DEMAND FOR MONEY

The idea about demand for money was put forward by

Lord Keynes. According to him, the demand for money
or liquidity preference as he called it, means the demand
for money to hold. Broadly speaking, there are mainly
three motives on account of which money is wanted by
the people.
Transaction motive: this motive can be looked at from
the point of consumers who want income to meet the
household expenditure which may be termed as income
motive and from the point of view of businessmen who
requires money and want to hold it in order to carry
their business.
 Contd..

Income motive: the transactions motive relates to the

demand for money or the need for cash for the current
transactions of individuals. Individuals hold cash in
order to bridge between the receipt of income and
expenditure. This is called income motive.

Business motive: the business men have to keep certain

portion of their resources in ready cash in order to meet
current needs of various kinds. They need money to pay
for raw materials and transportation, to pay salaries and
wages, and to meet all other current expenses incurred
by any business exchange. Keynes calls it the business
motive.
 Contd,,,

Precautionary Motive: it refers to the desire of the people to

hold cash for unforeseen contingencies. People hold a certain
amount of money to provide for the risk of unemployment,
sickness, accidents and other more uncertain perils.

Speculative motive: it refers to the desire of people to hold

one’s resources in liquid form in order to take advantage of
market movements regarding the future changes in the rate of
interest or bond prices. The cash held under this motive is
used to make speculative gains by dealing in bonds whose
prices fluctuate. If bond prices are expected to rise, in other
words the rate of interest is expected to fall; businessmen will
buy bonds to sell when the price actually rises.
 SUPPLY OF MONEY
Supply of money conforms to the stock concept. Just
as the demand for money is the demand for money
to hold similarly supply of money means the supply
of money to hold. Supply of money means the sum
total of all the form of money which are held by a
community at any given moment.
The stock money which constitutes the supply of it
consists of
(a) metallic money or coins
(b). Currency notes issued by the currency authority
of the country whether the central bank or the
government and
 Contd….

In old times, coins formed the bulk of money supply

of the country. Later, the currency notes eclipsed the
metallic currency and now the bank deposits in
current account withdrawable by cheque have
overwhelmed all other forms of money.
Thus money supply means total volume of monetary
media of exchange available to the community for
use in connection with the economic activity of the
country.
Broadly speaking, money supply in a country is
composed of two main elements (a) currency with
the public and (b). deposit money with the public.
 Contd..

In order to arrive at the total amount of currency

with the public, we add
(a) currency notes in circulation
(b). Circulation of rupee notes and coins
(c). Circulation of small coins. By adding total
currency with the public and the total demand
deposits, we get the total money supply with the
public.
 Quantity theory of money

There are several factors that determine the value of

money and the general price level.
(Value of money is the quantity of goods in general that
will be exchanged for one unit of money. The value of
money is its purchasing power. i. e the quantity of
goods and services it can purchase.)
The general price level in a community is influenced by
the following factors:-
(a). The volume of trade
(b). The quantity of currency
(c ). The volume of credit
(d). The velocity of circulation of money
 Contd…

These four factors change independently as well as in

relation to one another.
Money is used in exchanging goods. The greater the
volume of exchange required to be made, the greater is
the demand for money, and hence the greater will be
the value of one unit of money and vice versa. Thus
the value of money varies directly with the volume
of trade.
Value of anything depends also on its supply. The
more the wheat in a season, the less its price. In the
same way, greater the number of rupees to do a given
amount of money work, the less is the value of a rupee
and vice versa. In other words, the value of a unit of
money varies inversely with its quantity.
 Contd…

All the work of money is not performed by cash money. A

good deal of it is also done by credit money. Hence credit
instruments should also be taken into consideration when
we are trying to discover the total quantity of money which
will influence prices in a country.
However, money is not finished up in one use. A unit of
money is ready to perform another exchange after it has
served in making one. It passes from hand to hand. For e.g.
If a single rupee is used six times in a certain period, it
does the work of six rupees of they serve only once each in
the same period. Hence the number of times a rupee
changes hands in, say, a year, is known as its velocity of
circulation of money. Thus velocity of circulation of money
helps the total quantity of money in determining prices.
 Statement of the theory

The above conclusions have been put in the form of a

theory called the Quantity Theory of Money.
It states that the value of money depends upon its
quantity in circulation. In its most rigid form, this
theory asserts that
“any given percentage increase or decrease in the
quantity of money will lead to the same percentage of
increase or decrease in the general level of prices.”
 Contd..

In order to make it applicable to a modern

community, the theory may be stated thus:
The values of money falls (and the price level
rises) proportionately with a given increase in the
quantity of money.
Conversely, the value of money rises (and the price
level falls) proportionately with a given decrease in
the quantity of money, other things remaining
same.
Other things are (a) velocity of circulation of
money (b) the volume of credit (c) barter (d)
volume of trade.
 EQUATION OF EXCHANGE
Irving Fisher, who developed the quantity theory, puts it in the
form of the following algebraic equation of exchange:
M
P = ------- ---------------------- (I)
T
Where P is price level, M is money and T for trade or goods
exchanged.
This simple equation can be true only of a small isolated
community where
(i) the number of transactions is small
(ii) There are no barter transactions
(iii) Except coins, there no other types of money like notes and
cheques in use
(iv). every piece of money changes hands by once.
 Contd…….

Such isolated communities are not found nowadays.

However,
In modern communities, we observe that a coin
changes hands a number of times. The butcher takes
it to baker and the baker to the grocer and he again to
some other person. The work done by a coin which is
circulated five times equal to that done by five coins
which change hands only once each. As stated earlier,
this speed is called velocity of circulation of money.
Hence to find out the effective amount of money in a
country, we have to multiply the total number of
coins by their velocity.
 Contd..

Then equation (I) changes to

MV
P = ------- ---------------------- (II)
T
Where V is the velocity of circulation of money
But in addition to metallic money in every modern
community, there is a large amount of paper money
which helps in the exchange of goods. Instruments
of credit like cheques, drafts, and bills also serve the
same purpose. Their velocity of circulation has also
to be taken into consideration.
 Contd..

Hence equation – (II) finally develops into

MV + M’ V’
P = ------------------- ---- (III)
T
Where M’ stands for credit money and V’ stands for
velocity of circulation.
The equation (III) signifies that price level (P)
changes when the quantity of money (M) or
quantity of Credit money (M’) changes or their
velocities (V or V’ changes). Of course P will also
change if the quantity of goods (T) required to be
exchanged changes.
 CRITICISMS
 So long as quantity theory describes a tendency, it is
all right. But when it proceeds to lay down an
inflexible mathematical formula, it falls to the ground.
Only under very special circumstances doubling of the
amount of money exactly double the price level. The
price level may go up to more or fall down to less
than the amount of money.
 One of the main weaknesses of Fisher's quantity
theory of money is that it neglects the role of the rate
of interest as one of the causative factors between
money and prices. Fisher's equation of exchange is
related to an equilibrium situation in which rate of
interest is independent of the quantity of money.
 CRITICISMS
 The theory was challenged by Keynesian economics,
but updated by the monetarist school of economics.
Critics of the theory argue that money velocity is not
stable and, in the short-run, prices are sticky, so the
direct relationship between money supply and price
level does not hold.
 Simple Truism:
The quantity MV = PT is more truism, an obvious fact.
It indicates that the total quantity of money given in
exchange for goods and services (MV) is equal to the
money value of goods and services given in exchange
for money (PT).
 CRITICISMS
In other words, the total amount of money expenditures
of buyers is equal to the total amount of money receipts
of sellers. The equation does not tell us anything new or
precise about money and prices; it merely restates in a
simple form that is evidently true. It does not show
which is the cause; which is the effect , it simply shows
what has happened.
 Unreal assumptions
The quantity theory of money as stated by Prof. Fisher is
based on unreal assumptions like the existence of full
employment of resources and stability of expenditure.
The theory assumes that other things like V, V’, M’ and
T remain constant..
 CRITICISMS

But in actual practice a change in M is bound to affect

V, M’, V’ and T. In a dynamic world, change in one
factor induces changes in other factors. Experience has
shown that the velocity of money instead of remaining
constant varies in direct proportion to the volume of
production (T)
It Fails to Explain Trade Cycle:
The transactions approach to the quantity theory of
money does not help in explaining the trade cycle
though it may be taken as a satisfactory- explanation of
the long-term trends of prices. It is true that shortage of
money (M) and credit (M’) has brought a boom to a
sudden end but sometimes it collapses due to lack of
the supply of money and credit.
 CRITICISMS

• The Theory is Useful in the Long Period:

The quantity theory of money is also criticized on the
ground that it explains only long-run phenomenon; it
does not help to study the short-run phenomenon. Prof.
Coulborn criticized the theory on the ground that “the
theory is a concept of long- run phenomena”.
Fisher agrees that in the short-run of transition V and T
do change but over a long- run, as the economy attains
equilibrium they become constant. But in a
continuously changing world, there is hardly anything
like long period equilibrium; “equilibrium is like
tomorrow it never comes”.
 CRITICISMS

Interdependence of variables
The various constituents of the transaction equation
like M, V, M’, V’ P and T are not interdependent
variables as assumed by the quantity theorists. They are
independent. Therefore, it is difficult to know what
affects what, and what the consequence of what is. If
there is an increase in the physical volume of
transactions (T), there is bound to be an increase in the
velocity of circulation of money (V). Therefore, T and
V are interdependent and rise or fall together.
Similarly, M may increase without any rise in P on
account of the fact that T may have increased.
 CRITICISMS

In, advanced economies, where the bulk of the quantity

of money consists of bank credit, it is a consequence
rather than a cause of the price level. The quantity
theory of money unnecessarily overlooks the mutual
interdependence of the factors involved and stresses the
quantity of money as the cause and price level as the
consequence.
• It Ignores Money as a Store of Value:
The cash transactions equation upholds money because
it is a good medium of exchange. Its great fault is that it
completely ignores the significant role of money which
it plays as a store of value.
 CRITICISMS

Keynes upheld the store of value function of money

and laid great stress on the speculative motive for
holding money as against the classical emphasis on the
transaction and precautionary motives for holding
money.
 Mutually Inconsistent:
The theory is criticized on the ground that some of the
elements used in the equation are mutually inconsistent
for, example, P includes all sorts of prices, wholesale as
well as retail, wages and profits. Some prices move
fast, while others are rigid. It is very difficult to say
whether P represents highly fluctuating wholesale
prices of rigid retail prices.
 CRITICISMS

Similarly, T includes goods as well as services. Further,

whereas M refers to a point of time, V refers to the
velocity of money over period, MV involves the error
of multiplying mutually inconsistent and non-
comparable factors. Thus, the quantity theory of money
is said to consist of mutually inconsistent elements.
 Undue Emphasis on Quantity of Money:
Keynes points out that the change in economic activity
or the price level is caused not a change in the quantity
of money alone but also by other fundamental factors
like income, expenditure, saving and investment. Thus,
price level is not the function of money supply alone in
turn, it is influenced by a large number of monetary and
non­monetary factors.
 CASH BALANCE APPROACH
The cash balance version of the quantity theory of
money, though found in earlier writings of Locke, Petty
and Cantillon became popular only in the twentieth
century.
Following the lead of Dr. Marshall, some Cambridge
economists, specially Pigou, Robertson, Keynes
including R.G. Hawtrey, popularized and adhered to a
slightly different version of the quantity theory of
money, known as the cash balance approach, on account
of its emphasis on cash balance (instead of
transactions).
According to cash-balance approach, the value of
money depends upon the demand for money.
 contd..

But the demand for money arises not on account of

transactions but on account of its being a store of value.
Money has two characteristics—flatness and roundness
—money sitting and money on wings— to serve as a
store of value and as a medium of exchange. “In the one
use money piles up, in the other it runs round.”
Thus, according to the advocates of this theory the real
demand for money comes from those who-want to hold
it on account of various motives and not from those who
simply want to exchange it for goods and services: just
as the real demand for houses comes from those who
want to live in them and not from those who simply
want to construct and sell them.
 Contd..

The cash balance approach relates the process of

determination of the value of money to cash the
subjective valuations of individuals who are the real
force behind all economic activities.
Such an approach enables us to throw more light on the
puzzling phenomenon of the velocity of circulation of
money, by enquiring more deeply into the nature of the
demand for money, as the demand for the money in the
cash-balance approach has reference to the store of
value function of money.
This type of demand for money arises from the fact that
holding of money has great utility, as when it is held
(hoarded) it acquires wealth value.
 Contd..

Hence, instead of interpreting the ‘demand for money’

with reference to its ‘medium of exchange’ function as
is done in the transactions approach; it is interpreted
with reference to the ‘store of value’ function of money
in the cash balance.
It may, however, be made clear that in determining the
amount of these cash balances the individuals and
institutions are guided only by their real value. Thus, an
individual is concerned with the extent of his liquid
command over real resources. The community’s total
demand of money balances constitutes a certain
proportion of its annual real national income which the
community seeks to hold in the form of money (liquid
cash).
 Contd..

The community’s demand for real cash balances in this

sense varies from time to time.
Thus, given the state of trade (T) and the volume of
planned transactions over a period of time, the
community’s total demand for real money balances can
be represented as a certain fraction (K) of the annual
real national income (R).
The following lines from Marshall explain clearly the
substance of the cash-balance version of the quantity
theory, “In every state of society there is some fraction
of their income which people find it worthwhile to keep
in the form of currency; it may be a fifth or a tenth or a
twentieth.”
 Contd..

Holding of money involves a sacrifice because when we

hold (save), we spend less.
To have too little holding of money may mean
inconvenience, to have too much may mean
unnecessary.
Somewhere between the two extremes every person,
every family, every community fixes the amount of
money it will keep.
“It is convenient to think of this amount as given
proportion of the person’s or the family’s or the
community’s annual income.”
 Contd..

Whatever this proportion may be, it is always the result

of a deliberate decision. This is, in the most real sense,
the demand for money.
Suppose at one time people want to possess cash
balances worth one-tenth of the annual income. Now,
they want to have cash balances representing one-
seventh of the national income. This means they want to
have more cash with them, which is possible only by
curtailing expenditure on goods and services, which, in
turn, means less demand for them and hence a fall in
their prices.
Similarly, if they want to have less cash balances, they
will spend more and the prices will be pushed up.
 Contd..

It is, thus, the demand for ‘money sitting’ rather than

money ‘on wings’ that matters.
Thus, according to cash balance approach, the value of
money depends upon the demand for money to be kept
as cash.
To this extent the approach is similar to Fisher’s, but the
emphasis is on want to hold, rather than on have to
hold.
This is the basic difference between the Cambridge
monetary theory and Fisher’s framework. The essence
of this theory is that the demand for money, in addition
to depending on the volume of transactions that an
individual might be planning to undertake,
 Contd..

will also vary with the level of his wealth, and with the
opportunity cost of holding money, the income foregone
by not holding other assets.

Let us illustrate it with an example:

Suppose money supply in cash and bank deposits (M) =

Rs. 1,000.

The total annual national income (R) = 10,000 units.

The goods (income) which the community wants to

hold in money (K), say one-fifth of R = 2,000 units
 Contd..

Then, the value of money (one rupee) = 2,000 units

= 2000/1000 = (two units of goods, or prices level P =
(M/KR) = 1/2 = 0.50 paise per unit.
It is, therefore, clear that the value of money (its
purchasing power) is found by dividing the total amount
of goods, which the community wants to hold out of the
total income (KR), by the amount of the supply of the
money held by the public (M), and the price level (P) is
found out by dividing the money supply (M) by the
amount of goods which the community wants to hold
(KR), as the price level is the opposite of the value of
money.
 Contd..

Pigou expresses it in the form of an equation:

P = KR/M or (M/KR) where P stands for the value of

money or its inverse the price level (M/KR), M
represents the supply of Money, R the total national
income and K represents that fraction of R for which
people wish to keep cash.

Prof. D.H. Robertson’s equation is similar to that of

Prof. Pigou’s with a little difference. Prof. Robertson’s
equation is:

M = PKT or P = M/KT
 Contd..

where P is the price level, T is the total amount of goods

and services (like R of Pigou), K represents the fraction
of T for which people wish to keep cash. Prof.
Robertson’s equation is considered better than that of
Pigou as it is more comparable with that of Fisher. It is
the best of all the Cambridge equations, as it is the
easiest.