Theories of Demand for Money - Coursework Example

Contents THEORIES OF DEMAND FOR MONEY Introduction Money is one of the oldest means of conducting transactions and is considered as the foremost medium of exchange. A historical look at the history of trade would suggest that humans have evolved various means of exchanging with each other. Since not everyone possessed everything therefore humans felt the need of making transactions with each other so that what one does not posses can get by giving something in return of it. The earliest history suggests that man use to adapt barter with each other in which goods were given in return of goods without any other medium of exchange being used to carry out the transactions. However, barter had its own complications and lacunas as it sometimes became difficult to exchange two things mutually needed by both of the parties to the transaction. Money emerged out of that necessity. Money by serving as the medium of exchange during the transactions serves both economic as well as social causes. It makes the complicated economic exchanges more convenient and easy to execute besides allowing people to socialize through the ways the do best. (Nash)1 The main objective of money is to arrange transaction between different people and business organizations. The money and incomes are closely related as most of the incomes are obtained in the money hence money is also used to keep the wealth of the persons and nationals. It therefore means that with money: 1) Wealth can be kept 2) Income can be represented 3) Payments can be made 4) The future needs can be met. In the early stages of money, the major portion of money possessed by people was consisted of currency and demand deposits however with the passage of time; more substitutes of money became available also. It must also be noted that these different substitutes of money carried the same liquidity like traditional currency however the extent of liquidity varied with respect to the type of substitute. These substitutes included government securities, saving accounts, stocks, bonds etc. though these assets possess the quality of money being the store of value however they are not traditionally being used as medium of exchange. It is because of this reason that they are often termed as IOU or near money. Having served the critical functions and being the core of all the transactions taking place, the demand for money have different dynamics and it is because of this reason that different theories of demand for money have been developed. This essay will explore some of the theories of Demand for Money as a part of the assignment on the Monetary Theory and Policy. Quantity Theory of Money- Fischer Approach Quantity theory of money was presented by the Classical Economists. This is the reason that it is said that the classical have two pillars i.e. Says of Law of Markets and Quantity theory of Money. The says law of Markets is related with the real sector of the money whereas the Quantity theory of money is concerned with the monetary sector of the economy. The Quantitative theory of Money or QTM is considered as primitive theory of money and is popular since 17th century. The main philosophy or the idea behind this theory is that the changes in the price level occur due to the changes in the quantity of money. In 1911, Professor Irving Fischer presented his theory of the Demand for Money as: “the level of prices in an economy varies directly with the quantity of money in circulation provided the velocity of circulation of money and volume of transaction do not change”. (http://cepa.newschool.edu)2. Accordingly, an equation was developed by Fischer to explain his TQM. This equation is MV = PT M= Money V = Velocity of Money P= Price Level T = Amount of transaction The basic approach of Fisher was concerned with the supply side. It states that any increase in supply of money will lead to increase price level in the economy. However in addition to the supply side, Fisher also identified the demand aspect of the QTM. It is because of this reason that the right side of the equation represents the demand side whereas left side of the equation represents the supply side. Accordingly, the money market will remain in equilibrium when the demand for money is equal to the supply of money. The classical theory of Quantity of Money therefore outlines that, by keeping the T and V constant, only that much amount of money will be demanded which coincide with the full employment level in the economy. Thus according to this theory, money is demanded only for the purpose of purchasing goods and services or money is demanded for the transaction purposes therefore how much money will be demanded for this purpose depends upon the produced goods and services at the full level of employment and since at the full employment level, the amount of goods and services remain fixed therefore the demand for money also remains fixed at the full employment level. Pigou’s Demand for Money On the same lines of the Fischer’s Quantity Theory of Money, a theory was presented by Cambridge Economists like Robertson and Pigou which got popularity in UK. Known as Cash Balance or Cambridge Approach, this theory mostly attributed to the A.C.Pigou. According to this theory, the level of prices in the economy depends upon the cash balance which people like to keep with them. It means that the proportion of cash balance is responsible for the changes in the price level. The more the cash proportions held by the people, the circulation of money will reduce and prices will fall whereas on the other hand, if the proportion of cash balances held by the people decreases, the circulation of money will increase hence resulting into the increase of prices. Thus all such shows that according to Pigou, the demand for money i.e. the proportion of cash balance are responsible for changes in prices levels. It is because of this that this theory is being considered as representing the demand side. In other words, the changes in demand for money are held responsible for the changes in price level. Having discussed the above two theories of the Quantity of Demand, it is often put forward that the assumptions under which both the theories work are false that is the assumption that the transaction amount, T and Velocity of Money, V does not change is a flawed assumption. Further the variables which this theory takes into account i.e. M, V, P and T are independent which not the case always. It was because of these theoretical weaknesses that Keynes put forward his theory of demand for money. Liquidity Preference theory By the demand for money we mean why people keep money or what are the motives behind holding the money. According to the classical economist, money only serves as the medium of exchange and as result money is only demanded to carry out the transactions and how much money will be kept for this purpose will depend upon the level of the income of people. However later research on demand for money suggested that money also serves as a store of value and against the money, interest can be earned. This motive for holding the money was emphasized by J.M.Keynes and is given the name of speculative demand for money. This motive of demand for money is influenced by the changes in the interest rates. Accordingly, the demand for money emerged due to following purposes: (Dunne) 1) Transaction motive 2) Precautionary Motive 3) Speculative Motive The transaction motive outlines that people hold money to buy stuff and as income rises, the demand for money rises whereas the precautionary motive says that people hold money to meet the contingencies or uncertainties. Finally Speculative motive of demanding the money mentions that the money can earn money over it therefore by storing money, one can earn interest on it. While further discussing the transaction motive, we come to know that a time lag in involved in between income and expenditures therefore to meet the expenditure of such interval, people have to keep a certain proportion in the form of cash. Such demand is for the day to day transactions either on the part of the households or on the part of the business firms. According to Keynes, The transcative demand for money is influenced by the level of income. According to Keynes, an individual could hold his wealth in two ways. I.e. in cash or in bonds. If a person purchases a bond or securities, he is to be confronted with the fluctuations in their prices. As a result, the bond holder may face the capital gains or capital losses. If the bond holder realizes that the because of the fall of the prices of securities the loss incurred exceeds the capital gains earned in the form of interest, he will prefer cash over securities and will sell his securities to accumulative cash and when prices reach their lowest edge, he will buy them. Holding of money for such occasions is considered as the speculative motive of holding the money. Thus the speculative demand for money is affected by the interest rates in the economy since interest rates have the power to lower or increase the prices of the securities held by the person for investment as well as speculative purposes. Hence Keynes put forward the theory that the demand for money arises mainly due to the liquidity preference of the persons demand the money. James Tobin’s Optimum Portfolio Theory The Theory put forward by James Tobin is considered as an extension of the Liquidity Preference theory of Keynes. Tobin’s theory of money is also known as the Modern Liquidity Preference theory or portfolio theory of demand for money. According to Keynes, a person in his portfolio either keeps cash or bonds but Tobin’s objects Keynes by saying that no body keeps in his mind the concept of a normal rate of interest. If it does not happen then there will be no demand for bonds or no money will be kept for the speculative purposes and in such state of affairs there will be no possibility of profit or loss to the speculator. He further says that empirically it has not been found that a person either keeps bonds or cash. Moreover, no one can properly estimate future rate of interests as they may be low or high. Because of these weaknesses in the Keyne’s liquidity Preference theory, Tobin says that a wealth holder in his portfolio keeps both cash and bonds. Accordingly, Tobin presents the idea of optimum portfolio- the portfolio which consists of both the bonds as well as cash. Such portfolio will maximize the returns and minimize the cost. He further says that if a wealth holder keeps more bonds in his portfolio, he will be hoping to get more risk and on other hands if he possess more cash, he will be getting reduced returns though his risk will be minimum. This therefore shows that a wealth holder has to make a trade off between the risk and return. As risk increases, because of more bonds, the return would also increase and as risk decreases the return will also decrease. (doc. Ing. Vladimír Gonda) Conclusion Theories of Demand for Money are considered as the foundation of the monetary economics. Over the period of time they have evolved and efforts were being made to perfect them in order to get a realistic view of the demand for money hence the execution of monetary policy. Earliest theories of Demand for Money were put forward by the Classical Economists or supply side economists who believed in the working of economy within full level of employment however the episode of Great Depression and subsequent emergence of Keynesian Economics which provided a radically new approach to the study of dynamics of money demand. This was mainly focused on the assumption that economy do not necessarily to be in full employment level to achieve equilibrium. Further, US depression was partly because of increased speculative activity in the Stock Exchanges therefore the motives for holding money were perfectly proved empirically. References doc. Ing. Vladimír Gonda. "JAMES TOBIN." 2003. PROFILES OF WORLD ECONOMISTS. 07 April 2008 . Dunne. "Demand for Money ." 2008. 07 April 2008 . http://cepa.newschool.edu. "The Quantity Theory of Money." 2008. 06 April 2008 . Nash, Dr. Ronald. "What is Money?" 2008. A Puritans Mind. 06 April 2008 . Read More