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Week 5 - Demand for Money.

I. The Concept of Demand for Money

  • Definition: The desire to hold financial assets in the form of money (cash/bank deposits) rather than investments1.

  • Fundamental Role: Money acts as a medium of exchange2.

Three Motives for Holding Money (Keynesian/General)

  1. Transaction Motive:

    • Money held to cover routine operating expenses and regular obligations3.

    • Needed because cash inflows (sales) and outflows (expenses) do not align perfectly4.

  2. Precautionary Motive:

    • Money held as a safeguard against unexpected financial challenges (e.g., strikes, price fluctuations)5.

  3. Speculative Motive:

    • Money held to capitalize on potential future opportunities (e.g., favorable market changes, interest rates)6.

II. Fisher’s Quantity Theory of Money (Transaction Approach)

  • Focus: Emphasizes money’s role as a medium of exchange7.

  • Core Theory: Demand for money arises solely to facilitate existing transactions8.

  • The Equation (Cash Transactions Equation):

    • \[MV = PT\]

      or

      \[P = MV/T\]

      9999.

    • M: Money in circulation.

    • V: Velocity of circulation.

    • T: Total volume of trade transactions.

    • P: Price level.

  • Refined Equation (Including Credit):

    • \[P = (MV + M'V') / T\]

      10.

    • M': Credit/Bank Money.

    • V': Velocity of Credit Money.

Key Conclusions of Fisher’s Theory

  • Direct Proportionality: There is a direct proportional relationship between Money Supply (\(M\)) and Price Level (\(P\))11.

    • If \(M\) doubles, \(P\) doubles, and the value of money is halved12.

      • Assumptions (Crucial for MCQs):

    • Constant Velocity (\(V\)): Determined by institutional factors, stable in the short run13.

    • Full Employment: Economy operates at full resource utilization14.

    • Constant Trade (\(T\)): Not influenced by \(M\) in the short run15.

    • Passive Price Level: \(P\) is determined by other variables (\(M, V\)); it does not determine them16.

    • Long-Run Perspective: Relationship holds over long periods17.

Criticisms of Fisher

  • Truism: The equation is merely an identity (\(MV=PT\)) stating money spent equals money received18.

  • Ignores Interest Rates: Fails to account for the influence of interest rates19.

  • Neglects Store of Value: Ignores the speculative demand for money20.

  • Static: Assumes \(V\) and \(T\) are constant, which is unrealistic21.

III. The Cambridge Approach (Cash Balance Approach)

  • Key Economists: Marshall, Pigou, Robertson, Keynes22.

  • Focus: Emphasizes the demand for money (Store of Wealth/Value) rather than just supply23.

  • Core Concept: Value of money is determined by the demand for cash balances (\(k\)) relative to supply24.

    • If people want to hold more money (\(k\) rises), spending decreases, and prices fall25.

1. Marshall’s Equation

  • Formula:

    \[M = KY\]

    26.

    • K: Part of real income people want to keep as cash27.

    • Y: Total real income.

  • Significance: It is K (demand to hold), not just \(M\), that influences the price level28.

2. Robertson’s Equation

  • Formula:

    \[M = PKT\]

    or

    \[P = M/KT\]

    29.

  • Focus: Emphasizes the holding of money rather than the spending (Fisher’s focus)30.

3. Pigou’s Equation

  • Formula:

    \[P = KR/M\]

    31.

    • R: Total resources (Real Income).

    • P: Purchasing power of money (inverse of price level).

  • Modified Equation:

    \[P = kR/M \{c + h(1-c)\}\]

    32.

    • Includes bank notes/balances in demand.

  • Shape of Curve: A Rectangular Hyperbola (Unitary elastic demand)33.

    *

IV. Comparison: Fisher vs. Cambridge

  • Similarities:

    • Both conclude \(P\) depends on \(M\)34.

    • Direct proportional relationship between Money Supply and Price Level35.

  • Dissimilarities (Key Distinctions):

    • Nature: Fisher emphasizes Flow (Spending/\(V\)); Cambridge emphasizes Stock (Holding/\(K\))36363636.

    • Causal Chain: Fisher says only \(M\) changes \(P\); Cambridge says \(P\) can change if \(K\) (demand) changes, even if \(M\) is constant37.

    • Trade Cycles: Cambridge variable \(K\) better explains cycles (High \(K\) during depression, Low \(K\) during inflation)38.

V. The Real Balance Effect (Don Patinkin)

  • Origin: Introduced by Don Patinkin in Money, Interest, and Prices (1956)39.

  • Critique of Cambridge: Criticized the assumption that elasticity of demand for money is always unity40.

  • Core Concept: Changes in the Real Value of Money (Purchasing Power) affect consumption and investment41.

  • Mechanism: If prices fall, the real value of money balances rises, making people feel wealthier and increasing spending42424242.

Three Aspects of Real Balance Effect

  1. Net Wealth Effect:

    • Rise in real balances = Rise in Net Wealth.

    • Leads directly to greater spending43434343.

  2. Portfolio Effect:

    • Price drop increases real value of cash; portfolio now has "too much" cash.

    • Investors rebalance by buying securities or increasing consumption44.

  3. Cambridge Aspect:

    • Focuses on Income.

    • If real balances rise, money holdings exceed the ideal ratio to income, leading to increased spending45.

IS-LM Analysis & Liquidity Trap

  • Process:

    1. Price decline shifts LM curve to the Right (Real balances rise)46.

    2. Increased wealth shifts IS curve to the Right (Consumption/Investment rises)47.

    3. Result: Economy reaches Full Employment even in a Liquidity Trap (where interest rates don't work)48.

Key Takeaways regarding Real Balance Effect

  • Integration: Merges Monetary Theory and Value Theory49.

  • Neutrality: Supports the idea that money is neutral in the long run (affects prices, not real output)50.

  • Criticism: Some argue it ignores "Money Illusion" (people looking at nominal, not real values)51.