3 Main Approaches to Demand for Money – Notes

3 Main Approaches to Demand for Money are described below:

(A) Classical Approach to Demand for Money:

The main exponents of this approach are J.S. Mill, Irving Fisher, Marshall, Pigou and Robertson—all grouped as classical economists. They argued that money is not demanded for its own sake, that is, not for its store value.

Image Source: theextraaamile.files.wordpress.com

Instead, it is demanded for facilitating transactions of goods and services demanded by people to satisfy their needs. They hold that demand for money is the derived demand. The larger the volume of the transactions of goods and services, the larger the demand for money.

Also, the larger the volume of transactions of goods and services, the larger the level of income enjoyed. This is so because volume of goods and services demanded depends on the level of income enjoyed by the people.

Demand for money can thus be directly correlated to the level of income of the people. The classical version of demand for money (M^d) is thus limited to the transaction demand (M_t) and can be expressed as

M^d = M_t, and

M_t Y

M^d = k.Y

Where, Y is the income or money value of the output and Hs a constant of proportionality.

If Y is represented in terms of physical units, equation 7.19 can be expressed as

M^d = k(PY)

Where, P is the general price level.

Fig. 7.2 portrays the classical version of demand for money.

Equations 7.19 and 7.20 are equivalent. In equation 7.19, Y represents money value of output while in equation 7.20, it represents output in physical units.

(B) Keynesian Approach to Demand for Money:

J.M. Keynes, in his General Theory of Employment, Interest and Money, stressed on the store value function of money, while accounting for its demand. Keynes, in divergence from the Cambridge economists Marshall, Pigou and Robertson, held that money is demanded by people not only for transaction purposes but also for precautionary and speculative purposes.

According to him, it is the sum total of its demand for all the three purposes. Demand for money for transactory motives (M_t) is a function of income (Fig.7.3 (a)) and is perfectly interest inelastic (Fig.7.3 (6)). Exactly identical is the behaviour of demand for money for precautionary motives (M_p) [Figs. 7.4 (a) and (6)].

Transactory and precautionary demands are therefore clubbed together as one component (L₁) [Figs. 7.5(a) and (6)]. L₁ is a function of income and is perfectly interest inelastic following the trend of its transactory and precautionary components. Demand for speculative motives is the other component (L₂) of the total demand for liquidity. L₂ is interest elastic (Fig.7.6).

Before proceeding any further with the derivation of total demand for money, let us first understand its three components discussed above in a little more detail.

1. Transaction Demand for Money:

Transaction demand for money varies directly with income [Fig. 7.3(a)] and is perfectly interest inelastic [Fig. 7.3(6)]. Note that the Keynesian version of transaction demand for money is exactly the same as the classical version, but for the difference that the transaction demand for money is just one of the three components of the total demand for money in Keynesian Theory while in classical version, it is the only component of demand for money.

2. Precautionary Demand for Money:

It is the second component of L₁ People set aside a part of their incomes or wealth and hold it in cash as a safeguard against the unforeseen. Like the transactory demand, the precautionary demand is also interest inelastic depending solely on the level of income.

The first point of difference between the two is that the transaction demand for money is based on the medium of exchange function of money while the precautionary demand for it is based on the store value function of money.

The second point of difference between the two is that the transaction demand is meant for current or short run expenditures, most of which are anticipated ones while the precautionary demand is meant for unforeseen or non-anticipated expenditures whether in short run or in long run.

The third point of difference between the two is that the transaction demand is a recurring phenomenon while precautionary demand is not. Fig. 7.4 shows variation of the precautionary demand with income as well as with rate of interest.

Derivation of L₁ Component of Demand for Money:

We have seen that L₁ component of the total demand for money is interest inelastic but income elastic. As a function of income, it can be derived through a vertical summation of M_t and M_p (panel ‘a’ of Fig. 7.5) and as a function of rate of interest (r), it can be derived as a horizontal summation of the two (panel ‘b’ of Fig. 7.5).

In the first case,

L_x = Transactory Demand + Precautionary Demand = M_t + M_p

= αY + βy = (α + β) Y

= kY

In the second case,

L₁ = Transactory Demand + Precautionary Demand

L₁ component of demand for money is thus perfectly interest inelastic depending solely on the level of income.

(C) Speculative Demand for Money:

Speculative demand for money occupies a strategic position in Keynesian theory of demand for money. According to Keynes, theories of interest have little meaning if speculative demand for money is overlooked.

It refers to people’s preference for holding assets in liquid form at a given rate of interest. The purpose is speculation. People prefer to hold liquidity so that they may not miss an opportunity to buy bonds when their market prices are low.

The objective is appreciation expected on such paper assets. In due course of time, when bond prices go up, the holders sell them off striking capital gains. On the contrary, if the unexpected happens and prices run further down, they may even run into losses.

Due to highly volatile nature of the stock markets, gains are as likely as losses. That is why indulging in buying and selling of shares for capital gains is a speculative activity and those involved in it are speculators.

Preference for assets in their liquid form is called the liquidity preference. It varies inversely with market rate of interest. To demonstrate, suppose government issues a perpetual bond with the face value Rs 10,000.

Rate of dividend is 10% per annum payable to the holder at the end of each year. The bond being a perpetual one, the holder can never seek its redemption from government. Nevertheless, he is free to sell it off in the stock market.

In Chapter 5, we observed that the sum of the present values (LPV) of a given annual income of rupees ‘A’ accruing perpetually to an investor when market rate of interest is ‘r’, is given as,

(PV) = A / r

Dividend being 10%, A = Rs 1,000 (10% of Rs 10,000). It r = 10% per annum,

(∑PV) = 1,000 / 0.10

= 10,000

That is, when rate of interest is the same as the rate of dividend, present value of the perpetual income stream is Rs 10,000. This is equal to the face value of the bond. Market price of this bond, thus, is Rs 10,000.

If the rate of interest rises to 16%, its market price would fall to Rs 6,250; if the rate of interest rises to 20%, its market price would fall to Rs 5,000 and if the rate of interest rises to 25%, its market price would fall to Rs 4,000.

This establishes the statement that the present value or the market price of a bond is inversely related to the market rate of interest.

In other words, market price of the bond is low when rate of interest is high. Thus, demand for the bond would be high when its price in market is low or when rate of interest is high. That, is bond preference is high or liquidity preference low when rate of interest is high.

On the same lines, we can say that bond preference among the speculators is low or liquidity preference high when rate of interest is low. The inverse variation between rate of interest and demand for liquidity (liquidity preference) is portrayed in Fig. 7.6 with the horizontal axis representing the demand for liquidity and the vertical axis, representing the rate of interest. Mathematically, inverse variation of speculative component, L₂ with interest may be expressed as

L₂ = g(r)

Where, g(r), a function of interest, may take the forms

g(r) = n – gr and

g(r) = n / gr

Fig. 7.6: When rate of interest is r₃ (the highest), liquidity preference is the lowest (zero). When rate of interest is as high as r₂ liquidity preference is as low as L₂ When rate of interest is r_0, liquidity preference is L₀ as well as L₃ or even infinite because DE is horizontal.

Here, r₀ is the lowest rate of interest. Bond prices are the highest, bond preference the lowest and the liquidity preference, the highest (even infinite). In our illustration, suppose interest rate in an economy is known to vary from 10% to 25%. Let the current rate of interest be 25%.

The present value and hence the market price of the bond is Rs 4,000. This is the lowest possible price at which the bond can be bought. Any change in the rate of interest, as per our assumption, would involve a fall in it below 25% and hence a rise in the market price of the bond.

By the time the rate of interest falls to 10%, the market price of the bond rises to Rs 10,000, the highest under the assumption of the interest cycle with 10% as the lowest and 25% as the highest.

Speculators would prefer to buy bonds when bond price is the lowest, i.e., Rs 4,000 or when rate of interest is the highest, i.e., 25%. At this point (point A in the figure), bond preference is the maximum and the liquidity preference, the minimum. Speculators are busy converting their liquidity into bonds.

Now suppose rate of interest falls to 20% (point B in the figure) with the result that the market value of the bond shoots up to Rs 5,000. At this rate bond preference falls and liquidity preference rises.

Some of those having bought the bonds at Rs 4,000 per bond, would like to dispose off some of their bond holdings, tempted by a profit margin of Rs 1,000 (5,000 – 4,000) per bond. As a result, liquidity preference would rise from the zero-level to a level as high as L₂ Now suppose the rate of interest falls further to 16%, raising the market price of the bond to Rs 6,250 (point C in the figure) .

The profit margin of Rs 2,250 (6,250 – 4,000) per bond would tempt quite a few speculators to dispose off a sizable part of their bond holdings. As a result, bond preference would fall even further and the liquidity preference would go up even higher.

If the trend continues and the rate of interest drops down to the lowest of 10% (points D and E in the figure), the market price would rise to a highest of Rs 10,000. This price is equal to the face value of the bond and implies a profit margin of Rs 6,000 (1, 0000 – 4,000) per bond to the speculators.

Even others who bought the bonds at higher prices of Rs 5,000, and Rs 6,250, the profit margins are tempting enough to make them go all out to dispose off their bond holdings. As a result, every speculator would like to sell off the bonds rather than of buying them. The reason for lack of bond takers is a simple one.

Why would anyone buy a bond at the highest possible price (at the lowest interest rate of 10%) only to sell it at a lower price bound to result from an inevitable hike in the interest rate? The tendency would be to hold onto the liquidity possessed already as in case of prospective buyers, and to convert all the bond holdings into it as in case of bond holders.

As a result, liquidity preference would rise to infinitely high levels and the bond preference, to infinitesimally low levels. The curve in the figure correlates the rate of interest to the demand for liquidity and is called the liquidity preference curve.

The horizontal part of it (DE) is called the liquidity trap, signifying the fact that liquidity demand is infinitely high at the same (lowest) rate of interest. Demand for liquidity for speculative motives is known as speculative demand and is represented as

M_sp =L₂= g(r)

Where, g(r) is a function of rate of interest.