Demand for Money
Hey Mumbai University SYBA IDOL students! Today, we’re diving into the fascinating world of Macro Economics , exploring the chapter – “Demand for Money“. Here’s what we are going to cover:
First, we’ll explain the Keynesian approach to demand for money. We’ll explore how Keynes viewed money demand as being influenced by transactions, precautionary, and speculative motives.
Next, we’ll explain the classical approach to demand for money. We’ll look at how classical economists focused on the quantity theory of money, emphasizing the relationship between money supply and price levels.
Finally, we’ll explain Friedman’s approach to demand for money. We’ll understand how Milton Friedman expanded on the classical theory, incorporating factors like wealth and expected returns on different assets.
So, SYBA IDOL Mumbai University students, get ready to unwrap the mysteries of “Demand for Money” with customized IDOL notes just for you. Let’s jump into this exploration together.
Question 1:- Explain the Keynesian approach to demand for money
Introduction:
John Maynard Keynes, in his book “The General Theory of Employment, Interest, and Money” published in 1936, introduced a detailed approach to understanding why people hold money. According to Keynes, the demand for money is based on three main motives: the transactions motive, the precautionary motive, and the speculative motive.
- Transactions Motive: The transactions motive refers to the need for money to carry out everyday transactions. People hold money to pay for goods and services, bridging the gap between earning and spending. The amount of money needed for transactions depends on:
- Level of income: Higher income means more transactions and, thus, more money needed.
- Time interval between income and spending: If people get paid less frequently, they need to hold more money to cover their expenses until the next paycheck.
- Standard of living: People with a higher standard of living need more money for their regular expenses.
- Precautionary Motive: The precautionary motive involves holding money for unexpected expenses or emergencies. People keep cash reserves to cover unforeseen costs, such as medical emergencies or sudden repairs. This need for liquidity ensures they can handle these situations without having to borrow money or sell assets. Key factors influencing this motive are:
- Income stability: People with unstable incomes might hold more money as a precaution.
- Uncertainty: Greater uncertainty about the future increases the need for precautionary balances.
- Speculative Motive: The speculative motive is a unique idea introduced by Keynes. It refers to holding money as an investment strategy based on expectations about future interest rates. Key points include:
- Interest rates: When interest rates are high, people might prefer holding cash instead of investing in bonds or other assets, expecting rates to fall in the future.
- Investment opportunities: When interest rates are low, people might invest their money in assets rather than holding onto cash, anticipating higher returns.
- Dynamic Nature of Money Demand: Keynes’s approach highlights that the demand for money is not static. It changes based on economic factors such as:
- Income levels: Higher income generally increases the demand for money.
- Interest rates: Changes in interest rates affect people’s willingness to hold or invest money.
- Economic expectations: People’s expectations about future economic conditions also influence how much money they decide to hold.
Conclusion:
Keynes’s approach to the demand for money provides a comprehensive understanding of why people hold money. By considering the transactions, precautionary, and speculative motives, Keynes showed how various factors like income, interest rates, and economic expectations influence money demand. This framework helps policymakers design effective monetary policies to achieve economic stability and growth.
Question 2 :- Explain the classical approach to demand for money
Introduction:
The classical approach to the demand for money, supported by economists like J.S. Mill, David Hume, and Irving Fisher, focuses on money as a medium of exchange. This approach sees money primarily as a tool to facilitate the exchange of goods and services. The demand for money in the classical view arises from the need to conduct transactions involving real goods and services over time.
- Medium of Exchange: Money is demanded mainly to buy and sell goods and services. It acts as a medium of exchange in economic transactions. People hold money to make everyday purchases and sales easier.
- Objective Factors: The demand for money is influenced by objective factors such as the volume of goods and services produced and traded. When the amount of goods and services traded increases, the demand for money also rises because more money is needed for transactions.
- Velocity of Circulation: The velocity of circulation refers to how quickly money changes hands in the economy. A higher velocity means that each unit of money is used more frequently in transactions, which can reduce the demand for money. Conversely, a lower velocity means money is held for longer periods, increasing the demand for money.
- Fisher’s Cash-Transactions Approach: Irving Fisher developed the equation of exchange: MV = PT. In this equation:
- M stands for the money supply.
- V represents the velocity of money circulation.
- P is the price level.
- T is the volume of transactions. This equation shows the relationship between the money supply, price level, and volume of transactions in determining the demand for money. It suggests that the demand for money depends on the total value of goods and services exchanged in the economy.
- Cambridge Economists’ Cash-Balances Approach: Cambridge economists, like A.C. Pigou and Alfred Marshall, emphasized the store of value function of money. They viewed the demand for money as the amount people wish to hold. According to them:
- The demand for money is a constant proportion of real income.
- Changes in the price level or real national income lead to corresponding changes in the demand for money. This approach focuses on how much money people want to keep in their cash balances for future use.
Conclusion:
The classical approach to the demand for money highlights the essential role of money as a medium of exchange in facilitating economic transactions. It underscores the importance of money in buying and selling goods and services and explains how the volume of transactions, the velocity of money, and people’s desire to hold money influence the demand for money. This approach helps us understand the dynamic relationship between money, goods, and services in an economy.
Question 3 :- Explain the Friedman’s approach to demand for money
Introduction:
Milton Friedman, a renowned economist, provided a detailed approach to understanding the demand for money. His approach is closely linked to the quantity theory of money and highlights the factors that influence why people hold money. Friedman’s theory focuses on how money is used for transactions, as a store of value, and for speculative purposes. He also considers the impact of various economic variables on the demand for money.
A. Four Determinants of Demand for Money:
1. Level of Prices:
- General Price Level: When prices rise, people need more money to buy goods and services. This increases the demand for money.
- Impact: Higher prices mean people hold more money for their daily transactions.
2. Level of Real Income and Output:
- Income and Economic Activity: When people earn more and the economy is active, the demand for money goes up because more transactions are happening.
- Impact: Higher income and more economic activities lead to greater demand for money.
3. Rate of Interest:
- Interest Rates: The interest rate affects whether people hold money or invest it in assets that earn interest.
- Impact: Higher interest rates may reduce the demand for money, as people prefer to invest. Lower interest rates increase the demand for money.
4. Rate of Change in General Price Level:
- Inflation and Deflation: If people expect prices to rise (inflation), they might hold less money because its value decreases. If they expect prices to fall (deflation), they might hold more money.
- Impact: Expectations about future prices influence the demand for money as a store of value.
B. Quantity Theory of Money:
- Theory: Friedman’s approach is based on the quantity theory of money, which states that changes in the money supply lead to proportional changes in the price level.
- Equation of Exchange: MV = PT, where M is the money supply, V is the velocity of money, P is the price level, and T is the volume of transactions.
- Impact: Understanding the relationship between money supply and price levels helps in predicting inflation and economic activity.
C. Liquidity Preference:
- Preference for Liquidity: During uncertain economic times, people prefer to hold liquid money rather than invest it. This preference increases the demand for money.
- Impact: Economic instability or low-interest rates make people hold more money.
D. Wealth and Income:
- Money as Wealth: Friedman considers money as part of people’s overall wealth, including income from different sources and services.
- Impact: Changes in wealth and income levels influence how much money people hold. When wealth increases, people may hold more money.
Conclusion:
Milton Friedman’s approach to the demand for money provides a comprehensive framework to understand how various economic factors influence people’s decisions to hold money. By considering the level of prices, real income, interest rates, and expectations about future economic conditions, Friedman’s theory explains the dynamic nature of money demand. His insights help policymakers and economists in making informed decisions to maintain economic stability and growth.
Important Note for Students :– Hey everyone! All the questions in this chapter are super important!