Theory of Demand for money

• Pre – Keynesian theory:

– Quantity Theory of money (Fisher)
– Cambridge Cash Balance Approach

• Keynesian Theory:
– Liquidity preference theory of
interest
Money supply in India
• M1 = currency + demand deposits + other
deposits with the RBI. (narrow money)
• M2 = M1 + Saving deposit with post office saving
bank
• M3 = M1 + Time deposits (broad money)
• M4 = M3 + All deposits with post office savings
banks (excluding National Savings Certificates).
• M0 or H = Currency + Required reserves + Other
deposits with RBI
Quantity Theory of Money

• Irving Fisher Transaction version (1911)

• Cambridge cash balance Approach
attributed to A. Pigou (1917) and Marshall
(1923)

• “Quantity Theory of Money – A

restatement” (1956) Milton Friedman
QTM (Transaction approach)
• According to Fisher, “ Other things
remaining unchanged, as the quantity of
money in circulation increases, the price
level also increases in direct proportion,
and the value of money decreases and vice
versa”
• Equation of exchange
continued….
• Where
M = Total quantity of money
V = The velocity of circulation of M i.e. the
average number of times a unit of money
changes hands to effect transaction during
a period.
P = price level or 1/p = value of money
T = total goods and services (quantities)
transactions performed by money during a
period.
continued…..
• The equation assumes that T and V are
constant and M is exogenously given and
autonomous

• Price level varies directly with the quantity

of money, given V and T remain unchanged
Cambridge cash Balance Approach
• Demand for money

• At equilibrium

• Then

• Therefore
Similarities & Dissimilarities
• Similarities:
– same conclusion
– Similar Equation

• Dissimilarities:
•Functions of money
•Flow and Stock
•V and K are different
Criticisms

• A truism

• M relates to a point in time where as v

or k refers to period of time

• Neglects rates of interest

• V and k are not constant

Loanable funds Theory of interest
• An extension of savings and investment
theory of interest
• it is superior as it Incorporates both
monetary and non-monetary factors of
savings and investment.
• Propounded by Knut Wicksell, D H
Robertson, etc
 continued….
• The rate of interest is determined by the
demand for and the supply of Loanable
funds.
•

• At equilibrium
Keynesian demand for money
• Transactions motive
– depends largely on current income

• precautionary motive
– depends largely on current income

However, both the above motives also

depends on interest rates as well
continued….
• speculative demand
– demand for investment in the future in
bonds and other securities when interest
rate increases

• inverse relation interest rate between

speculative demand
• A point called liquidity trap when speculative
demand for money becomes perfectly elastic
Liquidity preference theory of interest
• interest is purely a monetary phenomena
• Money supply is exogenously given by
monetary authority. M
• demand for money

• At equilibrium
 continued…
• The key proposition of Keynes theory is
that changes in the demand or supply of
money affects the level of economy not
directly but indirectly through changes in
interest rate and thereby changes in real
investment in the economy.
• Ms r I Y N MPL P
•
• Md W