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Demand for Money

• 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.

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