The Post Keynesian Theory and Its Relation to Demand and Real Balance - Assignment Example

Running Head: THE POST KEYNESIAN THEORY AND ITS RELATION TO DEMAND AND REAL BALANCE. The Post Keynesian Theory Name Institution Date Explain the post-Keynesian transaction demand for money and discuss the effect that the distribution of income will have on the determination of the demand for real balances. The demand of money arises simply because money is a means of exchange and a store. This explains why individuals and business firms hold money in terms of assets and paltry. There is a direct link between the demand for money and the income level as persons with a higher income level have high demands for money and vice versa. In addition, the view of substitution holds a high course in defining the demand of money as it links the relative attractiveness in assets that can be substituted for money. When alternative forms of store for money like shares and bonds become valueless people and firms prefer to store their valuable in form of cash thus increasing the demand for money. This divides the two modes of the demand of money as precautionary and transaction. The theory on demand for money was not explicitly formulated by the classical economists who emphasized the demand for money in terms of transaction. They focused on the velocity in the circulation of money. When analyzing the transaction demand for money depending on behavior as individuals tend to hold on to handle cash balances that can do a particular job at the lowest cost possible. If for instance an individual will transact a business and pay out T pounds at a steady flow the cash he transacts with is either borrowed or withdrawn from a particular investment. This implies that his interest rate is I pounds per pound per period. If the same individual withdraws more and more C pounds at intervals spacing annually it implies that he will be able to part with a set fee of B pounds. This implies that H the transaction value is predetermined and I and B are expected to be constant. In this case, C is either less than or the same as T and will enable him purchase or transact a business as long as he withdraws his cash more often. If T 300 pounds, he can be able to transact his business by often withdrawing 150 pounds for every 6 months and 75 pounds in every 3 months. His withdrawal over the year will be T/C. The total set fee for withdrawal will amount to BT/C. If he withdraws the total amount of money C and uses it at a steady flow and has to get a similar amount of cash as soon as it is over, then the amount of cash he will be holding will amount to C/2 pounds and his total interest on an annual basis will be IC/2. If this occurs in a spaced out interval throughout the year then the total amount of interest and the total set fee will be; BT/C + IC/2 The set fee in this case meets the non interest expenditure of any cash withdrawal. Cash withdrawal expenses include things like opportunity loses that are as a result of the costs of asset disposal when an individual wants cash at that particular time and other incurred losses as a result of poor sales and when an item has depreciated in value. This could also cover for unforeseen eventualities like protection of money or assets against theft and fire. If he chooses the right spending manner and the most economical value of C and a set derivative of 1then we actually get; (BT/C2 + I/2 = 0. This implies that; C = √2BT/I The cash in demand is a proportion equal to the root square of the value of his business transactions. It is also important to note that the set fee in this instance that is the brokerage fee varies in amount with the amount of money that is handled at a particular time. In cases of borrowing, the set fee is always given as B + LC. This implies that the total amount of expenditure will amount to; T/C (B + Lc) = (T/C)B + Lt There are adverse effects of the interest rates on the loans or transactions that are done in short term. The gains are normally on the set fee (brokers fee) in cases where money has to be change in to liquid cash from bonds and in to bonds yet again. High rates of income always tend to discourage people and lure them in to holding cash as opposed to wealth as a better option that offers greater incentives. This is because the process of changing wealth or assets in to liquid cash incurs lose of value especially when dealing with second hand items and assets that tend to lose value in time. In holding on to money transaction costs as a result of the conversion of wealth in to liquid cash and the opportunity costs are considered vital. It is advised that the making of large transactions and immediate conversion of assets and wealth into liquid cash is essential to take full advantage of interest rates but it must also be understood that the amount of set fee (brokerage fee) incurred in such cases is seemingly higher as compared to the previous scenario. The most advantageous inventory of the operations balance has to be expressed as a square root edict. This implies that the transaction demand is dependent on the interest rate in addition to the operations cost and the intensity of transactions. To Karni, 1974, transaction cost is dependent on the time value in cases where it rises in quantity to real revenue which to Baumol, 1951 yields unity elasticity returns of ½ from operations cost and the other ½ to the transactions. Commodity stock is also introduced as an alternative store of value to money and income assets. This is because they are not frequently purchased than the rate at which income is acquired or received. This explains why the increase in inflation becomes an essential factor in the need for cash. This calls for the extension in the operations demand for cash analysis to pave way for the inclusion for the uncertainty in the flow of money. Other expansions are visible in the portfolio theory which employs the portfolio approach to financial examination. It is also evident in the financial intermediation that people hold on to money to avoid the risks associated in the holding of assets. Assets are not considered as perfect substitutes for cash as they carry a substitution cost with them. If the asset return interest rate exceeds the costs of converting the assets into cash leads to low demand for money and vice versa. The quantity need for cash is inversely dependent on the interest rate. Friedman, 1956 suggested that money should be treated like any other valuable assets that give rise to a continuous services flow. He also included wealth as a cash demand function. The law of demand states that there exists an inverse link between the commodity price and the demand if all other factors are constant. The transactions role for cash can be illustrated better in the parallel equilibrium model. If at a constant rate a person constantly spends the amount of money PY for a specific time interval it implies that to purchase some item you need to have money in advance. Money can be either in cash form or in asset form. For you to have money from your assets you need to access a bank that will enable you to change your assets into money. The cost of visiting a bank is high as we consider the number of times one does this. If for instance an individual visited a bank once during a period then the amount of money that person holds will be PY/2. If you assume the individual visits the bank N number of times then the cost will be PY/2N. It is assumed that money never pays interests but the cost and even the parts of money that pay interests do this at a very rate than monetary assets. Assets are able to make more interest returns r, which declines in value as a result of inflation to yield real returns –π. This shows that the difference between the two is; r – (- π) = r – π = i. The opportunity cost of holding money is the hypothetical rate. If the nominal expense of accessing a bank is PF as a result of the time it takes to access a bank the sum of holding on to cash is: i (PY/2N)+ PFN To minimize this there is need to derive the first order condition in respect to N; this implies that; 0 = i(PY/2)N-2 + PF Thus it means that; N =√ IY/2F. If the amount withdrawn every time the person visits the bank is PY/N then the normal cash holdings will be; M = PY/2N = P √ YF/2i Evidence predicts that persons go much often to the bank than is often the case from the expressions the interest elasticity = - ½ and the income elasticity = -½. The income elasticity is empirically too high but if F is proportional to income as it might be in case it is an opportunity cost then the elasticity will be close to -1. From the mode we can link real balances and commodity price levels in addition to the nominal interest intensity as well as the rate and the output which are a general property of monetary models. The model form determines the exact dependence. It is also important to note that money being a dominated asset makes it hard to model its demand which must come through its ability to smoothen the progress of transactions. It is therefore believed that people just get hold of money because of the good feeling they have when they have it as soon as it gets access its utility function. When money is put in to a utility value it is able to have the value it deserves as it provides liquidity for transactions for services which people value. Cash does not affect the steady state value of the other variables. This implies that cash is supernatural if put in a steady state. Real balances have an effect on the intensity of utility but utility is separable in consumption and cash. However we must note that money is a worse store of value and has minimal effects on the capital Goldfeld, 1973. References Fisher, D. "The demand for money in britain : quarterly results 1951-67", Manchester School, 36, 1968. Friedman, M. "The quantity theory of money : a restatement", Chicago University Press, 1956. Goldfeld, S The demand for money revisited, Brookings paper on economic activity, No. 3, 1973. Karni, "The value of time and the demand for money", Journal of money. credit, and banking, 6, 1974: 45-64. Keith Cuthbertson, "Modelling the demand for money", in Christopher Green and David Llewellyn (eds.), Surveys in monetary economics. Vol. 1, Basil Blackwell Ltd., Oxford, U.K., 1991 : 3. Lewis, M K and Mizen, P D, Monetary Economics, Oxford, 2000. Michie, J Managing the global economy, Oxford University Press, 1995. Baumol, J the transactions demand for cash: an inventory theoretic approach, Quarterly journal of economics 66545-556, 1952 Read More