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1.2 THE DEMAND FOR MONEY

Introduction

• Theory of demand for money focuses on classical, Keynesian theories, and subsequent theories.

• Demand for money relates to macroeconomic issues such as price level and interest income.

• General definition: Demand for money indicates how much of an asset individuals want to hold in monetary form vs. illiquid assets.

• Liquidity preference: The desire to hold cash.

• Functions of money include medium of exchange and store of value.

• Demand for money is actually for real money balances, accounting for price levels to avoid nomimal money illusion.

Theoretical Approaches

• Traditional approaches on demand for money include:

  • Transactions approach (Fisher’s Quantity Theory of Money)

  • Cash balance approach (Cambridge Equation)

  • Keynes's liquidity preference theory.

• Recent models by Baumol, Tobin, and Friedman also provide new perspectives on demand for money.

Learning Outcomes

• Discuss differences between Classical approach and Keynesian approach to demand for money.

• Analyze the determinants of speculative money holding.

• Explain Baumol and Tobin-Markowitz Models.

• Compare Monetarist and Keynesian views on money's role in the economy.

• Evaluate the microfoundations of money.

1.2.1 Classical Approach to Demand for Money (Fisher’s Equation)

Overview

• Classical economists did not develop explicit demand for money theory; however, they influenced Quantity Theory of Money through its medium of exchange function.

• Irving Fisher's cash transactions approach introduced in 1911 in his work "Purchasing Power of Money."

Fisher’s Equation

• Equation:M’V’ + MV = PT

  • M: total quantity of money

  • M’: credit money

  • V,V’: velocity of money and credit

  • P: price level

  • T: total goods and services

• This equation represents demand for money (PT) equal to its supply (MV).

Price Level and Money Demand

• Rearranged as: P = (MV + M'V') / T

• Positive correlation between price and quantity; if money supply doubles, so does price level.

• Key Assumptions:

  • Velocity of V is held constant, and influenced by technology and institutions.

  • Money supply set by central authority, treated as an exogenous variable.

1.2.2 Cambridge Quantity Theory

Overview

• Cambridge economists emphasized money as a store of value, shifting focus from Fisher's emphasis on the medium of exchange.

• Aggregate Demand for Money Equation:Md = kPY

  • Y: real national income

  • P: price level

  • k: the proportion of income held as cash

Features of Cambridge Approach

• Demand for money-related to income, showing a behavioral relation contrasting with Fisher's mechanical view.

• Different forms by Marshall, Pigou, and Robertson emphasize individual demand for cash balances proportional to nominal income.

1.2.3 Friedman’s Restatement of the Quantity Theory

Overview

• Friedman posits that money demand is stable and treats money as a capital asset needed for transactions.

• Demand Function:Md = f(W, h, rm, rb, re, P, ΔP/P, U)

  • Where variables relate to wealth, interest rates, price levels, and expectations.

Key Determinants

• Wealth (W), rates of return (rm on money, rb on bonds, re on equities), price level (P), expected inflation (ΔP/P), and institutional factors influencing demand.

1.2.4 Microfoundations of Money

Key Concepts

• By addresses individual behavior in demand for money, integrating it into neoclassical general equilibrium.

• Issues include the existence of fiat money, valuation, and necessity.

Models of Money

• Overlapping generations model: Money as a bridge between generations.

• Shopping-time models: Time saved by using money in transactions.

• Cash-in-advance models: Requires cash before purchases, changing demand dynamics.

1.2.5 Demand for Money vs Demand for Other Commodities

Definition and Treatment

• Money evaluated as a good based on individual preferences.

• Similar treatment of money in portfolio approaches, illustrating its role as a financial asset in relation to other goods and assets.

• Economic analysis views goods broadly, encompassing both beneficial and harmful items concerning individual desires.

1.2.6 Empirical Studies in Africa

Overview

• Demand for money is extensively studied in African economies, offering important insights despite data limitations.

• Studies focus on relationships like interest, wealth, and aggregate money demand

Studies Cited:

1. Stability of Money Demand in Nigeria

2. Money Demand Stability in South Africa

3. Evidence from Kenya

4. Money Demand in WAEMU states

5. Demand for Money in Ghana

6. Comparative stability study between Côte d'Ivoire and Ghana.