Fischer and the Baumol-Tobin Approaches to the Demand for Money - Essay Example

?What are key differences between the Fischer and the Baumol-Tobin approaches to the demand for money? The fundamental difference between Fischer's quantity theory of Money and the Baumol –Tobin approaches to the demand for money lies in the significance accorded to the real interest rate in determining the demand for money. Fischer's theory was essentially a formal restatement of the classical monetarist view of the demand for money. The central tenet of this theory was that the demand for money only depended on the nominal aggregate income of the economy. Essentially the idea was that the demand for money is generated solely from the need of entering transactions. Defining M as the money supply, P as the price level, Y as the real aggregate output and V as the Velocity of money, the average frequency of spending of a unit of money across all transactions in a given time period, the focal representation of the theory is through the equation of exchange: MV=PY. This equation simply states that the amount of money supplied multiplied by the number of times a single unit is circulated equals the nominal value of aggregate output or income. This is more or less a tautological identity. The equation of exchange however can be translated into a theory of money demand by noting that in equilibrium, money supplied is equal to money demand and therefore, M=MD and rewriting the equation of exchange as: (1) Thus, evidently, this theory implies that given a constant velocity in the short run and the price level, the demand for money is a function of Y only. Additionally, if Y is fixed at its full employment level and V is fixed in the short run then note that an increase in the money demand will lead to a proportional increase in the price level implying inflation. The assumption of a constant velocity in the short run follows from the belief that velocity is determined through technological and institutional factors of the economy and these factors undergo changes at very slow paces or are altered in discrete jumps over large intervals of time. Thus velocity remains unaltered over shorter time horizons. Therefore, to summarize Fischer's theory of money demand, money demand is determined by the magnitude of transactions generated by any particular level of nominal income PY and institutional and technological factors that determine the velocity of money. Rate of interest has no significance in the determination of the demand for money in an economy. The Baumol-Tobin approach to money demand is essentially an extension of Keynesian ideas regarding the demand for money. Keynes argued that interest rate has a substantial role to play in the determination of money demand. Particularly, Keynes noted that money demand has three components: the transactions demand for money, the precautionary demand for money and the speculative demand for money. Transactions demand for money is the demand that is generated due to the fact that receipts of money and expenses occur at different points in time and therefore, people have to maintain a reserve of money for transaction purposes at points in time when receipts do not occur but expenses must be made. Precautionary demand for money is the demand for cash that results due to people maintaining reserves for unforeseen contingencies. These two types of money demand, in Keynes' theory are functions of the income only. These were clubbed together by Keynes as L1(Y). The last part of money demand is the speculative demand for money which derives from the fact that people hold money since it is a store of value. According to Keynes' theory, people can either invest in bonds or hold cash money. The opportunity cost of holding cash as opposed to bonds is the forsaken interest payments or capital gains. The interest rate therefore has an inverse relationship with the speculative demand for cash. The idea was that if people expect a particular interest rate to prevail then if interest rates were above this, people would expect a decline in interest rates in future. This implies that bond prices would increase and thus, as a consequence of interest rates lying above the expected rate, the demand for bonds would rise and that of cash would fall. Analogously, if interest rates lay below the expected rate, then the demand for cash would increase. Thus, speculative demand for cash was inversely related to the rate of interest. This part was designated as: L2(r). In the Keynesian theory of money demand, (2) Thus, here, money demand is a function of interest rates as well as aggregate income. The Baumol -Tobin theories of money demand essentially extend the Keynesian arguments to establish that money demand is influenced by interest rates via transactions channels as well along with the speculative demand channel. Baumol and Tobin developed distinct theories to show that even cash balances held for transactions purposes could be sensitive to changes in interest rates. In their models, money which earns zero interest, is held only because it can be used to carry out transactions. The conclusion of the Baumol-Tobin analysis is as follows: as interest rates increase, the amount of cash held for transaction purposes will decline, which in turn means that velocity will increase as interest rates. The transactions component of the demand for money is negatively related to the level of interest rates. Thus, although both Baumol-Tobin and the Fischer Theories of Money demand are all based on the transactions motive of individuals, these differ in implications. In particular, while Fischer's theory implies that Money demand is not sensitive to changes in interest rates but rather is influenced by nominal income and the pace of transactions that this nominal income generates, Baumol-Tobin theories establish that Money demand is influenced by interest rates as well. Although Keynes already argued for this, the significance of Baumol and Tobin approaches were that these formally established the Keynesian arguments and further showed that the interest sensitivity of money demand could be a result of transactions and precautionary motives as well along with the speculative motive which was the only part of money demand what Keynes argued leads to interest sensitivity of money demand. Suppose that in the short run velocity rises but incomes have not changed. How would the Keynesian liquidity theory explain this? Combining equations (1) and (2), we arrive at: Note that incomes not changing imply Y remains fixed while V rises. Evidently this will occur if there is a decline in money demand. And such a change can be caused by an increase in the interest rate. If interest rate increases, and income remains the same, there will be a decline in money demand. Thus, in the expression for V, the denominator falls and consequentially there is a rise in V. Thus, Keynesian Liquidity theory would explain this by saying that because there was an increase in the interest rates, people expected interest rates to fall in the future and thus bond prices to increase in the future. Thus the demand for bonds went up and that for holding cash went down. As a consequence there was a decline in the demand for money which in turn reduces the pace at which a unit of money is circulated in the economy. Read More