3.

DEMAND FOR MONEY

Purpose: To introduce the learner to various theories for demand, in order to appreciate
the role of money in the economy
3.1 Introduction
Demand for money is the amount of wealth which individuals keep in the form of money.
We examine demand for money by looking and asking why people hold money. Money is
a mean to an end and thus individuals would want it for some ends. According to Adam
Smith, individuals demand money to enable them buy goods / services as they avoid the
costs involved in barter trade. Thus according to him money is needed to finance planned
transactions. The demand for money is linked to the level of planned transaction and the
price at which these transactions will take place. The demand for money falls under many
theories of which includes:
Classical theories
1. The quantity theory of money.
2. Cambridge equation
Neoclassical theories
3. Keynes demand theory of money
4. Monetary Theory of Money
5. Barmol transaction theory of money.
6. James Tobin demand of theory
7. Hicks demand theory for money
8. Fredman. demand theory of money
9. Portfolio demand theory of money.
18
3.2 Quantity Demand Theory of Money
The theory traces the connection between changes in the amount of money in circulation
and changes in general price level. Its originally can be traced in 16 century by John
Lacke. Later it was improved by Irving Fisher. According to this theory there is a direct
relationship between supply of money and the level of prices. The demand for money
depends on the level of transactions, which in turn depend on the level of income. If the
quantity of money doubled, price would also double.
P=∞M
P = priced
∞ = Constant
M = Money stock / supply
Irving Fisher developed this theory to what is known as the equation of exchange.
MV = PT
M = Money supply
V = Money velocity of circulation of money
P = Price (average)/general price levels
T = Index of expenditure/ Index measuring the volume of transactions in the economy/numbe
r of
economic transactions taking place in the period concerned.
Assumptions
(i) Proportion of change in money to money demand is constant
(ii) Demand for money is proportional to the volume of transactions
(iii) The theory is applicable in the long run
Transaction is defined as the exchange of commodities for money. The equation as the
stated, it’s a tautology (identity) for it must be true MV and PT at two ways of looking at
the same thing. When a commodity is purchased in money economy two things happen:-
a) The commodity passes from the seller to the buyer (PT)
b) Money passes from the from buyer to seller (MV)
Hence to get the total value under transaction we can trace the movement of commodities
or the movement of money. We might then say MV represents the money paid by the
consumers and received by procedures and PT is the value of goods obtained or supplied
in exchange for money during the year.
For example: If an economy has Kshs. 3,000 and those 3,000 shillings were spent five times i
n a month, the total spending for the month would be Kshs. 15,000.
Major assumption of Fisher Quantity Theory of money is that V (velocity) of money is
constant because it depends on institutional characteristics of an economy at particular
time such as the frequency at which people are paid. Money velocity also depends on
technology (modern banking). Money velocity is roughly constant. However price P
varies in proportion with to money supply M. Though these assumptions have been criticised,
particularly the assumption that V is constant. It’s argued that the velocity of circulation depe
nds on consumer and business spending impulses, which cannot be constant.
Weakness
(i) Keynes saw a major weakness of the theory in that V and T would not vary only
within narrow limits. There might be a disequilibrium in which transactions T
remained at a level far below full employment.
(ii) Money velocity might fluctuate considerably within a short time because of say
loss confidence by people holding idle money rather than undertaking business
venture or holding non risky assets.
(iii) The quantity theory of money can only hold if the velocity of money is stable or at
least predictable. Otherwise the equations of exchange cannot be used predict, the
effect of charge in money supply on nominal income. In Fisher’s analysis it’s the
function of money as a medium of exchange that is emphasized. Money is not
intrinsic, a source of utility but is useful for undertaking transactions. The amount
of money that an economy needs to facilitate transactions can be regarded as
bearing a fixed technical relationship to the level of money transactions.
3.3 Cambridge Equation Demand for Money
This was an extension of quantity theory of money where the exchange equation is stated
as Cambridge equation from Cambridge University. It is an alternative version known as the
cash balance version. It emphasizes the store of value aspect of money. It is
generally assumed according to the cash balance approach that the amount of
money that people will wish to hold as a temporary store of purchasing power will
be related to the real income of society as this limits the volume of potential
purchases available to society. We can therefore express the demand for money
as Md = uY where Y is real income and u is the percentage of real income over which people
collectively \vish to maintain control in the form of cash holdings. If
the money supply is exogenously determined to be M then equilibrium is brought
about by the price mechanism.
M = kY – Cambridge
It’s derived from quantity theory demand for money (MV = PT) .Assumes that transactions
are proportional to real income.
If T = ΛY
Then MV = PT = ΛYP
Where Y is money income
The income velocity of money is defined as V1
V1 = V/ Λ
Rewrite quantity theory identity.
As MV1 ≡ > ≡ PT
Letting 1/ VI = K it implies that

M/ k = Y

If M/ K = Y

for money demand function then it states that money function can be derived by:-
M = KY
In this case the Cambridge equation incorporates the Keynesian transactions and
precautionary demand for money but not the speculations demand. Cambridge
economists state that if there was an increase in supply of money while initially price and
income remained unchanged, people would find themselves holding more money than
they wished to hold. Their response to this situation is to spend the money on other assets
that yield a return and perhaps on consumption goods as well.
However assuming a condition of full employment as indicates by constant income Y
(output). Thus attempts by everyone to buy more goods are only going to push prices up.
Also it is apparent that although one individual may diminish his money but economy as
a whole cannot since the money supply is assumed exogenous. One individual’s
decreasing of his money holdings, leads to another increasing of his money holding.
Hence the process of adjustment of the money market to the increase money supply is
through a rise in price level and hence also in the level by money income transactions and
wealth which induces an increase in the demand for money.
Exercise 2.1
If the money supply in a given economy equals 500 while the velocity and price equals 8
and 2 respectively. Determine the level of real and nominal output.
Solutions
MV = PY; M=500; V=8; P = 2
Y = MV/P = (500x 8)/2 = 2000
Y= 2000
3.4 Keynes Money Demand Theory
It is a subset of his theory of the demand for different sorts of assets which is known as
theory of liquidity preference. Keynes believed that it was possible for resource to remain
idle and workers to be unemployed as a result of deficiency in aggregate demand. His
argument for demand for money was based on a near full employment level. Keynes
considered that there are three reasons why people demand for money rather than invest
that money in bond.
i) Transaction demand People need to hold a certain amount of money to meet their
normal everyday transactions such as entertainment, buying food, travel etc. This is
a first choice since it is not affected by the interest and depends on the consumer‟s
income. Whether interest increases or decreases the transaction motive for demand for
money will be perfectly inelastic. The demand for money for this purpose is related
to income. People with higher income will tend to have larger transaction demand
for money than those who have lower incomes. In inflation times the transaction
demand may increase because in order to obtain the same level of goods / service
more money is needed. It is also known as liquidity preference I (LPI)
ii) Precautionary demand for money This is holding idle money balance due to
uncertainties or emergency purposes. Money is kept to fulfil the function of store
of value. He argues that if the consequences of all our actions were known with
certainties the quantity theory would have been right to argue that money could
only be held for transaction purposes. In reality the world is dominated by
uncertainties. In consequence despite the opportunity cost of holding money
precautionary balance will be held incase there is a need for unplanned expenditure
e.g. getting sick at night, retirement, retrenchment etc. The amount kept under this
motive depends on the conditions under which one is living. It also depends on the
income and personality. It is also fairly affected by interest rates. Many people will
be tempted to invest in capital markets by buying securities or bonds in order to
receive higher rewards in the future. It also known as liquidity preference II (LP2).

iii) Speculative demand for money This is the demand for money to invest in business
which will generate higher returns. It is called liquidity preference III (LP3),
holding money for commercial purposes. It is the heart of Keynes theory on
demand for money. When considering speculative demand for money, the
opportunity cost of holding money is considered. Keynes argues that individuals
could hold money depending on the return tied to that money. According to Keynes,
when money is not required immediately as a means of payment it can be held as an
asset for future consumption or it can be converted into another asset. He talks of
bond as a major finance asset which can be acquired by an individual. A bond is a
government stock or security whose terms (capital repayment at maturity and
interest) are always honoured.
Individuals hold bond due to two reasons:-
a) To earn interest
b) For capital gain
The relationship between the price of bonds and its rate of interest is inverse relationship.
This implies that when interest rates are high prices of the bonds are low. This in effect
means that people may be reluctant to hold bonds for fear that the rate of interest may go
up and thus bond prices fall. On the other hand, if an individual strongly expects a fall in
interest rate, he will be anxious to hold bond in the expectation of making a capital gain
when their price goes up.
Given this scenario Keynes argues that individual expect that the rate of interest will fall
in future. He argues that if the current rate was thought to be exceptionally high and bond
prices thought to be exceptionally low. The expedition would be that the interest rate will
fall and the bond price rise. Keynes argues that in these circumstances individuals and
firms will want to buy bonds in the hope of making a speculative gain when the prices
rise. They would be unwilling to hold idle balances of money pre -favouring to buy bonds
instead.
Figure 3.1 Keynes theory demand for money

The diagram isn't complete.: shall complete it in class

Liquidity trap is a situation where the market interest rates are so low that everyone in the
economy expects an upwards movement in interest rates in the near future. This means
that everyone expects that the prices of bonds will drop in the near future and as such for
the present no one wants to buy or hold bonds. Everyone wants to hold money; demand
for speculative balances is almost infinite as indicated in the diagram
3.5 Debate between Classical Theorists and Keynes on Demand for Money
(i) According to classical economists money is a signed a passive role. It’s treated as
a mediator of transaction. Hence their emphasis is on the role of money as a
medium of exchange. They consider money to be neutral implying that it has no
influence on output.
(ii) Classical theorists‟ deals with a national economy where they regard interest as a
reward for capital on one hand and savings on the other. Interest is payment
made for the productiveness of capital and payment for the sacrifice involved in
savings. Interest rate equates investments and savings.
(iii) Classical economists debate on money demand on the assumption of full
employment. In that case an increase in money supply is seen to drive general
price level up due to constant volume of transactions.

(iv) Keynes disagrees with classical theorists as he assigns a key role to money. To
him money is a mobilizer of resources and full employment is only a limited
condition. The normal condition of the economy is one of under full employment
equilibrium. There is always excess capacity in the economy where some
resources are idle. (Include men and machines) money activates these idle
resources, to full employment in the excess capacity and increase output and
takes the economy to the road of full employment.
(v) According to Keynes money is more than a medium of exchange; it’s a store of
value. It not only buys goods and service now, it also stores value or purchasing
power for the future with deterioration in value due to inflation. Money links the
present and the uncertain future. It’s one form in which to hold an asset. Money
has thus an asset value in addition to its exchange value. He argues that it’s
desired for its own sake and not only for its purchasing power.
(vi) Keynes challenges the classical interest rate theory. He separates the interest
from Classical determinants i.e. savings and investment. He sees savings as only
not spending. Individuals saves what they cannot spent it entails no genuine
sacrifice. Saving is a negative act and hardly merits reward. Saving is
determined by the level of income and not the rate of interest. The demand for
capital does not arise out of its productiveness for capital is not productive. It’s
only productive because it’s scarce. To him capital is only labour working on
resources with a given technology and getting involved in material assets.
(vii) He regards interest as the price of money. The rate of interest is fixed by the
supply of money on one hand and the demand arising from the liquidity
preference of money on the other. According to him money is demand because
it’s a liquid asset. Liquidity is readily exchangeability of goods / service into final
utility hence money is one asset that is nearest to the final utility compared to
bond, equities, real estates etc.
(viii) Keynes agrees that interest and its efficient management, determines the volume
of investment but he argue that the rate of interest is determined by the money
stock.
(ix) Thus his transmission mechanism is that the money supply determines the rate of interest
which determines the volume of investment and investment determines
level of output (y). Keynes put money in the centre of the economic stage. His
economy is a monetary economy which money plays a crucial role.
In summary, in the quantity theory, money is demanded purely as a medium of exchange;
whereas in the Keynesian theory money is much more than a medium of exchange;
people also demand money for speculative purposes and as security against unforeseen
need for cash reserves. In the Keynesian theory people can hold idle balances where in
the quantity theory all money is either consumed or invested.
3.6 The New Quantity Demand for Money Theory by Fredman “Chicago version”
According to Fredman individuals may hold any of the three kinds of assets.
a) Money balances
b) Financial assets
c) Real assets
Financial assets such as bonds offer an explicit rate of return. Money offers no explicit
rate of return but it carries an implicit yield in terms of convenience and security. Thus
the cost of holding idle money balances includes the yields obtainable if money had been
invested and a rise in price incase of inflation.
According to this theory monetary expansion disturbs existing balance of assets holding
through increasing the amount of money and balance held which lead to excess demand
and hence inflation due to excessive public spending.
Fredman explains that demand for money is associated with permanent income where
individuals tend to have permanent income and they thus base their consumption on their
permanent income rather than current income.
Permanent income is defined as that income an individual expect to maintain on average
of time. If current income is below the permanent income, individuals would borrow or
run down their savings to finance consumption. If it’s above they would add to their
savings or reduce their debts.
Fredman saw a close relation between types of wealth and permanent income. Wealth
includes the physical assets (houses, machines) financial assets/securities (such as
commercial papers, shares, bonds) and human capital (skills and training).

According to him real money balance is a function of permanent income. The nature of
this function relationship is influenced by the rate of return of different types of assets
and the proportion of wealth held as human capital. Human capital is said to be illiquid
for it cannot be sold outright like other assets. Hence individuals using the human skill
would demand money balances to compensate for this illiquidity. Hence according to
Fredman, velocity of money which was seen in the Cambridge equation is determined by
economic variables rather than something given by institutional factors. Like Keynes,
Fredman is aware of the opportunity cost of holding money which affects the demand for
it. He does not just concentrate one single rate of interest as does Keynes rather he draws
in portfolio theory noting that different assets have different yields due to such factors as
riskness and liquidity different types of investments. The rate of return on different types
of financial and other assets many influence the demand for money.
Monetarist view of the Quantity Theory of Money
Monetarist argue that since money is a direct substitute for all other assets, an increase in
money supply, given a fairly stable velocity of circulation, will have a direct effect on the
demand for other assets since there will be more money to spend on those assets. If the
total output of the economy is fixed then an increase in the money supply will lead
directly to higher prices. Thus monetarists conclude that a rise in money supply will lead
to a rise in prices and probably also a rise in money incomes.
In the short run, monetarists argue that an increase in money supply might cause some
real increase in output and so an increase in employment. In the long run however, they
argue that all increases in money supply will be reflected in higher prices unless there is
longer-term growth in the economy.
The monetary school of thought argues that the private sector is basically stable and
therefore, the fundamental causes of economic fluctuations are the inappropriate
government actions. It is therefore supposed to the existence of large public sector and
also contends that money supply is the key determinant of the levels of production in the
short run, and the rate of inflation in the long run.
Limitations of the monetarists‟ theory of money

(i) Monetarist theories assume that the velocity of circulation is relatively stable and on this b
asis, they establish a direct connection between money supply and inflation. In practice, howe
ver, the velocity of money circulation is known to fluctuate up and down by small quantities
(ii) Price increases will not affect all goods equally. The prices of some goods will rise more
than other and so the relative prices will change.
(iii) A relatively higher rate of inflation in one country may adversely affect that country’s
balance of payments and exchange rate thereby introducing complications for the economy fr
om external factors.
(iv) In practice, prices of the economy may take some time to adjust to an increase in
money supply.
(v) Some Keynesians also argue that it is incorrect to assume that money supply is
independent variable under the control of the government. In certain, situations,
the money supply is completely demand determined which implies that any
increase in PT can cause an increase in the demand for money which may
automatically be matched by an increase in the money supply.
3.7 Review Questions
1. Outline the major differences between quantity and Keynesian liquidity preference
theories of money demand
2. Identify and explain the liquidity preference for money
3. Write notes on liquidity trap
4. Describe the monetarists‟ view of the quantity theory of money
5. Give four limitations of the monetarists‟ theory of money
5. Discuss the Keynesian Theory of demand for Money
6. State the classical quantity theory of money
7. Debate between Classical Theorists and Keynes on demand for money