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The term ‘Demand for money’ is used in two different senses by considering the functions of money as medium of exchange and store of value. Accordingly there are two concept of the demand for the money

1) Medium of exchange concept.

2) Store of value concept.

The first one is also known as classical view of the demand for money and second one is known as Modern view of the demand for money.

Broadly speaking there are three main approaches to the concept of demand for money they are as follows:

THE CLASSICAL APPROACH OF THE DEMAND FOR MONEY

Considering the functions of money as medium of exchange and store of value money is demanded by all. For considering the demand for money classical economist focused the medium of exchange function of money.

The Demand for Money

As per the view of classical economist like Irving Fisher, J.S.Mill, David Hume people demand for money for transaction purpose because they can purchase goods and services by the money as money is a medium of exchange. In other world,money is demanded by people for spending purpose in order to carry out their transactions over a period of time. The classical view of the demand for money is also known as “The Fisherian Approach”

The Fisherian Approach

This approach is also known as “The Cash Transactions Approach ”.Irving Fisher is the main exponent of the cash transaction approach. The classical economists and particularly fisher through that people hold cash balances only to carry on business transactions. In the absence of money, exchange had taken the form of barter. According to the classical approach the demand for money depends primarily upon the volume of transaction in a society. In the static economy the number of transactions involving the use of money is not likely to change, because the level of income will remain stable throughout the period. The growth of the economy and fluctuations in the level of economic activity will certainly affect the volume of business and also the number of transactions. Irving Fisher provides a formalistic expression to this cash transaction approach. Fisher’s equation of exchange also known as Cash-Transactions equation:

In this equation:

M = Quantity of Money, V = Velocity of circulation, P = Price level, and T = Volume of transactions. The fisherian demand for money { Md –Demand for Money} function in algebraic manipulation is derived as follows:

To illustrate the point ,assuming V as 2, in a year T is 2,000 units and P is Rs.10 per unit, then,

T and V remains constants in the short period the demand for money varies with changes in P, Price level. According to the Fisher ,changes in the price level are directly proportional to the changes in money supply { Ms } in the short period. From his equation of exchange, MV = PT Fisher defines money supply as :

it follows that, That means as per Fisherian view when the economy is under monetary equilibrium, the demand for money is always equal to the supply of money.

THE NEO-CLASSICAL APPROACH OF THE DEMAND FOR MONEY

(Marshall / Pigou Approach / Cambridge Approach )

This approach is also known as “The Cash-Balance Approach”. Marshall and Pigou are the main exponent of the cash-Balance approach. The Cambridge economist Marshall and pigou stressed on money as a store of value than as a medium of exchange. While Fisher was developing his quantity theory of money, group of Neo-classical economist in Cambridge, England which included Alfred Marshall and A.C.Pigou.were studying the same topic. Although their analysis led them to an equation identical to Fishers money demand equation, their approach differed significantly. Instead of studying the demand for money by looking solely at the level of transactions and the institutions that affect the way people conduct transactions as the key determinants. In Cambridge model individuals are allowed some flexible in their decisions to hold money and are not completely bound by institutional constraints such as whether they can use credit to make purchase. Accordingly the Cambridge approach did not rule out the effects of interest rates on the demand of money.

The Cambridge economists though that two properties of money make people want to hold it:

  1. Its utility as a medium of exchange
  2. Its utility as store of wealth.

 Cambridge economists agreed with Fisher that demand for money would be related to the level of transactions and there would be a transaction component of money demand proportional to nominal income. As far as money functions as a store of wealth ,the Cambridge economists suggest that the level of peoples wealth also affects the demand for money. They believe that wealth in nominal terms is proportional to nominal income ,they also believed that wealth component of money demand is proportional to nominal income. Cambridge economists also expressed the demand for money function as follows:

Where, Md = the demand for money.

K = the proportionality factor. It refers to the proportion of national income that the people desire to keep in the form of nominal money balances (cash balances)

PY = the nominal national income.

Although the Cambridge economists often treated as k as constant and agreed with Fisher that nominal income is determined by the quantity of money ,the Cambridge approach allowed individuals to choose how much money they wished to hold. This approach allowed for the possibility that k could fluctuate in the short run because the decisions about using money to store wealth would depend on the yields and expected returns on other assets that also function as store of wealth.

THE KEYNESIAN APPROACH OF THE DEMAND FOR MONEY: (J.M.Keynes Liquidity-Preference View )

John Maynard Keynes in his The General Theory Of Employment Interest and Money laid stress on the store of value function of money. To Keynes, “Demand for money does not mean the actual money balances held by the people, but what amount of money balances they want to hold”. He argued that there are three reasons why households and business in an economy prefer to hold their wealth in the form of cash balances.

Keynes distinguished three such motives which induce people to hold money. These are :

1) The Transactions Motive.

2) The Precautionary Motive.

3) The Speculation Motive.

d M = k × PY

Corresponding to these motives, thus Keynes separated the demand for money into three part :

  1. the transaction demand for money
  2. the precautionary demand for money ,
  3. the speculative demand for money .

The Transaction Demand for Money

The transaction demand for money is related to the ‘Medium of exchange function’ of money. People will have a certain amount of money to carry out their daily transactions. In practice people do not receive income as frequently as they spend. So when income is received at definite intervals and is paid frequently for the purchase of goods and services, people should keep a certain amount of money. In short the transactions motive concerns the demand for money as a medium of exchange, as a means to bridge the gap between periodic receipts and payments.

According to Prof.A.C.L.Day, “A major element in the demand to hold money is a transaction demanded. this demand to hold money is base on two characteristics of money which can be summed up as convenience and certainty .”. It is convenient to settle the transactions with money. It is certain because in normal times the price level expressed in term of money remains more or less stable.

The transaction demand for money is a direct , proportional and positive function of income .It is expressed as

LT = KY

Where LT is the transaction demand for money, K is the proportion of income which is kept for transaction purpose and Y is the income.

However it should be remembered that Keynes has made the LT function interest in elastic. But in recent years , two post – Keynesian economists William J. Baumol and James Tobin have spoken that the rate of interest is an important determinant of the transactions demand for money. Further they have also pointed out that there does not exist a linear and proportional relation between income and transactions demand. So according to the modern view , the transactions demand for money is a function of both income and interest rate . It can be expressed as

This relationship between income and interest rate and transactions demand for money is illustrated in the following figure.

The Precautionary Demand for Money

Beside the transaction purpose, people desire to have some ready cash to meet unforeseen contingencies. This is known as precautionary motive. Both individuals and businessmen keep cash reserves to meet unexpected needs .For instance people hold some ready cash to provide for illness, accidents , unemployment and other unexpected contingencies . Similarly businessmen keep cash to tide over unfavorable business conditions. Therefore “Money held under the precautionary motive is rather like water kept in reserve in a water tank”. The cash balances held by the people for precautionary motive represent the ‘Store of value’ function of money.

The precautionary demand for money is depend on the level income and business activity opportunities for unexpected profitable deals, availability of cash ,the cost of holding liquid assets etc.

Keynes held that like the transaction demand , the precautionary demand for money is also a function of income .But the post Keynesian economists believe that it is a function of both income and interest rate.

In practice it is difficult to separate the transactions demand and precautionary demand for money, as both are income determined. The combined money balances held under the transactions and precautionary motives is referred to as, “active balances” by Keynes. In symbolic terms, the demand for active balances may be stated as:

In the figure at income level OY1, OA is the demand for active balances .At higher income level OY2 is becomes OB .Thus there is a proportionate relationship between income and the demand for active balances.

The speculative demand for money

The speculative demand for money represents the demand for cash for being invested rapidly, as and when attractive opportunities for monetary investments appears.

The speculative motive confines itself to the store of value property of money . Money held under the speculative motive is used to make investments in stocks ,shares and bonds so as to earn some profit . To Keynes, people make capital gains by speculating in securities or bonds hoping to gain from knowing better than other in the market what the future holds in store for them.

L1 = LT + LP

People hold cash balances; just to preserve liquidity .But of cash does not yield any income. The yields-foregone in keeping cash balances is usually measured in the rate of interest. Thus the amount of money held under speculative motive depends on the rate of interest.

There is always an inverse relationship between the speculative demand and the rate of interest. When the rate of interest increases, the prices of fixed income yielding assets fall .

Therefore more money will be held in cash balances .On the other hand, if there is a fall in the interest rate, the prices of bonds and securities will increase and there will be a tendency to have more bonds and securities.

Thus the speculative demand for money is a function of the rate of interest . It is highly interest elastic. If the rate of interest is high the speculative demand for money will be low ; on the other hand if the rate of interest is low the speculative demand for money will be high . Thus there is an inverse relationship between the speculative demand and the rate of interest . It can be algebraically expressed as ;

The inverse relationship between the rate of interest and the speculative demand for money is represented geometrically

Figure  shows that at a very high rate of interest 12 % the speculative demand for money is Zero and people invest their cash in bonds .But when the interest rate falls to 8% the speculative demand is OS .With a further fall in the interest rate to 6 % , it rises to OS1 .Thus the shape of the LS curve shows that as interest rate rises ,speculative demand for money declines; and with the fall in the interest rate , it increases .

 THE LIQUIDITY TRAP

At the minimum rate of interest such as 4% the curve become perfectly elastic and the speculative demand is infinitely elastic .This portion of the LS curve is known as liquidity trap .At very low interest rate, people refer to keep money in cash rather than invest in bonds .This situation arises from the fact that the income from the assets at the very low rate of interest is so low and the risk of holding assets is so high that the wealth holders are willing to substitute money for assets . L-LS portion of the demand curve denotes the situation of liquidity trap.

The main reason for liquidity trap is as follows:

1 The process of substituting bonds for money involves some cost and inconvenience. Some minimum return is necessary to offset this .when the rate of interest is very low , there will be less inducement on the part of the people and they prefer to have cash.

2 At low rate of interest, the opportunity cost of holding idle balances tends to be minimum.

3 The liquidity trap sets the floor limit to the rate of interest. By expecting a high interest rate in future, people will keep cash and will not purchase bonds.

4 As the rate of interest falls , the investors expect that it will revert to the normal level .But a rise in interest rate from a higher level involves lesser capital losses than a rise in the interest rate from a very minimum level.

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