Classical and Keynesian approaches of Demand of Money

The Classical Approach:

The classical economists did not explicitly formulate demand for money theory but their views are inherent in the quantity theory of money. They emphasized the transactions demand for money in terms of the velocity of circulation of money. This is because money acts as a medium of exchange and facilitates the exchange of goods and services. In Fisher’s “Equation of Exchange”,

MV = PT

Where M is the total quantity of money, V is its velocity of circulation, P is the price level, and T is the total amount of goods and services exchanged for money.

The right-hand side of this equation PT represents the demand for money which, in fact, “depends upon the value of the transactions to be undertaken in the economy, and is equal to a constant fraction of those transactions.” MV represents the supply of money which is given and in equilibrium equals the demand for money. Thus, the equation becomes MV = PT

This transactions demand for money, in turn, is determined by the level of full employment income. This is because the classicists believed in Say’s Law whereby supply created its own demand, assuming the full employment level of income. Thus, the demand for money in Fisher’s approach is a constant proportion of the level of transactions, which in turn, bears a constant relationship to the level of national income. Further, the demand for money is linked to the volume of trade going on in an economy at any time. Thus, its underlying assumption is that people hold money to buy goods.

But people also hold money for other reasons, such as to earn interest and to provide against unforeseen events. It is, therefore, not possible to say that V will remain constant when M is changed. The most important thing about money in Fisher’s theory is that it is transferable. But it does not explain fully why people hold money. It does not clarify whether to include as money such items as time deposits or savings deposits that are not immediately available to pay debts without first being converted into currency.

It was the Cambridge cash balances approach which raised a further question: Why do people actually want to hold their assets in the form of money? With larger incomes, people want to make larger volumes of transactions and that larger cash balances will, therefore, be demanded. The Cambridge demand equation for money is Md = kPY

where Md is the demand for money which must equal the supply of money (Md=Ms) in equilibrium in the economy, k is the fraction of the real money income (PY) which people wish to hold in cash and demand deposits or the ratio of money stock to income, P is the price level, and Y is the aggregate real income. This equation tells us that “other things being equal, the demand for money in normal terms would be proportional to the nominal level of income for each individual, and hence for the aggregate economy as well.”

Its Critical Evaluation:

This approach includes time and saving deposits and other convertible funds in the demand for money. It also stresses the importance of factors that make money more or less useful, such as the costs of holding it, uncertainty about the future and so on. But it says little about the nature of the relationship that one expects to prevail between its variables, and it does not say too much about which ones might be important.

One of its major criticisms arises from the neglect of store of value function of money. The classicists emphasized only the medium of exchange function of money which simply acted as a go-between to facilitate buying and selling. For them, money performed a neutral role in the economy. It was barren and would not multiply, if stored in the form of wealth.

This was an erroneous view because money performed the “asset” function when it is transformed into other forms of assets like bills, equities, debentures, real assets (houses, cars, TVs, and so on), etc. Thus, the neglect of the asset function of money was the major weakness of the classical approach to the demand for money which Keynes remedied.

The Keynesian Approach: Liquidity Preference:

Keynes in his General Theory used a new term “liquidity preference” for the demand for money. Keynes suggested three motives which led to the demand for money in an economy: (1) the transactions demand, (2) the precautionary demand, and (3) the speculative demand.

The Transactions Demand for Money:

The transactions demand for money arises from the medium of exchange function of money in making regular payments for goods and services. According to Keynes, it relates to “the need of cash for the current transactions of personal and business exchange” It is further divided into income and business motives. The income motive is meant “to bridge the interval between the receipt of income and its disbursement.”

Similarly, the business motive is meant “to bridge the interval between the time of incurring business costs and that of the receipt of the sale proceeds.” If the time between the incurring of expenditure and receipt of income is small, less cash will be held by the people for current transactions, and vice versa. There will, however, be changes in the transactions demand for money depending upon the expectations of income recipients and businessmen. They depend upon the level of income, the interest rate, the business turnover, the normal period between the receipt and disbursement of income, etc.

Given these factors, the transactions demand for money is a direct proportional and positive function of the level of income, and is expressed as

L1 = kY

Where L1 is the transactions demand for money, k is the proportion of income which is kept for transactions purposes, and Y is the income.

Interest Rate and Transactions Demand:

Regarding the rate of interest as the determinant of the transactions demand for money Keynes made the LT function interest inelastic. But the pointed out that the “demand for money in the active circulation is also the some extent a function of the rate of interest, since a higher rate of interest may lead to a more economical use of active balances.” “However, he did not stress the role of the rate of interest in this part of his analysis, and many of his popularizes ignored it altogether.” In recent years, two post-Keynesian economists William J. Baumol and James Tobin have shown that the rate of interest is an important determinant of transactions demand for money.

They have also pointed out the relationship, between transactions demand for money and income is not linear and proportional. Rather, changes in income lead to proportionately smaller changes in transactions demand.

Transactions balances are held because income received once a month is not spent on the same day. In fact, an individual spreads his expenditure evenly over the month. Thus a portion of money meant for transactions purposes can be spent on short-term interest-yielding securities. It is possible to “put funds to work for a matter of days, weeks, or months in interest-bearing securities such as U.S. Treasury bills or commercial paper and other short-term money market instruments.

The problem here is that there is a cost involved in buying and selling. One must weigh the financial cost and inconvenience of frequent entry to and exit from the market for securities against the apparent advantage of holding interest-bearing securities in place of idle transactions balances.

Among other things, the cost per purchase and sale, the rate of interest, and the frequency of purchases and sales determine the profitability of switching from ideal transactions balances to earning assets. Nonetheless, with the cost per purchase and sale given, there is clearly some rate of interest at which it becomes profitable to switch what otherwise would-be transactions balances into interest-bearing securities, even if the period for which these funds may be spared from transactions needs is measured only in weeks. The higher the interest rate, the larger will be the fraction of any given amount of transactions balances that can be profitably diverted into securities.”

The Precautionary Demand for Money:

The Precautionary motive relates to “the desire to provide for contingencies requiring sudden expenditures and for unforeseen opportunities of advantageous purchases.” Both individuals and businessmen keep cash in reserve to meet unexpected needs. Individuals hold some cash to provide for illness, accidents, unemployment and other unforeseen contingencies.

Similarly, businessmen keep cash in reserve to tide over unfavourable conditions or to gain from unexpected deals. Therefore, “money held under the precautionary motive is rather like water kept in reserve in a water tank.” The precautionary demand for money depends upon the level of income, and business activity, opportunities for unexpected profitable deals, availability of cash, the cost of holding liquid assets in bank reserves, etc.

Keynes held that the precautionary demand for money, like transactions demand, was a function of the level of income. But the post-Keynesian economists believe that like transactions demand, it is inversely related to high interest rates. The transactions and precautionary demand for money will be unstable, particularly if the economy is not at full employment level and transactions are, therefore, less than the maximum, and are liable to fluctuate up or down.

The Speculative Demand for Money:

The speculative (or asset or liquidity preference) demand for money is for securing profit from knowing better than the market what the future will bring forth”. Individuals and businessmen having funds, after keeping enough for transactions and precautionary purposes, like to make a speculative gain by investing in bonds. Money held for speculative purposes is a liquid store of value which can be invested at an opportune moment in interest-bearing bonds or securities.

Bond prices and the rate of interest are inversely related to each other. Low bond prices are indicative of high interest rates, and high bond prices reflect low interest rates. A bond carries a fixed rate of interest. For instance, if a bond of the value of Rs 100 carries 4 per cent interest and the market rate of interest rises to 8 per cent, the value of this bond falls to Rs 50 in the market. If the market rate of interest falls to 2 per cent, the value of the bond will rise to Rs 200 in the market.