits & Bonds.
Money & Bonds
eg: Broker charges. eg: interest

COST People compare Cost & Benefits Benefits

Brokerage  DM  Interest  DM 
Brokerage  DM  Interest  DM 

An individual combines his asset portfolio of cash and bond in such proportions that his overall
cost of holding the assets is minimised

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Baumol has proved that the average amount of cash withdrawal which minimises cost is

given by –
C = Cash Withdrawal
2by b = broker’s Fees
c =
r
Y = Income
r = interest rate

This means that the average amount of cash withdrawal which minimises cost is the square
root of the two times broker’s fee multiplied by the size of an individual's income and divided
by the interest rate. This is also called Square Root Rule.

Friedman’s Milton Friedman (1956)

Re
Restatement Restatement Statement
of Keynes speculation Money Theory
Quantity Demand
Theory

Demand for Money is Just like

Demand for Any other capital Asset

Permanent income Return on Assets

(Wealth) (Risky Asset)
Like securities

4 Determinants of Nominal Demand for Money

Price Opport
Wealth unity Inflation
Level
Cost

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Permanent Income Price level Opportunity Inflation

Discount Rate Dm × P cost of Dm × Inf
Holding
Average Return Money
on 5 Assets
Dm × 1
Human
Capital oc WIP
Money Physical
Capital oc = i
Bonds Equity

Dm × W

Friedman treats the demand for money as nothing more than the application of a more
general theory of demand for capital assets.

Demand
For Money Propounded by Tobin
Behaviour
as
Theory
Behaviour
toward
Risk

What will be in Portfolio ?

Risk-free Risky
Asset Asset

According to Tobin, an individual's behaviour shows risk aversion, which means they prefer
less risk to more risk at a given rate of return.
 If an individual chooses to hold a greater proportion of risky assets such as bonds or
shares in his portfolio, then he will be earning a higher average return but will bear a higher
degree of risk.
 In the other case, an individual who, in his portfolio of wealth, holds only safe and riskless
assets such as money in form of cash or demand deposits, he will be taking almost zero
risk but will also be getting no return.

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Behaviour of People

If

Risk taker Risk Averter

Bonds Cash
shares DD
 
Risk Assets Risk-free

Therefore, people prefer a mixed or diversified portfolio of money, bonds and shares, with each
person opting for a little different balance between risk and return.

Tobin’s Liquidity Preference Function

 Tobin derived his liquidity preference function showing the relationship between rate of interest
and demand for money.
 He argues that with the increase in the rate of return on bonds, individuals will be attracted
to hold a greater proportion of their wealth in bonds and less in the form of ready money.
 At a higher rate of interest, the demand for holding money will be less and people will hold
more bonds in their portfolio and vice versa.
 In Tobin’s portfolio approach demand function for money as an asset slopes downwards, where
horizontal axis shows the demand for money and vertical axis shows the rate of interest.

i Purchase of Bond  Dm 

i Purchase of Bond  Dm 
Y
interest rate

Downward
slope curve.

x
Demand for Money

The downward sloping liquidity preference function curve shows that the asset demand for
money in the portfolio increases as the rate of interest on bonds falls.

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Inventory Theory

Cost – Benefit
Analysis

C
R
Restatement Theory
U
X Determinants

Behaviour Theory
Risk

Aversive Taker

All these theories establish a positive relation of demand for money to real income and an
inverse relation to the rate of return on earning assets, i.e. the interest rate. However, countries
differ in respect of various determinants of demand for money, we cannot expect any uniform
pattern of behaviour. Broadly, real income, interest rates and expectations in respect to
inflation are significant predictors of demand for money.

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