• Economists are interested in analysing the factors
and conditions that bring about equilibrium of money market. • Equilibrium in money market is reached when the supply of money equals the demand for money. • The main question of concern is what determines the demand for money? • Different theories have been put forward to answer this question. THEORIES OF DEMAND FOR MONEY
• The classical economists treated money only as
a medium of exchange. • In their opinion, people hold money only for transaction purposes. • They did not hold excess cash because that would mean loss of interest. • The classical economists did not recognize the asset function or store value function of money. • The Cambridge Theory of money did recognize the asset function of money, but did not go beyond. • It did not consider the idle cash balance vis-a-vis alternate forms of financial assets, especially bonds. • It did recognize that there is a possibility that future prices and interest rates could affect the demand for money, but did not specify the relationship between interest rates and demand for money. • Keynes extended Cambridge Theory to include holding bonds and securities as an alternative to holding cash balance as an asset. • He linked the demand for money to the variations in interest rate and introduced the concept of speculative demand for money. • According to Keynes, when people make choice between idle cash and income-yielding bonds, they speculate on interest rates. • The money which people demand to buy bonds is the speculative demand for money. • KEYNESIAN THEORY OF DEMAND FOR MONEY • Also known as “Liquidity Preference Theory” it is an extension of the cash balance theory of Cambridge. According to this theory, money is demanded for 3 motives: • Transaction Motive • Precautionary Motive • Speculative Motive • Transaction Demand for Money: • The need for money arises because there is a gap between receipt and expenditure. • It is directly related to the level of income. • Here it is assumed that prices are constant. • People know by their experiences the amount of money they need for transacting their planned expenditure. • The aggregate demand for transaction money is the sum of individual demands. • That is, the aggregate demand for transactional money is a function of national income • Precautionary Demand for Money: • People hold some money in excess of their transactional demand to meet unforeseen contingencies. • The money held for such contingencies is called precautionary demand for money. • This is also closely related to the level of income. • The higher the level of income, higher is the demand for precautionary demand for money. • Speculative Demand for Money: • People hold a part of their income for speculative purpose. This is because people want to take advantage of changes in the money market. • According to Keynes, it is not rational to hold idle cash instead of holding a bond if the rate of interest is expected to rise in the future. • If the interest rate increases in the future, the bond prices go down. • The person who holds cash can buy bonds at lower prices and make capital gain. • He also earns a higher rate of return on the bonds. • But if the interest rate does not increase in future, the person who is holding idle cash loses interest.