LESSON 16:

POST-KEYNESIAN APPROACH TO DEMAND FOR

MONEY:
Objectives:

After studying this lesson, you will be able to understood,

• The meaning of Real Balances

• Don Patinkin’s Real balances effect
• Baumol’s Approach to demand for money
• Tobin’s Approach to demand for money

16.1 Introduction

16.2.1 Patinkin’s Real Balances Effect

16.2.2. Baumol’s approach to demand for money

16.2.3 Tobin’s Approach to demand for money

16.3 Summary

16.4 Check your progress

16.5 Key concepts

16.6 Self Assessment questions

16.7 Answers to check your progress

16.8 Suggested Readings

16.1 Introduction

16.2.1 Don Patinkin’s Real Balances Effect:

Don Patinkin developed Real Balances approach, by criticising the cash balances
approach of Cambridge economists approach on the basis of two grounds 1)
homogeneity postulation 2) dichotomisation of goods & Money markets. In his
approach reconciles the two markets through the real balance effect. Homogeneity
postulate means that a doubling of money prices will have no effect on the demand
supply of goods. Mathematically, the demand and supply function for goods are
homogeneous of degree zero in prices. So that Patinkin criticises the postulate for its
failure to have any determinate theory of money and prices.

Dichotomisation means that the relative price level is determined by the demand and
supply of goods, and the absolute price level is determined by demand and supply of
money. So that the effect of price has no effect on the monetary sector and monetary
prices in turns has no influence on the real sector of the economy. But, he criticised it
and integrates the money market with goods market, with depend on real balance but
not one relative price. Real balances mean the real purchasing power of the stock cash
holdings of the people.

According to him, demand for a community depends on both the real balances and
relative prices, therefore, when the price level rises or declines this will
reduce/increase the real balances of the people respectively. When price level rises it
creates state of involuntary unemployment but it will not last continuously because a
wages and prices fall the full employment level of output and income will be restored.

Don Patinkin also introduces the real balances effect in general equilibrium analysis.
According to him absolute prices play a crucial role not only in the money but also in
the real sector. Further he said that ‘Once the real and monetary data of an economy
with outside money are specified, the equilibrium values of relative prices, the rate of
interest and the absolute price level are simultaneously determined by all the markets
of the economy. It is generally impossible to isolate a subset of markets, which can
determine the equilibrium values of a set of prices.
Patinkin also validates the quantity theory conclusion, he pointed out that the real
balance effect implies that people do not suffer from ‘money illusion’ they are
interested only the real value of their cash holdings. Therefore, Patinkins analysis is a
real improvement on the traditional quantity theory and its value lies in the integration
of commodity and money markets through the real balance effect.

Critical evaluation:

1) Archibald and Lipsey consider Patinkins treatment as quite inadequate

because it fails in the determination of long run equilibrium.

2) Patinkin has failed in providing a proper explanation of the manner in which

the monetary wealth gets increased.

3) JG Gurley and ES Shaw have also criticised the static assumptions of Patinkin and
have enumerated and elucidated the conditions to show under which money will not
be neutral.

16.2.2 Baumol’s Inventory theoretic Approach:

As mentioned earlier, in recent years, an alternative theories on demand for money

developed by Baumol, Tobin and Milton Friedman.
Particularly, Baumol and Tobin models are developed based on the conclusions
derived by Keynes in his demand for money theory. Keynes believed that the
transactions demand for money was primarily interest inelastic and the speculative
demand for money is determined by the relative yield on assets in an individual’s
portfolio. Has has limited his analysis only to bonds and money. Thus, this
combination of demand motives with two different approaches has been responsible
for the criticism at the hands of Baumol and Tobin. Therefore, Baumol has analysed
the interest elasticity of the transactions demand for money and Tobin has explained
liquidity preference as behaviour towards risk. The third approach by Friedman
explains that the demand for money is not merely a function of income and the
interest rate, but also of total wealth.

Theory:

Baumol’s analysis is based on the holding of an optimum inventory of money for

transactions purposes by a firm or an individual. In his model he has shown that the
relation between transactions demand for money and income is neither linear nor
proportional as was stated by JM Keynes. Rather, changes in income lead to less than
proportionate changes in the transactions demand for money, further he analyses that
the interest elasticity of the transactions demand for money. To substantiate the
argument, he stated that the cash balances maintain by a firm is to purchase of labour,
raw material etc., but it is expensive to tie up large amounts in the form of cash
balances, therefore, money could be invested profitably in securities thus, the lesser
would be the account for transaction balances the higher the interest rate on securities.

According to Baumol, the holding of cash balances involves two types of costs a)
Interest Costs b) Non-Interest costs. Holding cash balances mean that the individual
foregoes interest by not investing into other interest yielding assets. This is the interest
cost to the individual money holder. When bonds are converted into cash the investor
has to meet certain costs like brokerage fee, postal changes etc., there are known as
non-interest costs. Thus, whenever, a firm holds transaction balances it incurs interest
costs as well as no interest costs, similarly, the interest on bonds also incurs non-
interest costs, to the individual and firm. Therefore, the firm or an individual has to
maintain balance between the incomes to be foregone through fewer bond purchases
against the expenses to be incurred by making larger investments in bonds. The higher
the rate of interest, the larger the expenses a firm can bear in making bond purchases.
Another important factor which will affect the is will be the amount of money
involved in these t transactions, because the brokerage fees are relatively fixed. When
the money involved in these transactions is larger, the smaller will be the brokerage
fees, the larger the total amount involved the less significant will be the brokerage
fees, because of the operation of economies of scale. This means that at higher levels
of income the average cost of transactions is lower. With an increase in the level of
income the transactions demand for money also increases but this increase would be
les than increase in income. Since Baumol takes the income elasticity of demand for
money as one half but the demand for money will not increase proportionately to the
increase in income. In any case, an increase in income would lead to larger
investments in bonds and the investor will enjoy the economies of scale Baumol also
emphasis in this connection, the importance of demand for real balances, According
to Baumol the demand for real balances “is proportional to the square root of the
volume of transactions and inversely proportional to the square root of the rate of
interest”. Hence, the relation ship between price level and the transactions demand for
money is direct and proportional. If the price level doubles, the money value of the
transactions will also be doubled. When all prices doubled brokerage fees will also be
doubled so people would like to hold high cash balances and avoid investments and
withdrawals and brokerage cost which they would otherwise incur hence, the increase
in the money value of transactions and in brokerage fees brings about arise in the
optimal demand for money in exactly the same proportion as a change in the price
level.
Is Baumol’ s analysis superior to the classical and Keynesian approaches?

Baumol’s approach is superior to earlier approaches in the following respects.

1. Earlier approaches assume the relationship between the transactions demand
and the level of income as linear and proportionate. Baumol held that
transactions demand does increase with the increase in income, but less than
proportionately.
2. Keynes held that the transactions demand for money is interest – inelastic,
while Baumol has established that it is interest-elastic.
3. While analysing the transactions demand for money Baumol has emphasised
the absence of money illusion.
4. Finally, Baumol’s analysis integrates the transactions demand for money with
the capital theory approach by including assets and their interest and non-
interest costs.

16.2.3 Tobin’s The Risk Aversion Theory of Liquidity Preference Theory:

Jame’s Tobin formulated the Risk aversion theory of liquidity preference based on
Portfolio Selection. According to him, an investor is faced with a problem of what
proportion of his portfolio of financial assets he should keep in form of money
and interest bearing bonds. This theory removes two major defects of the
Keynesian theory of liquidity preference. First one, Keynes function depends on
the inelasticity of expectations of future interest rates and Second one, an
individuals hold either money or bonds. But according to Tobin, individuals are
uncertain about future rate of interest, and an individual’s portfolio holds money
and bonds rather than only one at a time. Moreover his analysis’s based on the
assumption that the expected value of
Capital loss or gain from holding interest bearing assets is always zero. According
to him, money neither brings any income nor does it imposes any risk on the
individual asset holder. Bonds do yield interest so as income. It is however
uncertain and involves a risk of loss or gain.

He categorised the investors into three categories. They are: 1) risk lovers who
enjoy putting all their wealth into bonds to maximise risk, they accept risk of loss
in exchange for the income they expect from bonds. They will either put all their
wealth into bonds or will keep it in cash. The second category is plungers. They
will either put all their wealth into bonds or will keep it in cash. Third category
investors are risk averters. They prefer to avoid the risk of loss that is associated
with holding bonds rather than money. Such investors always diversify their
portfolios and hold both money and bonds. Tobin in his model, for finding out
different averter’s preference between risk and expected return, has used
indifference curves having positive slopes, indicating that the risk averters expect
greater returns in order to bear more risk. This is illustrated in Figure.
 In Figure, the vertical axis measures the expected returns while the horizontal axis
measures risk OB is the budget line of the risk averter. OB line shows the various
combinations of risks and expected returns on the basis of which he arranges his
portfolio consisting of money and bonds. Ic and Ic’ are indifference curves.
Averter is indifferent between all combinations of expected returns and risks that
each point on these indifference curves represents. Combinations shown on Ic’
curve are preferred to those of Ic, but the averter will achieve equilibrium at the
point’T’ where his budget line is tangent to the indifference curve Ic. In the lower
portion of the diagram the vertical axis shows the wealth held by the risk averter
in his portfolio and the line OR shows the risk as proportional to the share of the
total portfolio held in bonds. Point E on OR line represents the portfolio mix of
money and bonds that is OM (bonds) and MW(money). Hence, the risk averter
diversifies his total wealth OW by putting partly in bonds and partly in cash. In
any case, he has a preference for liquidity, which can only be offset by higher
rates of interest. At higher rate of interest, the demand for money will be lower
and the incentive to invest into more bonds will be greater. The opposite will
happen in the case of lower interest rates.

At the outset, Tobin considers his theory is more sophisticated theory of liquidity
preference than the Keynesian theory. Because his theory starts with the
assumption that the expected value of capital gain or loss from holding interest-
bearing assets is always zero. Further, it is more practical oriented approach
because it explains that individuals and firm diversify their portfolios and hold
both money and bonds and not money or bonds. And he does not agree with the
view that at very low rates of interest the demand for money is perfectly elastic. In
this respect he is more practical than Keynes.

16.3 Summary:

Classical stated that the effect of price has no effect on the monetary sector and
monetary prices in turns has no influence on the real sector of the economy. But,
Patinkin criticised it and integrates the money market with goods market, which
depend on real balance but not on relative price. Baumol’s analysis is based on
the holding of an optimum inventory of money for transactions purposes by a firm
or an individual. In his model he has shown that the relation between transactions
demand for money and income is neither linear nor proportional as was stated by
JM Keynes. Tobin’s theory removes two major defects of the Keynesian theory of
liquidity preference. First one, Keynes function depends on the inelasticity of
expectations of future interest rates and Second one, an individuals hold either
 money or bonds. But according to Tobin, individuals are uncertain about future
rate of interest, and an individual’s portfolio holds money and bonds rather than
only one at a time.

16.4 Check your progress

State whether following statement are true or false

a) Portfolio selection model has been developed by Baumol
b) According to Baumol investors are classified as risk lovers, diverters and
plungers
c) Inventory theoretic approach given by Tobin
d) Tobin’s analysis is based on the holding of an optimum inventory of money
e) Patinkin in his work criticises the dichotomisation of goods and money
markets
f) Real balance effect means integration of goods and money markets

16.5 Key concepts

a) Real balance effect
b) Relative prices
c) Portfolio
d) Interest costs and non interest costs
e) Risk Aversion
f) Plungers
g) Risk diversifiers
h) Gamblers
i) Classical Dichotomy

16.6 Self Assessment questions

Short answer type questions:

a) Write a note on Real balances effect?

b) What do you mean by Portfolio Selection?
c) Explain about the different types investors given by Tobin?
d) List out the Post-Keynesian approaches to demand for money?

Essay type questions:

a) Explain how Don Patinkin’s Real Balance Effect is an improvement over the
classical quantity theory?
b) Discuss the Portfolio selection approach, how is it superior to Keynes
approach?
c) Critically examine the Baumol’s Inventory theoretic approach?

16.7 Answers to check your progress

a) False b) True c) False d) False e) True f) True

16.8 Suggested Readings

D. Patinkin: Money, interest and Prices
Froyen RT: Macro economics; theories and Policies
Surrey MJC : Macro economics themes
Rana & Verma ; Macro economic analysis