The Alternative Theories of the Demand for Money - Research Paper Example

The Alternative Theories of the Demand For Money Can Have Very Different Implications for Our View of the Role of Money in the Economy Table of Contents Introduction 2 Analysis of the Theories of Demand for Money 4 Classical Quantity Theory of Money: 4 Purchasing Power of Money as Related To the Equation of Exchange 4 Cambridge Cash Balance Approach to Quantity Theory of money 5 Keynesian Liquidity-Preference Theory and Policy 6 IS-LM Curve 8 Explanation of the IS-LM curve: 8 Goods Market (IS) 8 Assembling the Model (IS and LM) 9 Reasons for Regarding Keynesian Theory as A New One 10 Neo-Keynesian Developments 10 Assumptions 11 Friedman’s Modern Quantity Theory of Money 13 Distinguishing Between Keynesian and Monetarist Approaches 15 Monetary Policy: Keynesian vs. Monetarist Views 15 Role of the Monetary Policy and Its Effectiveness 16 Price Stability 16 Economic Growth 17 Framework for Monetary Policy to Overcome Critical Issues 21 Managed Exchange Rate 21 Flexibility in Exchange Rate and Monetary Targeting 21 Inflation Targeting 22 Inflation Targeting With Exchange Rate Flexibility 22 Issues Concerning Monetary Institutions 22 Time Inconsistency 25 Coordination Issue among the Fiscal and Monetary Policy Making 26 Difference between the Inflation and Monetary Targets 27 Conclusion 28 References 30 Introduction Money is the valuable asset in our economy that provides liquidity. The demand for money is displayed by the desired holding of it in the form of cash or bank deposits. The economists over time have developed many theories related to the demand for money which at times has created different views with respect to the role of money in our economy. The research paper deals with the implication of different monetary theories. The purpose of the research paper is to deal with different theories of the demand for money and their implications on the various aspects of the economy. There are basically three theories to the demand for money: they are the Classical, Keynesian and the Quantity theory of Money. The research paper will describe these theories and their implications on the economy. The monetary policy and theories plays a very important role in defining the demand for money in an economy. In other words, monetary policy is the controller of the supply of money. In recent times, there have been a lot of dilemmas regarding the perception of the role of money in the economy. The research paper, for this reason makes a complete overview of all the theories to the demand of money and tries to analyse different implications of those theories in the minds of the people. In the introductory part of this research paper, a clear approach towards the implications of monetary theory and policy has been made. The issues related to the monetary policy and theories, which are also described in the demand theories of money, will be taken care of in this research paper. The monetary theories describe the relationship between the macroeconomic systems and money stock. The macroeconomics consists of the economy as a whole and it opposes the individual or sectors. Monetary theory analyses the function of money in the system of macro economy with respect to the demand and supply of money and the natural tendency of the economic system to adjust to a point where a perfect balance of the demand and supply of money is achieved. Analysis of the Theories of Demand for Money Classical Quantity Theory of Money: In the nineteenth and during the beginning of twentieth century, the classical economists developed the quantity theory of money which determines the nominal value of aggregate income. The most important feature of this theory is that it suggests that interest rate have no effect on the demand for money. It states that money supply has a positive relationship with the price level (Meridith, 2010). Purchasing Power of Money as Related To the Equation of Exchange (Irving Fisher’s Approach to Quantity theory of money) The basics of the theory can be demonstrated by the equation: MV=PT Where, M is the Money; V is the Transaction Velocity of money; P is the Price Level; T is the level of transaction Here, V & T are fixed with respect to the money supply output is determined by the macroeconomic factors and money is arranged by institutions. Considering the above factors, the quantity theory of money goes like this: Since V and T are fixed and M is exogenous, then an increase in the supply of money will also increase level of price. Thus the money supply expansion will only cause price inflation (The New School, n.d.). Cambridge Cash Balance Approach to Quantity Theory of money Cambridge approach towards the quantity theory of money implies that there is a motive of the people to store money as a store of wealth because sale and purchase are not simultaneous in nature. Considering the precautionary modes it is considered that money is demanded by consumers for itself. The implication is that when the volume of income is high, the amount of sales and purchases are also high. Thus Cambridge denoted that real money is a function of real income. M/P=kY Where, k is the “Cambridge constant”. This can be compared with the Fisher’s system by recognising real income (Y), transaction (T) is in equilibrium. The transactions which are only transferrable of ownership are not transactions at all and thus do not fall under the head of income. It can be stated that in long run, T=Y. thus the Fisher’s equation can be re-written as: M/P= (1/V) Y. Thus due to the approach of Cambridge towards cash balance, the equation of Fisher could be modified though the assumptions of the theories are different. Keynesian Liquidity-Preference Theory and Policy Keynes used the term “Liquidity Preference” by which his theory of interest is commonly known. Liquidity Preference is the desire to hold money. Keynes abandoned the classical view that velocity is constant and emphasised the importance of interest rates. He emphasized that there are three motives behind the demand for money: the transaction motive, the precautionary motive and the speculative motive. The Transaction motive states people prefer to hold money with them because income is not always certain and for avoiding interruptions in their basic consumption they prefer to hold. This amount of money is determined by the respective level of income. The Precautionary motive states that people have a preference of holding money for handling unexpected problems that may encounter any time. The Speculative motive states that people keep hold of liquidity in order to cogitate that bond related prices have the possibility or will fall. When the interest rate decreases, people demand to keep the hold of money till the time the interest rate increases. Thus lower the interest rate, the more is the money demand and vice-versa. According to Keynes, interest rates play an important role in deciding the amount of wealth that is to be held (Auburn University, n.d.). IS-LM Curve The basic IS-LM model consists of three parts: the IS block consists of a consumptions or savings curve (as a function of income), an investment curve (as a function of rate of interest) and an equilibrium condition that holds that investment must equal savings for the goods market to clear. Explanation of the IS-LM curve: The IS-LM model describes the dynamics of economies in the short run. The model deals with two schedules: goods and money. In the IS-LM model there is an upward and downward schedule (Massachusetts Institute of Technology, 2010). Goods Market (IS) According to classical and neo-classical theories of interest, investment is a decreasing function of the rate of interest i.e., I=f(r) and saving is an increasing function of income i.e., S=f(Y). This means that the volume of investment increases when the rate of interest is low and vice-versa. Similarly, with the increase in the income, the volume of savings also increases. The various rate of interests and the corresponding levels of income at which investment is equal to savings is known as the IS schedule. On the basis of it, the IS curve can be drawn. Money Market (LM) The equilibrium condition in the monetary sector is at the point at which demand for money is equal to the supply of money. The transaction demand for money is interest inelastic and depends on the level of income and speculative demand is interest elastic and it is a function of the rate of interest. Given the two different demands for money, the point of equilibrium where the total demand for money for liquidity purposes is equal to the total supply of money can be arrived at. The total supply of money depends on the policies of the government and the central bank of the country. The rate of interest and the level of income at which the liquidity demand for money is equal to the supply of money are referred to as LM schedule (ICFAI University, 2005). Assembling the Model (IS and LM) The equilibrium rate of interest can be determined by IS=LM at the point of intersection between the IS and LM curve. Y Rate of Interest (%) LM 24 19 16 8 IS 0 100 400 600 800 900 X Income (Amount in £) OX represents income and the OY represents the rate of interest, attained at the point of intersection between the IS and LM curves. Taking the above example, the equilibrium rate of interest is 19 percent and the equilibrium level of income is £ 700 (Danby, 1997). Reasons for Regarding Keynesian Theory as A New One Keynes was a Cambridge economists and he extended the Cambridge theory. He included alternative of holding idle cash and that is bonds and securities. The asset function of money was not only emphasised but another form of assets-bonds, have also been mentioned. The most important aspect that he added is that he linked the demand for money and the difference in the interest rates. Thus he included the concept of speculative demand for money. He emphasised that when people comes to a position of making choice between idle cash and bonds that yield income, they speculate on the interest rates. According to Keynes, the demand for money to buy bonds whose prices are expected to increase in the future is the speculative demand for money. This innovative contribution was made by Keynes to the theory of demand for money. Neo-Keynesian Developments William Baumol (1952) and James Tobin (1956) independently developed an economic model of the transactions demand for money. The theory depicts the trade-off between liquidity that is provided by holding the power of transaction (i.e. holding money) and the interest that foregoes by holding assets in the form of non-interest bearing money. The theory concentrates on the optimum amount of transaction of a household. Assumptions The model assumes that the consumer’s wealth is alienated into two: cash and deposits. The benefit of holding money is the convenience but the cost of this convenience is the interest amount that is foregone due to keeping the money on hand. The average holding of an individual can be determined by the number of transaction or the number of times the person withdraws money. In general, a person’s average holding will be equal to Y/2N; Y is the total income and N is the number of withdrawals. Thus the total cost of money management can be given by the formula: NC+Yi/2N Where NC is the total cost of withdrawals and i is the nominal rate of interest that will be received by holding money in the banks. The presumption of this model is that as N increases, the cost of foregone interest falls but the cost of travelling to the bank rises. The goal of the person is to minimise the total cost by taking into account all the variables mentioned. Friedman’s Modern Quantity Theory of Money Milton Friedman developed a modern theory of money based on the asset demand factor. The demand for money is the function of the returns of other assets and wealth relative to money. This money demand function is as follows: Where Yp = permanent income (the expected long-run average of current and future income) rb = the expected return on bonds rm = the expected return on money re = the expected return on stocks pi (e) = the expected rate of inflation According to Friedman, the aggregate demand for money is the summation of individual demand functions. Friedman defines that wealth consists of all sources of income which is capitalised. According to him, income is the ‘permanent income’ which is defined as the average expected yield on wealth during its lifetime (OSWEGO State University of New York, n.d.). According to Friedman, in the long run, prices will increase due to increase in monetary growth but there will be no effect on the output. In the short run, increased monetary growth increases employment and output (Library of Economics and Liberty, 2008). The demand function states that an increase in expected yields on different assets decreases the amount of money demanded by a wealth holder, and an increase in wealth increases the demand for money. The income to which cash balances is the expected long-term level of income rather than current income expected. According to Friedman, income velocity decreases over time. Friedman restated that the supply of money is independent of the demand for money and is unstable due to the measures taken by the monetary authorities. A change in the supply of money results in a proportionate change in the level of price or income or both. If the economy experiences less than full employment level, an increase in the supply of money will increase output and employment; given an increase in total expenditure and this is likely to occur only in the short-run. The most visible element that Friedman adds to the previous quantity theory of money is that the wealth holder holds goods in the form of assets and during inflation, will transform them to money. Friedman’s contribution is entirely sensible and adds a dimension towards the Keynesian approach that assumes excess money holdings and is used to purchase interest bearing assets such as bonds. The excess money holdings can be used to purchase assets such as a house or an automobile. Yet, if disequilibrium in portfolio is inclined in this manner, this will have a direct impact on the aggregate demand and thus on output (Red Hat Enterprise Linux, n.d.). Distinguishing Between Keynesian and Monetarist Approaches Making a criticism and incorporating different approaches to the above two important theories could have added a few more dimensions to the research paper but it could have also led to some confusion. However, it has been chosen to enumerate the differences between the two with the intention that a clearer picture can be drawn of those assumptions. The following few points would help in the process: Monetary Policy: Keynesian vs. Monetarist Views In the Keynesian Model, it has been depicted that interest rates and investment are the transmission mechanism of the monetary policy. But the Monetarists believe that monetary policy affects prices but not real GDP or unemployment. Keynesian believes that a decline in the money supply (Contractionary monetary policy) will increase interest rates, decrease spending, decrease aggregate demand and decreases price and real output. On the other hand, monetarists believe that a decrease in the money supply will also cause a decrease in the interest rate because the anticipated inflation rate will fall ultimately. Keynesian believe that an enhanced money supply which is an expansionary monetary policy would cause a decrease in the interest rates, increase spending, increase aggregate demand, increases prices and output and decrease unemployment. But according to the monetarists an increase in the supply of money will mainly affect the prices and not the output as this would raise inflationary expectations and would in fact augment nominal interest rates. Monetarists consider that expansionary monetary policy is only effective when the economy is very below the full-employment (OSWEGO State University of new York, n.d.). Thus far the research paper has dealt with the theoretical aspects of the demand for money. The paper further has tried to display the different roles that monetary policy has to play in the modern economy. Role of the Monetary Policy and Its Effectiveness The major role of the monetary policy is price stability and economic growth. These roles will be discussed in the section and along with that the degree of effectiveness of the roles in the economy will also analysed. Price Stability Volatility in the price can create uncertainty in the decision making. Price rise results in the increment of the inflation and which have an adverse effect on the savings and can lead to liquidity crisis also. Again, on contrast downward movement of the price instability will make the investments riskier. Basically the upward rise of the price usually affects the economies worldwide. Before determining the tools that bring price stability, it needs to understand the reason behind the price instability. First of all in long run, excess liquidity can be the cause of price rise. Again during recession, which occurred because of the liquidity crunch may also increase the interest rates. This can be considered as another reason of the price hike. It can be linked with the economic growth also. Because of the monetary expansion, interest rate may fall and that can attract investors which will boost the investment and have a positive impact on the economic growth. Again to sustain this growth an adequate level of credit off-take is also required which can raise the production level to match the monetary expansion. Otherwise inflationary effect may be noticed. It has been observed from the above discussion that the two major reasons behind the price instability are; high level of monetary contraction and excess monetary expansion and both are contradictory by nature. Economic Growth Economic growth is the contribution of various attributes and those are exchange rates, money supply and interest rates. Unevenness in the money supply can also create fluctuations in the interest rates. Upward move of the interest rate might be restricting economic growth. Money supply also has an effect in the economic growth as domestic currency can depreciate due to the hike in the money supply. Again the measures taken for preventing the depreciation might be having an adverse affect in the economic growth. Now the exchange rate can be related with the economic growth. Rise of exchange rate implies that foreign currency reserve will also increase and following that link high powered money will again enhance which has a direct impact on the money supply. It can be also demonstrated in a simple way. Depreciation in the domestic currency leads to capital inflow which leads to excess money supply. From all the above discussion it is quite evident that excess money supply is the utmost problem related to the monetary policy. It is now necessary to understand that how the authority develop the policy to check those problems. There are certain tools those are utilised to face high inflation. First of all the statutory reserve, which refers to cash reserve ratio and statutory liquidity ratio is the major technique of taking away the excess money from the economy. Secondly, the Repo transaction which refers the repurchase agreement between the Central Bank and other banks; can be considered as the important tool to reduce the credit availability in the banks. This further has an effect in the money supply. Open market operation is another technique through which central bank use to sell their bonds and securities among the general people and that is the alternate way to grab the excess money from economy. All these three steps are considered as the tight monetary policy and lower monetary policy encompass with lowering interest rate and depreciating the domestic currency. Conduct of the Monetary Policy in Emerging Markets The Central Banks in different parts of the world faces problems in terms of institutional as well as technical that act as constraints towards the effective implementation of the policy. The Central banks are either under the purview of the Finance Ministry or are forced by different political powers. Thus despite the legitimate independency, the central banks are faced with constraints such as the exchange rate objectives. Fiscal Dominance is another constraint that the central banks of most of the economies are facing. Lacking in long term fiscal discipline often act as the constraint. The other challenges that the monetary policy faces in the economies is extreme openness of the capital account in the rising market economies. Despite the tight control over the inflows of money within the economy, they keep on flowing into the economy. Maintaining the exchange rate regime restricts the central banks to use policy instruments such as the interest rates to pursue an independent domestic monetary policy. Monetary policy is even hampered by the weak transmission mechanism due to the drawbacks in the financial system. Framework for Monetary Policy to Overcome Critical Issues Each country follows certain framework for the conduction of monetary policy in terms of formulation and implementation. It is possible to set a broad perspective that is used by the emerging markets and economies to remove the constraints. Managed Exchange Rate Considering the present scenario of various emerging markets that are largely involved in trade, the economies have chosen to use the exchange rate as a nominal anchor to varying degrees. The feature is that the economy losses the monetary autonomy and the ‘importing’ of monetary policy from abroad. Pegging the domestic currency to the currency of a foreign country which has high reliability in maintenance of low and stable inflation helps keep the domestic inflation low. Flexibility in Exchange Rate and Monetary Targeting In conducting this framework, the central bank involves a managed float where the currency is kept within a tight band. The monetary aggregates provide visible targets that make them appealing to the economies with underdeveloped financial systems. Inflation Targeting It is an economic policy in which the central bank of a country estimates a target inflation rate and then it endeavours to guide the real inflation towards that target by applying different interest rates. If inflation is above the target, the bank is likely to raise the interest rates and vice versa. Inflation Targeting With Exchange Rate Flexibility Many emerging markets of the world, both developed and those who has strong potentials to grow, has considered this regime to be the final measure for the evolution of their monetary framework. The forward looking nature of this framework is that under certain situation monetary policy needs alteration even when present inflation is three percent (Global Economy and Development, 2009). Issues Concerning Monetary Institutions This part of the paper will demonstrate not only the issues concerned with the monetary institutions but also of the monetary policy. Monetary policy can be considered as the ultimate guideline for operation of all monetary institutions. According to the Besley (2008), the member of Monetary Policy Committee of Bank of England, rise in food price and energy has a significant role in the monetary policy as it squeezed the ‘real take home pay’ and thus pushed the annual Consumer Price Index (CPI) inflation. The same had happened during the world wide economic crisis also which can be considered as the greatest instance of the monetary policy issue. Certain facts and attributes have been revealed from this crisis. House price rising have a negative impact on the economy as it leads to increase in the household-debt to income ratio and as a whole the credit availability has also increased. Again from his discussion it is quite apparent that balance of payment, which is supported by the current account deficit, can also be responsible for the imbalance in the monetary policies. Another one is the household savings rate. Reduction of this rate can influence the entire monetary condition also. As per the statistic of the total household rate over 20 years, only during the period of recession in 2008, the rate had been declined beneath negative 1%. While discussing the current monetary policy issues, Besley has pointed out the reason behind fall in the pound that can be taken into account as the concerning issues for the monetary policy as well as the monetary institutions. He determines that demand from the higher risk premium from the foreign investors is the real fact behind the monetary issue. Another major factor has been revealed from the article which indicates the causes of sharp rise of inflation during past few years. According to him, rapid increase in the import price leads to enhance the import price inflation also. He has bestowed a vital fact that due to the same reason the import price inflation was in the peak (at 11.4%) in the year of 2008 since 1985 (Besley, 2008). Beddies (2000) has cited three major problems in the monetary institutions and those are the time inconsistency problem, difference between the inflation and monetary targets and the coordination problem in the fiscal and monetary policy making. All three points can be discussed in the following section. Time Inconsistency Earlier when the decisions used to be taken by the private agents there were no issues but once the ultimate decisions have been taken by the policymakers, certain problems have arisen. Now a difference has become prominent between the ex post optimal policy and ex ante optimal policy. The major problem will be in the wage rate. Once government announces any rules or rates, all the private agents take this declaration for granted and start preparing their own policy in accordance to that. And when a private agent adopts a policy, it is obvious that the policy must have fixed for a long term horizon. Again due to the economic condition if government rule will be changed then the general people will also adopt the rule and will behave rationally. It implies that they will expect the private entities to do the same and on that context problem will arise. It is obvious that the private entities will get affected but it will have an impact on the monetary institutions also as it deals with all government, semi-government and private players. Declaration of the inflation rate and on basis of that fixing up of the wage rate can be proved as the biggest instance of the time inconsistency. On this note few recommendations can be given. Firstly, the policymaker can be advised not to diverge from the optimal policy through making the difference costly for the policy maker. Secondly, all the private and government institutions should develop their policy in respect to the trend analysis and on the basis of the five years government plans or the vision of government. Coordination Issue among the Fiscal and Monetary Policy Making It is a standard fact that to raise the coordination problem, presence of two less or more independent parties are required. The authorities of monetary and fiscal policy are also separate and independent. They have their own set of rules, regulations and guidelines. Most importantly with the decentralised policymaking approach, both the authorities are dealing according to their own objective and priorities. While taking decisions in a major aspect such as unemployment both the policy need to be merged and have to take decision jointly. Basically monetary policies are looked after by the Central Bank where ruling government takes care of the fiscal policy. According to the Andersen Schneider study, interaction between these two policy can be considered as a game between two parties where the possible actions and approaches will be determined as per the rules of the game. As the two authorities set their policy independently, therefore it is evident that due to the different priorities, different weights will be attached to the targets which will result in a conflicting objective. Even coordination problem can also arise as a characteristic of strategic decision situations. The ultimate outcome can be described in context of Keynesian and New Classical Theory coupled up with sequential Stackelberg game and simultaneous Nash game. According to the pure Keynesian theory, inefficiencies are the ultimate outcome of the uncoordinated monetary and fiscal policy applicable for both Stackelberg and Nash game. It has also been revealed from this framework that at any cooperative solution, monetary policy is contractionary and fiscal policy is too expansionary. Again as per the pure New Classical theory, there are no such Nash and Stackelberg equilibrium. Stackelberg game indicates that only monetary authority cares about the inflation. Not only inflation but tax rate is also the matter of concern for both the authority as a whole. Basically tax rate increment or deduction is the weapon of the fiscal policy to fight against the inflation. Even in general terms also, tax rate is fallen under the fiscal policy but it has a significant impact on the monetary policy also as changes in the tax rate leads to bring changes in the overall money supply. Thus the monetary institutions might be facing problem. Difference between the Inflation and Monetary Targets According to the Cukierman (1995), selection of the monetary target is a subject of trade off between the visibility and controllability. Because of easily manageable and controllable nature, targeting of the monetary instrument has less impact on the expectation of the private sector. Even less visibility is another reason. In contrast, inflation targeting possesses comparatively higher visibility. It has also been found that the control mechanism of rate of inflation is very hard. Therefore, if the monetary institution is unable to focus on the right track as per its impact on the private sector then they might have to face problems (Beddies, 2000). Conclusion The research paper has tried to deal with the implications of various monetary theories on different aspects of the economy. The different view of different economists has been evaluated and the effect of different monetary policy on the overall performance of the economy has been dealt with. The overall views over the role of money on an economy are based around the Keynesian and Monetarist assumptions. The objective of this research work is to analyse different verdicts of monetary theories from time to time. The monetary policy is the lively controversy between the two schools of economies. Monetary policy deals with the demand side of macroeconomic effects (Tobin, 2008). If the economy of UK is considered and the effect of the different monetary policy incorporated, then the explanation would go as such; the economy is on a rising trend after the great economic recession and execution of a well developed monetary policy would take the economy to greater heights. Due to the increase in VAT during January 2010, the inflation rate had exceeded two percent targets and a further increment in VAT during 2011 would keep the inflation rate on the higher margin. In order to keep inflation matched to targets, a monetary stance is needed to support exports. The monetary measures taken after the recession period like low interest rate can lead the economy to grow faster than expected pace. The near zero policy rates have supported the economy and have helped to repair the balance sheets. But it is always to be kept in concern that monetary policy without the support of the financial system of an economy cannot work. An economy which is a house to a large number of financial institutions would require certain tools like capital and liquidity surcharges to deal with the ensuing systematic risk (International Monetary Fund, 2010). Keynesianism is an economic theory that states that private sector organisations will often make good decisions for them but at times will lead to a bad outcome for the economy as a whole. The public sector in turn will try to correct the situations by applying certain monetary measures and ultimately ensure balance within the economy. The intervention of public sector institutions is necessary from time to time in order to restrain perfect operation of the economy and avoid any monetary problems. If all government spending are collected through taxes, there would be no money left for private savings. Money cannot be created by private banks. Spending of the government is the source for net savings of the private players. References Auburn University, No Date. Study Problem: Liquidity-Preference Theory in the IS-LM Framework. An Exercise in Keynesian Liquidity. [Online] Available at: www.auburn.edu/~garriro/liquidity.pdf [Accessed November 04, 2010]. Besley, T., 2008. 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