Abdul Bundu- 09202932-

Abdul Bundu 09202932 Word count 1939 6BUS0341 - Money, Banking and Finance
Explain in detail the various determinants that imply a link between the interest rate and the demand for money?

Abdul Bundu- 09202932The main theme in this essay is to look at the main factors that determine the demand for money and the link it has with interest rate. In order for us to clearly establish this link between demand for money and interest rate, it would be appropriate to point out the factors and theories that explain why individuals demand money. The factors and theories that we will concern our self within this essay are, The reason why people hold money, Transactional motive, Precautionary motive, Speculative motive and portfolio motive (Keynesian view) and Quantity Theory for Money (classical view). According to (P. Howells and K. Bain, 2002) in order to determine what money is, in the traditional sense, is to look at what it does or what we require it to do and then to see what in practice we use for that purpose. Using this notion it is right for us to say money is a token used to quantify income, saving and wealth (capital). (P. Howells and K. Bain, 2002) moves on to say that money is use as a medium of exchange as it allows buyers and sellers a medium to exchange their capital in a quantifiable sum. For instance individuals sell their labour to employers who organize production and pay them their wages and salaries in the form of money. So when we pose the question, why do individuals demand money, it is only right that we ask ourselves why people hold money. The general accepted answer to this question is stressed by (P. Howells and K. Bain, 2002) saying that money is a component of wealth which brings us on to our next question. Why do people choose to hold some of their wealth in form of money? The use of the classical and the Keynesian school thought would best explain as to why individual choose to hold their wealth in the form of money. According to (P. Howells and K. Bain, 2002) the classical school of thought believed that money was a veil, meaning something that hid what was going on, but which had no effect upon it. The reason being that they believed money supply was exogenous. SO using the classical Quantity Theory of Money (QTM) in the most basic form assumes that changes in money supply results in changes in price, for instance an increase in money supply will cause increase inflation. This in turn motivates individuals to demand more money because of the increase in inflation which eats away current value of their money. The Quantity theory for money equation in its simplest form suggest that an increase in money supply would result in an increase in spending and thus for there to be an increase in spending, people would need to have more money (demand more money).Using this approach it would suggest that people demand money when prices increase in order to replace the value lost from inflation. QTM Equation- MV=PT [Each variable denote the following] M- Money supply V-Velocity of circulation P- Average price Level Thus if an economy has 3, and those 3 were spent 5 2 times in a month, total spending for the month would be

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According to (P. Davidson, 1965) Keynes distinguishes between three motives for holding money, (i) the transactions-motive-i.e. the need of money for the individuals current transaction of personal and business exchanges. This would be a proportion of an individual income that they would use on transactional propose. Using transactional motive for demand for money (Tutoronnet, 2011) uses the equation Lr=Ky where by Lr, is the transactions demand for money, K is the ration of earnings which is kept for transactions purposes and y is the earnings. The equation aims to show the ratio between money that they will demand for transactional purpose. Figure 2

Transaction demand for money

KY1 Y2 Y1 Y4 Y3 A C D B KY2

X1

X2

Earnings (income)

Presuming k = and earnings X1, the demand for transactions balances would be Y1 at point A. With enhancement in earnings to X1 the transactions demand would be Y1 million at point B on the curve kY1. If the transactions demand drops due to a variation in the institutional and structural situations of the fiscal system, which leads the value of k to diminished to 1/5 and the new transactions demand curve is kY2. It represents that for earnings of X1 and X2 million, transactions balances would be Y3 and Y4 million at point C and D correspondingly in the diagram.

(ii) The precautionary-motive, i.e. the desire for security as to the future cash equivalent of a certain proportion of total resources. This suggests that a subject would demand money as a precaution of being too illiquid when certain unforeseen cost arises for that individual. (iii) the speculative-motive, i.e. the object of securing profit from knowing better than the market what the future will bring forth, which is the assumption that 3

Abdul Bundu- 09202932individuals will demand more or less money depend on what they expected the marginal gain or cost of having wealth stored in asset yielding interest. (Keynes argued that only speculative-motive for holding money out of the three responds to changes in interest rates.)The graph below aims to show how speculated interest rate changes will affect an individual demand for money.

Figure 3 Interest Rate

I2

C A Md3 MD1

i1

I3

B MD2 MS1 MS2 Demand for money

Lets presume that the interest rate is at i1 with the equilibrium point for money demand and money supply being at point A. For argument sake, the subject believes interest rates are going to increase to i2, for instance high levels of inflation .The result of this is that MD1 would shift to the left to MD2, the reason being that the marginal gain that the individual will get from the increase in interest rate outweighs the marginal cost of having wealth stored in money. This will boost the money supply from MS1 to MS2 to form point B due to increase in deposits. This will result in the government decreasing interest rate from i2 to i3 levels in order to decrease the level of money supply and for those that will anticipate this beforehand would demand more money at MD3 in order to avoid the marginal cost of having their money in low yielding asset. This would cause money demand curve to move to the right as individuals take their money from low yielding asset as marginal gain no longer out weights the marginal cost of holding money.

It was later argued by ( J.Tobin, 2010) that not only speculative motives for hold money was dependant on interest rate but all so transaction and precautionary motives were reliant on interest rate. He argues that not only do people demand 4

Abdul Bundu- 09202932money for transactional needs in the future but also interest rates are taken into consideration when deciding in what form to hold wealth in order to carry out these transactions. The argument goes as such, if interest rates are high, people would see that holding wealth in current accounts outweighs the cost( time) of taking money out their account. This is the opposite when interest rates are lower. (J. Tobin, 2010) use the mathematical derivation of a subjects behaviour in order to clarify his point.

Figure 4

(J. Tobin,2010) also argued that precautionary motives are also responsive to interest rate , the argument propose that when interest rate are high will result in the individual to face a greater marginal cost of withdrawing money from their account. This will cause the individual to stop or withdraw less money (i.e. from current accounts) in order to take advantage of the marginal gains from high interest rate. This will be the opposite when interest rates are low which causes the marginal benefit of holding money increases as there is less chance of being illiquid when unexpected cost arises. Using (D.J. Thomas, 2011) expected cost equation (
Expected Cost = iM + ( M , )q.

), we able to derive the graph below that

shows how interest rate will determine the level at which an individual would increase or decrease their precautionary money demand for money.

Figure 5

Abdul Bundu- 09202932MC(i) MC(0)

Marginal Cost ad Marginal Benefit

MB (Y1) MB(Y)0 ) Precautionary Demand

According to (D.J. Thomas, 2011) when we look at the above graph it suggest that the higher the rate of interest, the greater the marginal cost of the withdrawal, and lowered precautionary demand for money, culminates in a shift of the MC-curve to the left, from MC (0) to MC (i).If the marginal benefit of increasing money holding rises from the lower expected costs of illiquidity. An increase in cash balances will reduce the probability of illiquidity at decreasing rate. Ultimately, an increase in income (or uncertainty) leads to increase money holdings because it shifts the MB-curve upwards, from MB (Y0) to MB (Yi). According to (Vladimr Gonda, 2003) Tobin elaborated on Keynes theory of speculative demand for money and developed it into a form of portfolio section theory. Tobin worked from Keynes assumption that a subject holds wealth in money or in bonds, where money bears zero yields. Tobin assumption is that due to risk involved with uncertainty of interest rates will force the subject to hold both money and hold bonds in order to minimize the risk of uncertainty. So depending how risk adverse an individual is, will determine the ration between investment portfolios.

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Figure 6

Using the graph from (G. Thomas) it shows that if interest rates levels are at i1 and individual will earn E1 on bonds brought which means they will demand money at M1. The graph then goes on to show what happens when an individual speculates that interest rates will decrease due to high inflation which will bring cause for the individual to capitalise on their speculation. With this assumption the individual would see his or hers earning drop from E1 to E2 as interest rate drop from i1 to i2. This would lead a rational individual to sell off bonds when interest rate are at i1 in order to avoid the loss in earnings that would happen if the individual try to sell the bond when interest rates are at i2 which will only give an earning of E2. The reason being, other subject wont want to buy the bond at i2 at the original purchase price as the earning on the bond has now decrease to E2. This would cause the individual to demand more money from M1 to M2 as the sells the bonds at i1. Using the Keynesian improved approach by J.Tobin, it becomes clear that individuals are motivated to demand money by interest rate through how much of their wealth they decide will suit their needs inform of money, needs such as being liquid or being able to take risk of investing in order to make more money. It must be stated that although these theories point out what an individual will likely do when it comes to demanding money, it does not take into account the highly sophisticated financial services that are now offered in modern times. It also fails to take into account how complex these financial services are and the 7

Abdul Bundu- 09202932level of uncertainties that it creates. The final point that I would like to bring up is that as globalisation continues to take hold and becomes highly sophisticated results in difficulties arising for individuals to read the market. This makes it harder for an individual to make an inform decision as to what level of money they should demand to suit their needs as there are so much factors to now take into consideration. References & Bibliography

ANUM KAZI. (3/15/2010). QUANTITY THEORY OFMONEY. Available: http://www.scribd.com/doc/29042071/Quantity-Theory-of-Money. Last accessed 4/dec/2011 Davidson, P. (2010). Keyness Finance Motive. Oxford Economic Papers. P47-65

Gonda, V. (2003). James Tobin, Profiles of World Economists. XI (1-5), p.1-25

Howells, P and Bain, K (2002). The Economics of Money, Banking and Finance. 2nd ed. London: Prentice Hall. p219-280.

Mishkin, F. (2009). The Economics of Money, Banking and Financial Markets. 9th ed. Boston: Pearson. p499-516

Modigliani, F. (1944). Liquidity Preference and the Theory of Interest and Money. Econometrica. 12 (1)

Patinkin, D. (1972). Friedman on the Quantity Theory and Keynesian Economics. The Journal of Political Economy. 80 (5), p885-892. Smith, A. (2011). Keynesian Approach or the Liquidity Preference . Available: http://www.tutorsonnet.com/homework_help/macro_economics/monetar y_theory/keynesian_approach_or_liquidity_preference_assignment_help_ online_tutoring.htm.

Abdul Bundu- 09202932Thomas, G. (2011). The Demand for Money, 6BUS0314 Money, Banking and Finance. Hertfordshire University, unpublished.

Thomas, G. (2011). The Demand for Money, 6BUS0314 Money, Banking and Finance. Hertfordshire University, unpublished.

Tobin, J. (1958). Liquidity Preference as Behavior Towards Risk. Review of Economic Studies: p7-8