WHAT IS DEMAND FOR MONEY?

The demand for money is the relationship

between the quantity of money people want
to hold and the factors that determine that
quantity
FACTORS WHICH INCREASES THE
DEMAND FOR MONEY
A reduction in the interest rate.
A rise in the demand for consumer spending
A rise in uncertainty about the future and
future opportunities
A rise in the demand for a currency by central
banks (both domestic and foreign)



Overview
Fishers Quantity Theory of money
The Cambridge Cash-Balance Theory
Keyness Liquidity Preference Theory
Baumol-Tobin Optimal cash Management
Model
Friedmans Approach
The Velocity Of Money
Liquidity Trap
Notation
velocity of money
price level
real income/output/GDP
nominal income/output/GDP
quantity of money (supplied)
quantity of money demanded
d
V
P
y
Y Py
M
M

Fishers Quantity Theory of

Money
This theory states that nominal income is
determined soley by movements in the quantity of
money.
It assumes that velocity is fairly constant.
It concludes that movements in the price level
result soley from changes in the quantity of
money.
P y M V =
The equation of
exchange
Quantity Theory of Money
Demand
Equilibrium Condition: M
d
=M
The theory suggests that the
demand for money is purely a
function of nominal income,
and that interest rates have
no effect on the demand for
money.
People only hold money to
conduct transactions.
1
1
Let and set
d
d
M Py
V
k M M
V
M k Py
=
= =
=
The Cambridge Cash Balance
Theory
The Cambridge approach emphasises that there
are alternatives to holding money in the shape of
shares and bonds.
These assets yield a return which can be viewed as
the opportunity cost of holding money.
As interest rates rise, agents will economise on
money holdings and vice versa.


Cash balance Theory (contd)
Another factor that will influence money
holdings is the expected rate of inflation. If
inflation is expected to be high, then the
purchasing power of money will fall. This
will prompt agents to buy securities or
commodities as a hedge against inflation
Cash balance Theory (contd)
We can set out the Cambridge cash balance
approach as follows


k=Md/k Y

Keyness Liquidity Preference Theory
Proposes that individuals hold money for 3
reasons:
Transactions Motive
Precautionary Motive
Speculative Motive
Concludes that money demand is negatively
related to the level of interest rates.
Velocity is therefore unstable.
TRANSACTION MOTIVE

People need money as consumers as well as
producers.
As consumers they need money in the form
of income to meet their day to day needs,
and as producers they need money in the
form of capital to make investments
Therefore the transaction motive can be
classified into Income Motive and Business
Motive

PRECAUTIONARY MOTIVE:
All individuals want to cover unforeseen
events such as sickness, accidents and
losses, for which they want money as
precaution for contingency.

Speculative Motive:
People need money for making gains from
speculation on future value of bonds and
securities.

Liquidity Preference Theory (Contd)
nominal interest rate
real money balances
demand for real money balances
( , ) liquidity preference function
d
R
M
P
M
P
f R Y

( )
( , )
,
d
d
e
M
f R Y
P
M
f Y
P
t
=
= +
_
+
Friedmans Approach
Friedmans restatement of the quantity theory
of money simply stated that the demand for
money must be influenced by the same factors
that influence the demand for any asset.
Friedman applied the theory of asset demand
to money.
, , , / , ,
nominal return on bonds
nominal return on equity
rate of inflation (measuring the return on money)
human wealth
nonhuman wealth
other omitted factors
d
B E
h n
B
E
h
n
M
f R R W W y u
P
R
R
W
W
u
t
t

+ +
| |
=
|
\ .

Friedman argued that when the return on equity

or bonds change, the return on money would not
necessarily remain constant. A simplified version
of Friedmans view of the demand for money, is to
view it as a function of permanent income, y
p
.
( )
d
P
M
g y
P
=
Friedmans view
Friedmans theory suggests that changes in
interest rates should have little effect on the
demand for money.
Another conclusion from Friedmans theory is
that velocity is predictable.
Baumol-Tobin Optimal Cash
Management Model
states that the transactions component of the
demand for money is negatively related to the
level of interest rates.
Assumes individuals choose between two
assets: money and bonds.
2 2
where is the number of transactions per period
d
Y Py
M
n n
n
= =
In panel (a), the individual is paid
$1000 monthly. Therefore the
monthly average cash holdings is
In panel (b), the individuals biweekly
income is $500. Therefore the
monthly average cash holdings is
$1000 0
$500
2
d
M

= =
$500 0
$250
2
d
M

= =
0.5
0.5 0.5
2
where is the cost each time a transfer is made
in our out of cash
d
M b
y R
P P
b

| |
=
|
\ .
The Velocity of Money
The velocity of money is the rate of turnover of
money; the average number of times per year
that a dollar is spent in buying the total
amount of final goods and services produced
in the economy.
Nominal Income
Quantity of Money
Py Y
V
M M
= = =
Liquidity Trap
This is an extreme case of ultrasensitivity of
the demand for money to interest rates.
Under these circumstances, monetary policy
has no effect on aggregate spending because
changes in the money supply has no effect on
interest rates.
Liquidity Trap
I
n
t
e
r
e
s
t

R
a
t
e
,

R

Quantity of Money
M
d
M
S
0
M
S
1
M
S
2
Money demand is very
elastic so that very
large changes in
money supply are
needed to get minimal
change in interest
rates.
Is Money Demand sensitive to
interest rates?
If interest rates do not affect the demand for
money, velocity is more likely to be constant,
or at least predictable.
The evidence on interest rate sensitivity of
money demand found by various researchers is
remarkably consistent: the demand for money
is sensitive to interest rates, however it is not
ultra-sensitive (i.e. little evidence that a
liquidity trap has ever existed).