Unit 1: The Concept of Money Demand and Important Theories

NATURE AND FUNCTIONS OF MONEY

Money plays an essential role in causing the things in life to work as they should and underlies the fulfillment of the needs of human existence. Most people handle it daily, yet few can define it precisely. Money is defined as anything that serves three specific purposes. First, it is a store of value, meaning people can save it and use it later to smooth their purchases over time. Second, it serves as a unit of account, providing a common base for prices. Third, it is a medium of exchange, which people use to buy and sell from one another. In short, money is something that holds its value over time, can be easily translated into prices, and is widely accepted. Historically, items like cowry shells, barley, peppercorns, gold, and silver have served as money.

To understand money's role, consider a barter economy where money does not exist. In a barter system, every item desired would have to be exchanged for something the person can provide, requiring a double coincidence of wants. For example, a person specializing in fixing cars who needs food would have to find a farmer with a broken car. If the farmer has nothing to fix or offers more eggs than the mechanic can use, trade fails. Specialization becomes difficult, and people might starve before finding the right person to barter with. Money allows people to sell goods or services in a market for a common medium of exchange, which can then be used to buy necessities from anyone else who accepts it. As specialization increases, production and the demand for transactions—and thus for money—also increase.

The evolution of money led to the creation of fiat money. Originally, heavy metals like gold and silver were used. Eventually, it became more convenient to deposit these metals in banks and use notes claiming ownership of the deposits. When the link between paper claims and the actual metal backing was broken, fiat money was born. Fiat money is materially worthless but has value because a nation collectively agrees to ascribe value to it; it works because people believe it will. The source of money's authority evolved from individuals in a barter system to collective acceptance (barley/shells) to governments in modern times. According to the Reserve Bank of India Manual on Financial and Banking Statistics (2007), money can be defined for policy purposes as the set of liquid financial assets where variation in stock impacts aggregate economic activity. Statistical money includes liquid liabilities of financial intermediaries.

CHARACTERISTICS AND MEASUREMENT OF MONEY

For money to serve its functions effectively, it must possess specific characteristics. It must be generally acceptable, durable or long-lasting, effortlessly recognizable, and difficult to counterfeit (not easily reproducible). It must be relatively scarce but have elasticity of supply, be portable or easily transported, possess uniformity, and be divisible into smaller parts or fractions without losing value.

In official statistics, the amount of money in an economy is measured through broad money, which includes items providing a store of value and liquidity. Liquidity refers to the extent to which financial assets can be sold at close to full market value at short notice. Narrow money consists of currency and transferable deposits. The International Monetary Fund (2000) identifies several components of broad money. These include national currencies issued by the central government and transferable deposits. Transferable deposits encompass demand deposits (transferable by check or money order), bank checks (if used as medium of exchange), travelers checks (for resident transactions), and other payment deposits like foreign-currency deposits. Broad money also includes other deposits, such as nontransferable savings deposits, term deposits (funds left for a fixed period), and repurchase agreements where a party sells a security and agrees to buy it back at a fixed price. Finally, it includes securities other than shares of stock, such as tradable certificates of deposit and commercial paper (corporate IOUs).

THE CONCEPT OF DEMAND FOR MONEY

Demand for money exists if people desire to hold it. This demand is a derived demand, meaning money is demanded for its purchasing power rather than for its own sake. It is essentially a demand for real balances, as people wish to have command over real goods and services. Money demand is a decision about how much of one's given stock of wealth should be held as money rather than other assets like bonds. Although money yields little or no return, individuals, households, and firms hold it because it is liquid and offers the most convenient way to accomplish day-to-day transactions.

Money demand is a crucial factor in determining interest rates, prices, and income. The quantity of nominal money people wish to hold depends on factors such as income, general price levels, the rate of interest, real GDP, and financial innovation. Higher income leads to higher expenditure, meaning richer people hold more money. The quantity desired is directly proportional to the price level; higher prices necessitate higher money holdings. Holding money involves an opportunity cost, which is the interest rate a person could earn on interest-yielding assets. Consequently, higher interest rates lead to higher opportunity costs and lower demand for money. Conversely, innovations like internet banking, application-based transfers, and automated teller machines (ATMs) reduce the need to hold liquid money.

CLASSICAL APPROACH TO MONEY DEMAND

The Quantity Theory of Money (QTM) is one of the oldest economic theories. It was propounded by Irving Fisher in his 1911 book, 'The Purchasing Power of Money', and later by neoclassical economists. QTM posits a strong relationship between money and the price level, asserting that the quantity of money is the main determinant of the price level or the value of money. Fisher’s version, known as the 'equation of exchange' or 'transaction approach', is stated as:

$MV = PT$

In this equation, $M$ is the total amount of money in circulation on average; $V$ is the transactions velocity of circulation (the average number of times a unit of money is spent on goods and services); $P$ is the average price level; and $T$ is the total number of transactions. Later economists replaced $T$ with real output ($Y$). The price level can be derived as:

$P = \frac{MV}{T}$

Fisher extended this to include demand (bank) deposits ($M'$) and their velocity ($V'$). The expanded equation is:

$MV + M'V' = PT$

Total money supply consists of actual money ($M$) and its velocity ($V$). In this model, $V$, $V'$, and $T$ are assumed to be constant or fixed in the short run (as full employment prevails). Thus, the demand for money ($PT$) is equal to the supply of money ($MV + M'V'$). The theory implies that more transactions lead to a greater demand for money.

THE CAMBRIDGE CASH BALANCE APPROACH

In the early 1900s, Cambridge economists including Alfred Marshall, A.C. Pigou, D.H. Robertson, and John Maynard Keynes introduced the cash balance approach. This version suggests money increases utility in two ways: by enabling the split-up of sale and purchase over time (transaction motive) and by acting as a hedge against uncertainty (precautionary motive). Because sales and purchases are not simultaneous, people need a 'temporary abode' of purchasing power.

The quantity of money demanded depends on income, wealth, and interest rates. Higher income increases purchases and the need for money as a temporary abode to overcome transaction costs. The Cambridge money demand function is stated as:

$M_d = k PY$

Here, $M_d$ is the demand for money balances; $Y$ is real national income; $P$ is the average price level; and $PY$ is nominal income. The parameter $k$ (Cambridge $k$) reflects the economic structure and monetary habits, representing the proportion of nominal income people want to hold as cash. This neoclassical theory shifted the focus to money demand as a function of money income, emphasizing its role in exchange and transactions.

KEYNESIAN THEORY OF LIQUIDITY PREFERENCE

John Maynard Keynes developed the 'Liquidity Preference Theory' in his 1936 work, 'The General Theory of Employment, Interest and Money'. 'Liquidity preference' describes the desire to hold money instead of securities or long-term interest-bearing investments. Keynes identified three motives for holding money: the transactions motive, the precautionary motive, and the speculative motive.

The Transactions Motive relates to the need for cash for current personal and business exchanges due to a lack of synchronization between receipts and expenditures. This is divided into the 'income motive' (for individuals) and the 'business (trade) motive' (for firms). Keynes believed transaction demand is not affected by interest rates but is a direct proportional and positive function of income. It is stated as:

$L_r = kY$

where $L_r$ is transaction demand, $k$ is the ratio of earnings kept for transactions, and $Y$ is earnings.

The Precautionary Motive involves keeping income for unforeseen or unpredictable contingencies. The amount demanded depends on income size, economic/political conditions, and personal traits (optimism, farsightedness). Keynes regarded precautionary balances as income elastic and relatively insensitive to interest rates.

THE SPECULATIVE MOTIVE AND THE LIQUIDITY TRAP

The Speculative Motive reflects the desire to hold cash to exploit attractive investment opportunities. People hold money to take advantage of future changes in interest rates ($i$), which are inversely related to bond prices. Keynes assumed the return on money is zero, while bonds offer interest and capital gains/losses. If someone believes the current interest rate is high compared to a 'normal' or 'critical' rate ($r_c$), they expect interest rates to fall and bond prices to rise. They will trade cash for bonds to earn interest and capital gains. Conversely, if the current rate is low, they expect it to rise (and bond prices to fall), leading them to hold liquid cash to avoid capital losses and eventually buy bonds at lower prices.

For an individual, the decision is discontinuous: if the current rate ($r_n$) is above the critical rate ($r_c$), they hold only bonds. If it is below, they hold only cash. However, the aggregate speculative demand for money is represented by a continuous, downward-sloping curve showing an inverse relationship between interest rates and money demand. Higher interest rates result in lower speculative demand, and vice versa.

A 'Liquidity Trap' occurs when expansionary monetary policy fails to increase interest rates or income. This is an extreme effect where the public is willing to hold any amount of money supplied at a given rate, often due to fear of deflation or war. In this case, the speculative demand becomes perfectly elastic (the curve becomes parallel to the X-axis). At a zero percent short-term interest rate, people prefer hoarding money over bonds because money is usable for transactions and has zero opportunity cost. Monetary policy becomes powerless to stimulate the economy. A real-life example of this was seen in Japan, where the 10-year yield dropped to a record 0.2\,\text{%}, and printed money was hoarded rather than invested.

POST-KEYNESIAN DEVELOPMENTS: THE INVENTORY APPROACH

Most post-Keynesian theories emphasize the store-of-value function of money. Baumol (1952) and Tobin (1956) developed the 'Inventory Theoretic Approach' to transaction demand. They viewed real cash balances as an inventory held for transactions. This model assumes two media for value: money and an interest-bearing alternative financial asset. Transitions between these involve fixed costs (e.g., broker fees).

Baumol argued that individuals keep an optimum inventory of money for daily transactions while comparing the opportunity cost (forgone interest) of cash versus saving deposits or bonds. While bonds are risky, saving deposits are safer and provide interest. People hold cash for convenience. Baumol’s 'Square Root Rule' defines the cost-minimizing average cash withdrawal as:

$C = \sqrt{\frac{2bY}{r}}$

This means the average withdrawal is the square root of two times the broker's fee ($b$) multiplied by income ($Y$), divided by the interest rate ($r$). An increase in brokerage fees raises transaction demand for money because it becomes more costly to switch funds temporarily into bonds.

FRIEDMAN'S RESTATEMENT AND TOBIN'S RISK AVERSION

Milton Friedman (1956) extended speculative demand into asset price theory. He treated money demand as an application of the general theory of demand for capital assets. Demand is determined by permanent income (Friedman's measure of wealth, which is the present expected value of all future income) and relative returns on assets (accounting for risk). Nominal demand for money is a function of total wealth, represented by permanent income divided by the discount rate across five asset classes: money, bonds, equity, physical capital, and human capital. Demand is positively related to the price level ($P$), declines if returns on bonds and stocks rise, and is influenced by inflation, which reduces the real value of money.

James Tobin analyzed money demand as 'behavior toward risk'. He assumed people prefer more wealth and are risk-averse, preferring less risk for a given return. Investors face a trade-off between ready money (safe, no return) and bonds/shares (risky, higher return). To manage this, they diversify their portfolios with a balance of safe and risky assets. As the rate of return on bonds increases, the demand for holding money decreases. Tobin’s liquidity preference function is a downward-sloping curve showing that asset demand for money increases as interest rates fall. Empirical studies have supported the interest elasticity of demand for money as an asset.

QUESTIONS & DISCUSSION

1. Which is the incorrect statement? (a) Anything that would act as a medium of exchange is money. (b) Money has generalized purchasing power and is generally acceptable in settlement of all transactions. (c) Money is a totally liquid asset and provides us with means to access goods and services. (d) Currency which represents money does not necessarily have intrinsic value. Answer: (a) is incorrect.

2. Money performs all of the three functions mentioned below, namely: (a) medium of exchange, price control, store of value. (b) unit of account, store of value, provide yields. (c) medium of exchange, unit of account, store of value. (d) medium of exchange, unit of account, income distribution. Answer: (c).

3. Demand for money is: (a) Derived demand. (b) Direct demand. (c) Real income demand. (d) Inverse demand. Answer: (a).

4. Higher the interest rate, higher would be the opportunity cost of holding cash and lower will be the demand for money.Answer: (d).

5. The Quantity Theory of Money holds that: (a) changes in the general level of prices are caused by changes in money quantity. (b) there is a strong relationship between money and price level. (c) changes in the value of money are determined by changes in circulation quantity. (d) All the above. Answer: (d).

6. The Cambridge approach is also known as: (a) Cash balance approach. (b) Fisher’s theory. (c) Classical approach. (d) Keynesian Approach. Answer: (a).

7. Fisher and Cambridge approaches consider money as: (c) money as a means of transactions and therefore, demand for money is only transaction demand for money. Answer: (c).

8. Real money is: (a) nominal money adjusted to the price level. (b) real national income. (c) money demanded at given rate of interest. (d) nominal GNP divided by price level. Answer: (a).

9. Precautionary money balances are: (a) income elastic and not very sensitive to rate of interest. Answer: (a).

10. Speculative demand for money is: (c) negatively related to interest rates. Answer: (c).

11. According to Keynes, if the current interest rate is high: (c) people will expect the interest rate to fall and bond price to rise in the future. Answer: (c).

12. The inventory-theoretic approach explains the negative relationship between money demand and interest rates.Answer: (a).

13. According to Baumol and Tobin, optimal average money holding is: (d) All the above (Positive function of income and price, positive function of transaction costs, negative function of nominal interest). Answer: (d).

14. Who considered demand for money as an application of more general theory of demand for capital assets? (d) Milton Friedman. Answer: (d).

15. Nominal demand for money rises if: (a) the opportunity costs of money holdings (bonds/stock returns) decline and vice versa. Answer: (a).