Keynesian Money Demand Theory

Traditional View

Money is medium of exchangeHas no intrinsic valuePeople hold money for transactions

Keynes Money Holding Motives

Transactions motivePrecautions motiveSpeculative motive

Transaction Motive

Holding money to carry on day to day transactions

Higher Income More Transactions More Money Demand

Mdt =f (y)

Precautions Motive

Holding money for emergencies

Expected transactions in futureMoney demand expected, rises

with incomeMdp =f (y)

Speculative motive

Way for people to store wealthSavings in banks for gaining interest Major idea is to increase profitsIncrease in interest rates, decrease

the money demandHigher Interest Rate Higher

Opportunity Cost of Money Lower Money Demand

Mds = f (i)

Keynes Money Demand Function

Md = Mdt + Mdp + Mds

Mdt =f (y) ----------------------K1Y

Mdp =f (y) ---------------------K2Y

Mds = f (i) --------------------- -miMd = Mdt + Mdp + Mds

= K1Y + K2Y – mi

= KY- mi

The Keynesian demand for money function

An increase in household income shifts the money demand function to the right.

Money Market Equilibrium

Money demand = Money SupplyMoney Supply is exogenous

controlled by Central Bankms=mo

md = ms

Ky-mi = mo

KY-mo = mi

Equilibrium in the money market

Increase in Money supply

Bond Holding Motives 

Annual Return ARAR= PB x i

Capital Gains = expected price of bond – actual price of bond

Pe-Pa

Expected Yield E(y) = AR + Pe-Pa

As

Pe = AR ie

Pa = AR i

Expected Yield E(y) = AR + Pe-Pa

= AR + AR - AR ie i

AR + AR = AR ie i

AR( 1+ 1/ ie ) = AR / i1+ 1/ ie = 1 / i(1+ ie ) / ie = 1 / i

Critical Rate of Interest

i = ie / (1+ ie )

The Liquidity Trap

X = critical interest rate

Quantity Theory of Money

The Quantity Theory of Money states that there is a direct relationship between the quantity of money in an economy and the level of prices of goods and services sold.

According to QTM, if the amount of money in an economy doubles, price levels also double, causing inflation (the percentage rate at which the level of prices is rising in an economy). The consumer therefore pays twice as much for the same amount of the good or service.

The Theory’s Calculations

Irving Fisher, in his Purchasing Power of Money (1911), stated this theory by referring it to the infamous “equation of exchange”.

MV = PT

Each variable denotes the following:M = Money SupplyV = Velocity of Circulation (the number of times

money changes hands)P = Average Price LevelT = Volume of Transactions of Goods and Services

QTM Assumptions

1. The theory assumes that V (velocity of circulation) and T (volume of transactions) are constant in the short term.

According to Fisher V depends on the institutional and technical conditions of the economy. Institutional and technical conditions mean frequency of payments and credit availability. These are constant over a certain time period. Therefore V is also constant.

2. The theory also assumes that the quantity of money supplied, is exogenous i.e. determined by the outside forces, and is the main influence of economic activity in a society. A change in money supply results in changes in price levels and/or a change in supply of goods and services.

3. Finally, the number of transactions (T) is determined by labor, capital, natural resources (i.e. the factors of production), knowledge and organization. The theory assumes an economy in equilibrium and at full employment. T is the constant proportion of income. Within a year the number of transactions is of constant proportion.

4. Also, price level is the determinate not the determinant. Price level is determined by the other 3 variables, but it does not determine anything itself.

MV = PT income expenditure

In the above equation, V and T are constant.MV = PT

MV / T = PAssume that V / T =

M = PMoney Supply can change the Price Level but the Price level cannot change the Money Supply. Now, if there is a change in Money Supply, then

M / P = P / P

Now, P = M

M / M = P / PM / M = P / P

Proportionate change in Money will cause proportionate change in Price Level.

 Summing up Keynesian Demand Money Theory

Interest is purely a monetarist phenomenon

Change in i/ change in Md > 0Change in i /change in Ms < 0 Interest is used to activate the economy

Implications Of Quantity Theory Of Money

Implications

The monetary theory of price levelProportionality thesisCausality thesisExogenity thesisNeutrality thesis

The Monetary Theory of Price Level

Price level is determined by the money market.

Price level cannot affect the Money Supply but the Money Supply can effect the price level.

Md,Ms P

Proportionality thesis

Change in the price level will be proportionate to the change in money supply.

It is the assertion which needs to be proved. Assume Md is unitary elastic Md E = 1 Ms is independent of price level. 1/p is used to show proportionate change

with Ms and to keep Md curve downward slope

E1 = equilibrium

E2 = new equilibrium

New equilibrium shows increase in price level

As Money supply is independent of price level.

If Ms is doubled Price increases by the same proportion.

Causality Thesis

There is one way causality, meaning causality runs from one side.

It is a cause and effect relationship.

P/P = M/M

Exogenity Thesis

Ms is exogenous and Md is a positive function of income level.

According to classical, Future is certain and there is no Mds or Mdp.

Only Mdt exists

Thus where Md=Ms we can determine income Y.

According to classical, Money can effect the variables in Nominal terms but not in Real terms.

Neutrality Thesis

According to neutrality thesis Money can be divided into two parts:

1. Real2. Monetary or Nominal

Money is neutral as far as the real variables are concerned.

It can only change the nominal values of real variables.

Real variables are determined in the real sector and money has no influence on them.

DL = f(w/p)

SL = f(w/p)

Where DL = SL w/p determinedWe know Y= f(L,K)Assume K is constant

Loanable Funds Market

The loanable funds market balances the demand for funds generated by borrowers & the supply of funds provided by lenders.

Interest rate - the price charged by a lender to a borrower for use of lender's savings for one year.

There is an inverse relationship between the quantity of loanable funds demanded and the interest rate.

There is a direct relationship between the quantity of loanable funds supplied and the interest rate.

How to determine interest rate

I = f (i)If i I When S = I Md = Ms

Lfd = Lfs

Bd = Bs

Choices Of Income Earners

Spending on Goods and Services. SavingInvestment

Players of Credit Market

LendersBorrowers

Supply Of Loanable Funds

SavingsDishoardingBank moneyDisinvestment

Now, if we add up all these factors we come to an equation:

Lfs = S + Dishoardings + Disinvestment + Bank Credit

Lfs = S + Other Factors

Lfs = f(S)

Demand Of Loanable Funds

Households/HoardingsGovernmentProfitability of the loan takenForeign firmsDemand to spend on rituals

Now, if we add up all these factors we come to an equation

Lfd = f(I)

Equilibrium of Market

Lfs = Lfd