# give and explain the three theories of money demand

Among these three approaches, quantity velocity approach and cash balances approach are grouped under quantity theories of money. Now, a proportion of the monetary national income is held in liquid form by individuals in an economy. For example, change in trade volume, better transport facilities, and increase in credit facilities would also bring a change in the level of price. So people demand less of it. The three reasons are: Transactions: This is the money needed for fulfilling transactions. ( Handa, 2000, p25 ) . For example, if a stock market crash seemed imminent, the speculative motive for demanding money would come into play; those expecting the market to crash would sell their stocks and hold the proceeds as money. The way in which these factors affect money demand is usually explained in terms of the three motives for demanding money: the transactions , the precautionary , and the speculative motives. This website includes study notes, research papers, essays, articles and other allied information submitted by visitors like YOU. It explains why the public may hold surplus cash (over and above that demanded due to the other two motives) in the face of interest- earning bonds (and other financial assets). Among these three approaches, quantity velocity approach and cash balances approach are grouped under quantity theories of money. However, in extreme conditions, an increase in the quantity of money would lead to a proportional decrease in the value of money, while keeping other factors at constant and vice versa. In quantity theory, most of the factors remain constant, which is not true as real world conditions are dynamic in nature. Therefore, change in quantity of money can only bring changes in the price level when it can change the aggregate expenditure with respect to the supply of output. Precautionary Motive We all know that the future is always uncertain. Conversely, a price decrease increases its demand. If interest rates are expected to rise, the opportunity cost of holding money will become greater, which in turn diminishes the speculative motive for demanding money. The theory also considers that money is only used for the transaction purposes. Share Your PPT File, Inflation: Definitions, Kinds, and Causes of Inflation. If the circulation of money takes place only once, the amount of money required would be equal to the monetary national income. In other words, an increase or decrease in the price level would occur due to increase or decrease in the quantity of money. Let us get started. Macroeconomics deals with aggregate economic quantities, such as national output and national income. The Quantity Theory of Money is an economic theory that states that the level of money supply in an economy is directly proportional to the general price level. Therefore, he/she is required to hold enough cash with him/her to buy food grains and other products from month after month. c.The stock market crashes. ﻿ ﻿ Keynesians believe consumer demand is the primary driving force in an economy. Let us discuss these theories of money in detail. It is called liquidity preference III (LP3), holding money for commercial purposes. a. Such transactions are either discarded or considered to increase the quantity of money. 3. Unexpected expenses, such as medical or car repair bills, often require immediate payment. Classical and Keynesian Theories: Output, Employment, Equilibrium in a Perfectly Competitive Market, Labor Demand and Supply in a Perfectly Competitive Market. The demand for money is affected by several factors, including the level of income, interest rates, and inflation as well as uncertainty about the future. 2 Reading 13 Demand and Supply Analysis: Introduction INTRODUCTION In a general sense, economics is the study of production, distribution, and con- sumption and can be divided into two broad areas of study: macroeconomics and microeconomics. Prof. Fisher has explained that in short run, there are no or negligible changes in the economic factors, such as population, consumption, production, production techniques, technology, customer’s tastes and preferences, and circulation of money. The three main approaches are used for the monetary analysis of a country, which are as follows: a. (a) List, explain, compare and contrast the three principal theories about the demand for money. So the transactions demand for money depends on three things: a) interest rate: as we have noted above, the interest rate is in effect the price of holding money balances. The Classical Approach: The classical economists did not explicitly formulate demand for money … Demand for a given good is the consumers' willingness and ability to consume that good, and it is often represented by a downward-sloping line called the demand curve. Involves transactions that take place without the use of money. In addition, it also expresses the desire of individuals in an economy to have liquid cash that is termed as liquidity for buying. The increase of business or individuals, all’s future is really uncertain, so they keep cash to meet the future uncertainty risks to overcome. However, he did not agree with the view that determining relationship between quantity of money and price level is as easy as demonstrated by quantity theory. He also said that money is the most liquid asset and the more quickly a… Share Your Word File Keynes was agreed with the concept that changes in quantity of money produces changes in the price levels, as given in the quantity theory of money. The presence of a speculative motive for demanding money is also affected by expectations of future interest rates and inflation. Similarly, expectations of higher inflation presage a greater depreciation in the purchasing power of money and therefore lessen the speculative motive for demanding money. Prof. Irvin Fisher has provided a formula for explaining the relationship between quantity of money and its value, which is as follows: In the preceding formula, the supply and demand of money becomes equal. Value of money is a term that is necessary to be understood to get acquainted with the theories of money. The demand for money is affected by several factors such as income levels, interest rates, price levels (inflation), and uncertainty. and any corresponding bookmarks? In case, the expenditure rises but the supply of output is fairly elastic, then also the price level would not rise. The main reason for the change in the price level is the changes that occur in the aggregate income or expenditure. M d. {\displaystyle M^ {d}} is the nominal amount of money demanded, P is the price level, R is the nominal interest rate, Y is real income, and L (.) As a result, the theory supports the expansionary fiscal policy. In this part, I will discuss three theories of the demand for money. Fisher’s Transactions Approach to Demand for Money: In his theory of demand for money Fisher … The demand curve for money shows the quantity of money demanded at each interest rate, all other things unchanged. The quantity theory of money is the idea that the supply of … People often demand money as a precaution against an uncertain future. If there is no rise in the expenditure, then the demand for goods would not rise and consequently, the price level would not increase. Privacy Policy3. With respect to the supply of money, the circulation of money and credit is dependent on the habit of people. The Effects Of Inflation. Quantity of money comprises cash (M) and its velocity (V). Functions of Money, Next For example, if a ten-rupee note circulates through 10 individuals, then the quantity of money would be 100, but not 10. In other words, the interest rate is the ‘price’ for money. The proportional change between M’ and M depends on bank policies. In other words, the value of money (I/P) is inversely proportional to quantity of money (M). The need to have money available in such situations is referred to as the precautionary motive for demanding money. Each of us has an individual demand for particular goods and services and our demand at each price reflects the value that we place on a product, linked usually to the enjoyment or usefulness that we expect from consuming it. PT is equal to the supply of money as it includes cash and credit instruments along with their velocities (MV + M’V’), which is described as follows: According to Fisher, in short-run, the values of T, V, and V remain constant. Audit theories provide a framework for auditing, uncovers the laws that govern the audit process and the relationship between different parties of a firm, forming the basis of the role of audit. is real money demand. Medium of exchange. In monetary economics, the quantity theory of money (QTM) states that the general price level of goods and services is directly proportional to the amount of money in circulation, or money supply.For example, if the amount of money in an economy doubles, QTM predicts that price levels will also double. In the quantity theory, the other factors that are kept constant are as follows: Refers to the frequency at which a single money unit flows from one individual to another. An increase in the use of credit instruments, such as bank cheques and book credit, would lead to an increase in the quantity of money. However, in case the rate of interest is very low, then the increase in quantity of money would not be able to reduce rate of interest further. Keynes positioned his argument in contrast to this idea, stating that … An alternate name for. The demand for an asset depends on both its rate of return and its opportunity cost. The total number of transactions made in an economy tends to increase over time as income rises. Previous The Demand For Money. Hence, as income or GDP rises, the transactions demand for money also rises. Keynesian economics is a theory that says the government should increase demand to boost growth. (b) Use real world examples to explain how each works. Before publishing your Articles on this site, please read the following pages: 1. This is because holding a large amount of cash as idle cash would be a loss or danger for the individual On the other hand, cash balances held by individuals should also not be very low, so that contingencies cannot be overcome. Welcome to EconomicsDiscussion.net! L ( R , Y ) {\displaystyle L (R,Y)} is the liquidity preference function . Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 37 Till now, the economists believed that the price level show changes because of the changes in quantity (demand and supply) of money. One of the primary research areas for this branch of economics is the quantity theory of money. Thus, if in an economy individuals are habitual for holding money for overcoming their expenditure for a longer period of time, then the demand for money would be more. Explain how the following events will affect the demand for money according to the portfolio theories of money demand: a.The economy experiences a business cycle contraction. We will also look at the Elasticity of Demand and the concept of Demand Forecasting. The quantity theory of money is the most-discussed theory of money. The Liquidity Preference Theory says that the demand for money is not to borrow money but the desire to remain liquid. However, in the present scenario, most of the economists have believed that quantity theory of money is not applicable in practical situations. The Law of Demand is the basis for price determination in an open market. Therefore, P and M are directly proportional to each other. Cash Balances Approach/Cambridge Equation: Cash balances approach is the modification of quantity velocity approach and is widely accepted in Europe. Among these factors, one factor can easily bring changes in other factors. So everybody holds money and maintain a cash balance for the future uncertainty. The impact of these factors on the demand for money is explained in terms of the three primary reasons to hold money. Type of relation between aggregate expenditure and volume of production. Monetary economics is a branch of economics that studies different theories of money. An increase in the quantity of money would decrease the rate of interest. This is because it may be possible that the proportional increase in price level is very less as compared to increase in money supply. According to Keynes, the demand for money is split up into three types – Transactionary, Precautionary and Speculative. Quantity Velocity Approach/Cash Transaction Approach/Freidman’s Restatement. Quantity Velocity Approach: All rights reserved. The speculative motive for demanding money arises in situations where holding money is perceived to be less risky than the alternative of lending the money or investing it in some other asset. i) Classical Quantity Theory (Fisher, Irving): ii) Liquidity Preference Theory (Keynes, Maynard): Demand for money is negatively related to interest rates, thus velocity rises. which way would this event shift the curve. However, logically, value of money is associated with its purchasing power, which refers to the quantity of goods and services that can be purchased with a unit of money. bookmarked pages associated with this title. According to the modern theory of money, changes in price level are brought by the changes in national income rather than quantity of money. This theory is commonly associated with the ideals of neoclassical economists.… Therefore, the impact of change in quantity of money would depend on the following factors: a. According to Marshall, “A man fixes the appropriate fraction (of his income) after balancing one against another the advantages of a further ready command and the disadvantages of putting more of his resources into a form in which they yield him no direct income or other benefit.”. CliffsNotes study guides are written by real teachers and professors, so no matter what you're studying, CliffsNotes can ease your homework headaches and help you score high on exams. The reduced rate of interest would help in increasing the rate of investment by individuals, which would further result in increase in income. The increase in income would increase the aggregate expenditure of a nation. Because it is necessary to have money available for transactions, money will be demanded. The opportunity cost of holding money is the interest rate that can be earned by lending or investing one's money holdings. explain the three reasons the aggregate demand curve slopes downward. Help in increasing the quantity of money. Volume of transactions refers not only to the amount of goods and services exchanged, but the number of times money changes hand. Then, it led to a rush of research the demand for money which includes the Keynes system, monetary system, rational expected system and so on. For example, when money in the economy is doubled, inflation will increase by twofold as well. Therefore, apart from the quantity of money, other factors may also produce changes in level of price and consequently in the value of money. Keynesian demand-side – Keynes argued that aggregate demand could play a role in influencing economic growth in the short and medium-term. Typically, money holdings provide no rate of return and often depreciate in value due to inflation. In addition, the proportional change between M’ and M also remains constant. Are you sure you want to remove #bookConfirmation# Theory of Demand is the principle/law that correlates the demand for a product with the price of the product. They are the classics theory, the modern quantity theory and Keynes theory. For example, change in M can produce changes in V, which further make changes in the value of P. b. The amount of expenditure depends on the consumption function, investment demand schedule, liquidity preference schedule, and supply of money. For example, an individual would not purchase food grains for the whole year at once, but he/she would purchase on monthly basis. In the authoritative theory, the economic system ever keeps the full-employment degree and monetary value can set any clip to maintain the balance in the market. from your Reading List will also remove any give an example of an event that would shift the aggregate demand curve. This approach is based on national income approach and considers the concept of liquidity. There are many theories which may explain demand for audit services in modern societies. Monetarist Theory: The monetarist theory is an economic concept which contends that changes in the money supply are the most significant determinants of the … In addition, the quantity theory has not explained the process by which the change in quantity of money produces change in the price level. Putting those three sources of demand together, we can draw a demand curve for money to show how the interest rate affects the total quantity of money people hold. For example, when the price level in a country is high, the value of money is low and vice-versa. Thus, the income and aggregate expenditure would simultaneously fail to show any type of increase. Effect of change in money supply on level of aggregate expenditure and volume of production, b. However, it can also be held by individuals as idle cash and savings. However, in recent years Baumol, Tobin and Friedman have put forward new theories of demand for money. At nowadays of the money theory came from two different theories: one is measure theory which belongs to the authoritative theory ; the other is Keynesian theory. TOS4. When price rises, a good or service becomes less desirable. Therefore, an individual should hold a particular amount of cash with him/her to fulfill his/her needs as well as overcome uncertainties. The quantity theory is criticized on a large scale due to its static nature. •Thus, portfolio theories cannot explain the demand for these dominated forms of money. This is because they are indirectly related to each other and depend on aggregate expenditure and elasticity of supply of output. pR represents the monetary national income. On the other hand, the income-expenditure approach is the modern theory of money. In short-run, factors, such a population, frequency of transactions, and velocity of circulation, change either at a low rate or at high rate, but show changes. Our mission is to provide an online platform to help students to discuss anything and everything about Economics. The Quantity Theory of Money. b.Brokerage fees decline, making bond transactions cheaper. Speculative motive. Removing #book# 11 3. iii) Speculative demand foe money This is the demand for money to invest in business which will generate higher returns. Precautionary motive. Let us express the fraction of income that should be held by individuals ask. Money, like other stores of value, is an asset. The income-expenditure approach is given by Keynes. The speculative motive giving rise to the speculative demand for money is the most important contribution Keynes made to the theory of the demand for money. It is the heart of Keynes theory on. Therefore, it can be concluded that price level and quantity of money are directly proportional to each other. It is also termed as the modern theory of money. Its main tools are government spending on infrastructure, unemployment benefits, and education. Apart from this, other factors, such as M, V, M’, and V’, are not independent factors. However, when the increased quantity of money is not able to reduce the rate of interest as it is already very low, the investment would not show any increase. It also known as liquidity preference II (LP2). Now, the equation usually used is as follows: R = real national income (total of final goods and services that are directly consumed), P = average price-level of real national income (average of price of clothes, food, shelter, and services). John Maynard Keynes published a book in 1936 called The General Theory of Employment, Interest, and Money, laying the groundwork for his legacy of the Keynesian Theory of Economics. The values of money and price levels in a country are inversely proportional to each other. Fiscal and Monetary Policy. It is the income I forego when I hold money balances. However, it is also not guaranteed that if the increase in quantity of money reduces the rate of interest, then price level would rise or not. David Laidler conducts an investigation of the importance of the demand for money, particularly in the light of interest rates and income levels. Other has defined the value of money as the value of Indian currency against foreign currencies. Economists give this a term - utility Effective Demand. In economics, different economists have defined the term value of money differently. Demand is different to desire! On the other hand, the income-expenditure approach is the modern theory of money. 4. The transactions motive for demanding money arises from the fact that most transactions involve an exchange of money. Let us discuss these theories of money in detail. John Maynard Keynescreated the Liquidity Preference Theory in to explain the role of the interest rate by the supply and demand for money. © 2020 Houghton Mifflin Harcourt. The demand for money is not only dependent on the quantity of goods and services that would be exchanged, but also on the time period at which the transaction takes place. What Is the Quantity Theory of Money? It is also termed as the demand for money. The other factors remain same due to various reasons. Share Your PDF File Requires to be constant. On the other hand, few economists have associated the term value of money with the internal purchasing power of a nation. The velocity of circulation of cash depends on various factors, such as frequency of transactions, trade volume, type of business conditions, price levels, and borrowing and lending policies. Therefore, all the factors in this dynamic world keep on changing with time. Therefore, it is hard to determine relationship between changes in money supply and changes in price level. Transactions motive. Therefore, these factors also remain constant in short-run. According to cash balances approach, the value of money depends on the demand and supply of cash balances for a given period of time. Money's most important function is as a medium of exchange to facilitate transactions. Content Guidelines 2. Though most growth theories ignore the role of aggregate demand, some economists argue recessions can cause hysteresis effects and lower long-term economic growth. When the price level is multiplied by the transactions performed by money, it provides the total value of transactions (PT). Some of the economists explained value of money as the value of gold and silver in terms of their weight and fineness. The law of demand assumes that all determinants of demand, except price, remains unchanged. Baumol-Tobin Money Demand Model(s) These are further developments on the Keynesian theory Variations in each type of money demand: transactions demand is also affected by interest rates so is precautionary demand speculative demand is affected not only by interest rates but also by relative riskiness of available assets Bottom line: demand for money is still positively The theory can be expressed using the equation of exchange: $$M\times V = P\times Y$$ Where: $$M$$ is the quantity of money; $$V$$ is the velocity of circulation of money in the economy; $$P$$ is the price level; and $$Y$$ is the real output. However, if circulation of money takes place twice, then only half pR is required for buying national product. The Demand for Money Portfolio Theories of Money Demand •Economists refer to M1 as a dominated asset: as a store of value it exists alongside other assets that are always better. In such a case, the price level would not rise even with the rise of quantity of money.