Second, Friedman postulates a demand for money function quite different from that of Keynes. Thus the total demand for money can be derived by the lateral summation of the demand function for transactions and precautionary purposes and the demand function for speculative purposes, as illustrated in Figure 6 (A), (B) and (C). It also yields real return in the form of convenience, security, etc. Since the value of average cash holdings over the year is K/2, the demand for real balances for transactions purposes becomes. His saving is zero. A bond carries a fixed rate of interest. In this case, changes in the quantity of money have no effects at all on prices or income. Speculative demand for money occupies a strategic position in Keynesian theory of demand for money. But people also hold money for other reasons, such as to earn interest and to provide against unforeseen events. Theories of Demand for Money - Free download as Word Doc (.doc), PDF File (.pdf), Text File (.txt) or read online for free. 1. This book provides an account of the existing literature on the demand for money. Fourth, there is the difference between the two approaches with regard to the motives for holding money balances. Empirical evidence suggests that the income elasticity of demand for money is greater than unity which means that income velocity is falling over the long run. At time 1 /3f, the first half of the bonds purchased ($400) mature which it sells for cash until time 2/3f. The structure of cash and short-term bond holdings is shown in Figure 2 (A), (B) and (C). We saw above that LT = kY. Baumol shows that the relation between transactions demand and income is neither linear nor proportional. The income to which cash balances (M/P) are adjusted is the expected long-term level of income rather than current income being received. It shows how the money demand function fits intostatic and dynamic macroeconomic analyses and discusses the problem ofthe definition (aggregation) of money. Third, like Keynes, Tobin regards the demand for money as closely dependent on interest rates and inversely related to interest rates and his theory provides a basis for liquidity preference. One, Keynes’s liquidity preference function depends on the inelasticity of expectations of future interest rates; and two, individuals hold either money or bonds. A more important factor which determines this decision is the amount of money involved in transactions because brokerage fees of buying and selling bonds are relatively fixed and do not change much in relation to the former. The theories are: (1) Fisher’s Transactions Approach, (2) Keynes’ Theory, (3) Tobin Portfolio Approach, (4) Boumol’s Inventory Approach, and (5) Friedman’s Theory. It is an inverse function of the rate of interest. The classicists emphasized only the medium of exchange function of money which simply acted as a go-between to facilitate buying and selling. Suppose the firm has $ 1,200 which it has to spend every quarter at a constant rate over the year. Content Filtration 6. The return on portfolio R is R = B (r+g) where O < B < 1, Since g is a random variable with expected value zero, the expected return on the portfolio is, The risk attached to a portfolio is measured by the standard deviation of R, that is, σ R-. All theories of demand for money give a different answer to the basic question: If bonds earn interest and money does not why should a person hold money? No doubt, a policy of general wage cut would lower wages and prices, and thus release money from transactions to speculative purpose, the rate of interest would remain unaffected because people would hold money due to the prevalent uncertainty in the money market. This is shown as Y curve in Figure 3. He is not prepared to accept more risk unless he can also expect greater expected return. Hence, not in the case of M1 = CC + DD, which earn either zero or very low interest rates. Thus the speculative demand for money is a decreasing function of the rate of interest. The cash balances quantity theory of money assumed the relationship between the transactions demand and the level of income as linear and proportional. Wealth can be held in five different forms: money, bonds, equities, physical goods, and human capital. According to Keynes, it is expectations about changes in bond prices or in the current market rate of interest that determine the speculative demand for money. Further, in the Keynesian analysis the speculative demand for money is analysed in relation to uncertainty in the market. The demand for money is affected by several factors, including the level of income, interest rates, and inflation as well as uncertainty about the future. If the time between the incurring of expenditure and receipt of income is small, less cash will be held by the people for current transactions, and vice versa. Why do people prefer liquidity? The way in which these factors affect money demand is usually explained in terms of the three motives for demanding money: the transactions, the precautionary, and the speculative motives. For ultimate wealth holders, the demand for money, in real terms, may be expected to be a function primarily of the following variables: The total wealth is the analogue of the budget constraint. In this respect, Tobin regards his theory as a logically more satisfactory foundation for liquidity preference than the Keynesian theory. For ultimate wealth holders, the demand for money, in real terms, may be expected to be a function primarily of the following variables: 1. As the rate of interest increases, from r1 to r2 and r3, risk averters hold successively more bonds OB2 and OB3 and reduce money to B2W and B3W in their portfolios. Transaction demand for money – the money we need to purchase goods and services in day to day life. Now the problem is how to hold assets by a firm, “given that there exist interest-yielding bonds that can be owned as well as cash, and given that there is a fixed cost involved in exchanging bonds for cash.”. These are Rm, the yield on money; Rb, the yield on bonds; Re, the yield on securities; gp, the yield on physical assets; and u referring to other variables. 13.2.1 Classical approach to demand for money 13.2.2. ADVERTISEMENTS: Keynes Theory of Demand for Money (Explained With Diagram)! However, income from bonds is uncertain because it involves a risk of capital losses or gains. These tangency points also determine the portfolio selection of risk averters as shown in the lower portion of Figure 9. Friedman’s theory of demand for money is a capital or wealth theory, because he regards money as an asset or capital good. where V is the current market value of a bond, R is the annual return on the bond, and r is the rate of return currently earned or the market rate of interest. The speculative (or asset or liquidity preference) demand for money is “for securing profit from knowing better than the market what the future will bring forth” .Individuals and businessmen having funds, after keeping enough for transactions and precautionary purposes, like to make a speculative gain by investing in bonds. They do not have any negative values. The demand for money theory is the chief component of the pecuniary economic sciences theory and an indispensable portion in the macroeconomic theory. This is illustrated in Figure 8 where the horizontal axis measures risk (sR) and the vertical axis the expected returns (smR). 200 in the market. Neglects Real Balance Effect: This approach includes time and saving deposits and other convertible funds in the demand for money. But the risk averter will achieve an equilibrium position between expected return and risk where his budget line is tangent to the indifference curve. So he has Rs900 idle money in the first week, Rs600 in the second week, and Rs300 in the third week. But he pointed out that the “demand for money in the active circulation is also to some extent a function of the rate of interest, since a higher rate of interest may lead to a more economical use of active balances.”. 11 3. Friedman in his latest empirical study Monetary Trends in the United States and the United Kingdom (1982) gives the following demand function for money for an individual wealth holder with slightly different notations from his original study of 1956 as: where M is the total stock of money demanded; P is the price level; Y is the real income; W is the fraction of wealth in non-human form; Rm is the expected nominal rate of return on money; Rb is the expected rate of return on bonds, including expected changes in their prices; Re is the expected nominal rate of return on equities, including expected changes in their prices; gp =(1 /P) (dP/dt) is the expected rate of change of prices of goods and hence the expected nominal rate of return on physical assets; and u stands for variables other than income that u may affect the utility attached to the services of money. But the conversion of human wealth into non- human wealth or the reverse is subject to institutional constraints. Thus the risk averter diversifies his total wealth OW by putting partly in bonds and partly keeping in cash. This paper "The Alternative Theories of the Demand for Money" focuses on the fact that money is a valuable asset in our economy that provides liquidity. Thus plungers either go all the way, or not at all. When all prices double, brokerage fee (b) will also double “so that larger cash balances will become desirable in order to avoid investments and withdrawals and the brokerage costs which they incur.” Thus the increase in the money value of transactions and in brokerage fees leads to a rise in the optimal demand for money in exactly the same proportion as the change in the price level. In practice, estimates of total wealth are seldom available. Assume that at the beginning of the year, Y is the income of the firm which is equal to the real value of the transactions performed by it, and K is the size of each cash withdrawal at intervals over the year when the bonds are sold. “But it is expensive to tie up large amounts of capital in the form of cash balances. Tobin has removed both the defects. The structure of cash for holdings and bond holdings by a firm is shown in Figure 7. For example, at r rate of interest, the total demand for money is OD which is the sum of transactions and precautionary demand OT plus the speculative demand TD, OD=OT+TD, where TD = OS. In other words, the optimal cash balance will increase because the firm will invest less in bonds. 5. The paper "Theories of Demand for Money" states that it is important to note that the US depression was partly because of increased speculative activity in the Stock StudentShare Our website is a unique platform where students can share their papers in a matter of giving an example of the work to be done. Thus the fraction of total wealth in the form of non-human wealth is an additional important variable. Our website is a unique platform where students can share their papers in a matter of giving an example of the work to be done. The Demand for Money: Theoretical and Empirical Approaches. Second, this theory is superior to Keynes’s theory in that it explains that individuals hold diversified portfolios of bonds and money rather than either bonds or money. For instance, when the interest rate falls from r10 to r8, the demand for money increases by AB which is smaller than OA. 3. “Thus we conclude that the chief determinant of changes in the actual amount of the transactions balances held is changes in income. Explain how the following events will affect the demand for money according to the portfolio theories of money demand: a.The economy experiences a business cycle contraction. But it does not explain fully why people hold money. They are prepared to bear some additional risk only if they expect to receive some additional return on bonds, provided every increase in risk borne brings with it greater increase in returns. Tobins’ risk aversion theory of portfolio selection is superior to the Keynesian liquidity preference theory of speculative demand for money on the following counts: First, Tobin’s theory does not depend on inelasticity of expectations of future interest rates, but proceeds from the assumption that the expected value of capital gain or loss from holding interest-bearing assets is always zero. Terms of Service Privacy Policy Contact Us, Cash Balances Approach and Transactions Approach | Money, The Classical Theory of Interest (With Criticisms), Keynesianism versus Monetarism: How Changes in Money Supply Affect the Economic Activity, Keynesian Theory of Employment: Introduction, Features, Summary and Criticisms, Keynes Principle of Effective Demand: Meaning, Determinants, Importance and Criticisms, Classical Theory of Employment: Assumptions, Equation Model and Criticisms, Classical Theory of Employment (Say’s Law): Assumptions, Equation & Criticisms. Similarly, when the national income is Rs. which the purchaser has to pay. The Keynesian Approach Liquidity Preference 3. In the following section, we will see the theory of demand … A Meta-Theory of the Demand for Money and the Theory of Utility1 Michael Ellwood 0044 7881 998649 michaeldavidellwood@yahoo.co.uk www.economictheoriespro.com Abstract This theory postulates that the demand for any good or service is derived from an underlying need. Account Disable 12. Plagiarism Prevention 5. The second category is of plungers. brokerage fees are lower. It is CD in Figure 10. It is the interaction of this need with the functions of the good or On a million dollar transaction they are negligible. This equation is illustrated in Figure 1 where the line kY represents a linear and proportional relation between transactions demand and the level of income. Moreover, it explains that an individual’s portfolio holds both money and bonds rather than only one at a time. Half the bonds purchased carry maturity of 1 /3t (4 months) and the other (half) bonds carry maturity of 2/31 (8 months). This is because risk averters prefer to hold more bonds than money. 4/0.02=Rs.200. Keynes, on the other hand, does not make such a distinction. Rather, changes in income lead to proportionately smaller changes in transactions demand. One of its major criticisms arises from the neglect of store of value function of money. •Thus, from the view point of yield and risks of holding money, M2 is more appropriate. Since precautionary demand, like transactions demand is a function of income and interest rates, the demand for money for these two purposes is expressed in the single equation LT = f (Y,r).9 Thus the precautionary demand for money can also be explained diagrammatically in terms of Figures 2 and 3. The bond market is perfect where there is easy conversion of bonds into cash and vice versa. The precautionary motive relates to “the desire to provide for contingencies requiring sudden expenditures and for unforeseen opportunities of advantageous purchases.” Both individuals and businessmen keep cash in reserve to meet unexpected needs. Given these assumptions, the firm buys bonds with 2/3K ($800) of its income at time f=0 and keeps 1/3K ($400) in cash, as shown in the figure. The demand function for business is roughly similar, although the division of total wealth and human wealth is not very useful since a firm can buy and sell in the market place and hire its human wealth at will. by Apostolos Serletis. Money held for speculative purposes is a liquid store of value which can be invested at an opportune moment in interest-bearing bonds or securities. Permanent income is the amount a wealth holder can consume while maintaining his wealth intact. The solution of this problem requires minimising the cost of holding cash balances over the year. The transactions between money and bonds are transparent and occur in a steady stream. If there is change in the interest rate, the long-run demand for money is negligible. 50 each when the rate of interest is high (8 per cent), and sell them again when they are dearer (Rs. 2. The first category is of risk lovers who enjoy putting all their wealth into bonds to maximise risk. In fact, an individual spreads his expenditure evenly over the month. It refers to people’s preference for holding assets in liquid form at a given rate of interest. But the other factors are important. This can be worked out with the help of the equation. By income, Friedman means “permanent income” which is the average expected yield on wealth during its life time. Low bond prices are indicative of high interest rates, and high bond prices reflect low interest rates. Keynes’ Theory of Demand for Money 1 Keynes’ approach to the demand for money is based on two important functions- 1. His portfolio consists of a proportion M of Money and B of bonds where both M and Badduptol. Thus when r>rc, an investor holds all his liquid assets in bonds, and when r Bangalore Famous Food Recipe,
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