Quantity Theory of Money: Fisher’s Transactions and Cambridge Cash Balance Approach
1. Quantity Theory of Money: Fisher’s Transactions Approach:
The general level of prices is determined, that is, why at sometimes the general level of prices rises and sometimes it declines. Sometime back it was believed by the economists that the quantity of money in the economy is the prime cause of fluctuations in the price leve
The theory that increases in the quantity of money leads to the rise in the general price was effectively put forward by Irving Fisher.’ They believed that the greater the quantity of money, the higher the level of prices and vice versa.
Therefore, the theory which linked prices with the quantity of money came to be known as quantity theory of money. In the following analysis we shall first critically examine the quantity theory of money and then explain the modem view about the relationship between money and prices and also the determination of general level of prices.
The quantity theory of money seeks to explain the value of money in terms of changes in its quantity. Stated in its simplest form, the quantity theory of money says that the level of prices varies directly with quantity of money. “Double the quantity of money, and other things being equal, prices will be twice as high as before, and the value of money one-half. Halve the quantity of money and, other things being equal, prices will be one-half of what they were before and the value of money double.”
The theory can also be stated in these words: The price level rises proportionately with a given increase in the quantity of money. Conversely, the price level falls proportionately with a given decrease in the quantity of money, other things remaining the same
There are several forces that determine the value of money and the general price level.
The general price level in a community is influenced by the following factors:
(a) The volume of trade or transactions;
(b) The quantity of money
(c) Velocity of circulation of money.
The first factor, the volume of trade or transactions, depends upon the supply or amount of goods and services to be exchanged. The greater the amount or supply of goods in an economy, the larger the number of transactions and trade, and vice versa.
But the classical and neoclassical economists who believed in the quantity theory of money assumed that Jull employment of all resources (including labour) prevailed in the economy. Resources being fully employed, the total output or supply of goods (and therefore the total trade or transactions) cannot increase. Therefore, those who believed in the quantity theory of money assumed that the total volume of trade or transactions remained the same.
The second factor in the determination of general level of prices is the quantity of money. It should be noted that the quantity of money in the economy consists of not only the notes and currency issued by the Government but also the amount of credit or deposits created by the bank
The third factor influencing the price level is the velocity of circulation. A unit of money is used for exchange and transactions purposes not once but several times in a year. During several exchanges of goods and services, a unit of money passes from one hand to another.
Thus, if a single rupee is used five times in a year for exchange of goods and services, the velocity of circulation is 5. Hence, the velocity of money is the number of times a unit of money changes hands during exchanges in a year. The work done by one rupee which is circulated five times in a year is equal to that done by the five rupees which change hands only once each.
Let us illustrate the quantity theory of money. Suppose in a country there is only one good, wheat, which is to be exchanged. The total output of wheat is 2,000 quintals in a year. Further suppose that the government has issued money equal to Rs. 25,000 and no credit is issued by the banks. We further assume that one rupee is used four times in a year for exchange of wheat.
That is, velocity of circulation of money is four. Under these circumstances, 2,000 quintals of wheat are to be exchanged for Rs. 1, 00,000 (25,000 x 4 = 1, 00,000). The price of wheat will be 1, 00,000/2,000 = Rs. 50 per quintal. Suppose the quantity of money is doubled to Rs. 50,000, while the output of wheat remains at 2,000 quintals. As a result of this increase in the quantity of money, the price of wheat will rise to 2, 00,000/2,000 = Rs. 100 per quintal
Thus with doubling of the quantity of money, the price has doubled. If the quantity of money is further increased to Rs. 75,000, the amount of wheat remaining constant, the price level will rise to 3,00,000/2,000 = Rs. 150 per quintal. It is thus clear that if the volume of transactions, i.e., output to be exchanged remains constant, the price level rises with the increase in the quantity of money.
Fisher’s Equation of Exchange:
An American economist, Irving Fisher, expressed the relationship between the quantity of money and the price level in the form of an equation, which is called ‘the equation of exchange’.
This is:
PT = MV….(1)
Or P = MV/T
Where P stands for the average price level:
T stands for total amount of transactions (or total trade or amount of goods and services, raw materials, old goods etc.)
M stands for the quantity of money; and
V stands for the transactions velocity of circulation of money.
The equation (1) or (2) is an accounting identity and true by definition. This is, because MV which represents money spent on transactions must be equal to Pr which represents money received from transactions.
However, the equation of exchange as given in equations (1) and (2) has been converted into a theory of determination of general level of prices by the classical economists by making some assumptions. First, it has been assumed that the physical volume of transactions is constant because it is determined by a given amount of real resources, the given level of technology and the efficiency with which the given available resources are used.
These real factors determine a level of aggregate output which necessitates various types of transactions. Another crucial assumption is that transactions velocity of circulation (V) is also constant. The quantity theorists accordingly believed that velocity of circulation (V) depends on the methods and practices of factor payments such as frequency of wage payments to the workers, and habits of the people regarding spending their money incomes after they receive them.
Further, velocity of circulation of money also depends on the development of banking and credit system, that is, the ways and speed with which cheques are cleared, loans are granted and repaid. According to them, these practices do not change in the short run.
This assumption is very crucial for the quantity theory of money because when the quantity of money is increased this may cause a decline in velocity of circulation of money, then MV may not change if the decline in V offsets the increase in M. As a result, increase in M will not affect PY.
The quantity theorists believed that the volume of transactions (T) and the changes in it were largely independent of the quantity of money. Further, according to them, changes in velocity of circulation (VO and price level (P) do not cause any change in volume of transactions except temporarily.
Thus classical economists who put forward the quantity theory of money believed that the number of transactions (which ultimately depends on aggregate real output) does not depend on other variables (M, V and P) in the equation of exchange. Thus we see that the assumption of constant V and T converts the equation of exchange (MV = PT), which is an accounting identity, into a theory of the determination of general price level.
The quantity of money is fixed by the Government and the Central Bank of a country. Further, it is assumed that quantity of money in the economy depends upon the monetary system and policy of the central bank and the Government and is assumed to be autonomous of the real forces which determine the volume of transactions or national outp
Now, with the assumptions that M and V remain constant, the price level P depends upon the quantity of money M; the greater the quantity of M, the higher the level of prices. Let us give a numerical example.
Suppose the quantity of money is Rs. 5, 00,000 in an economy, the velocity of circulation of money (V) is 5; and the total output to be transacted (T) is 2, 50,000 units, the average price level (P) will be:
P = MV/T
= 5, 00,000 × 5/ 2, 50,000 = 2,500,000/ 2, 50,000
= Rs. 10 per unit.
If now, other things remaining the same, the quantity of money is doubled, i.e., increased to Rs. 10, 00,000 then:
P = 10, 00,000 × 5/ 2, 50,000 = Rs. 20 per unit
We thus see that according to the quantity theory of money, price level varies in direct proportion to the quantity of money. A doubling of the quantity of money (M) will lead to the doubling of the price level. Further, since changes in the quantity of money are assumed to be independent or autonomous of the price level, the changes in the quantity of money become the cause of the changes in the price level.
Quantity Theory of Money: Income Version:
Fisher’s transactions approach to quantity theory of money described in equation (1) and (2) above considers such variables as total volume of transaction (T) and average price level of these transactions are conceptually vague and difficult to measure.
Therefore, in later years quantity theory was formulated in income from which considers real B
income or national output (i.e., transactions of final goods only) rather than all transactions. As the data regarding national income or output is readily available, the income version of the quantity theory is being increasingly used. Moreover, the average price level of output is a more meaningful and useful concept.
Indeed, in actual practice, the general price level in a country is measured taking into account only the prices of final goods and services which constitute national product. It may be noted that even in this income version of the quantity theory of money, the function of money is considered to be a means of exchange as in the transactions approach of Fisher.
In this approach, the concept of income velocity of money has been used instead of transactions velocity of circulation. By income velocity we mean the average number of times per period a unit of money is used in making payments involving final goods and services, that is, national product or national income. In fact, income velocity of money is measured by Y/M where Y stands for real national income and M for the quantity of money.
In view of the above, the income version of quantity theory of money is written as under:
MV = PY…(3)
P = MV/PY … (4)
Where
M = Quantity of money
V = Income velocity of money
P = Average price level of final goods and services
Y = Real national income (or aggregate output)
Dia 20.1
Quantity Theory of MoneyLike that in the transactions approach, in this new income version of the quantity theory also the different variables are assumed to be independent of each other. Further, income velocity of money (V) and real income or aggregate output (Y) is assumed to be given and constant during a short period.
More specifically, they do not vary in response to the changes in M. In fact, real income or output (Y) is assumed to be determined by the real sector forces such as capital stock, the amount and skills of labour, technology etc. But as these factors are taken to be given and constant in the short ran, and further full employment of the given resources is assumed to be prevailing due to the operation of Say’s law and wage-price flexibility supply of output is taken to be inelastic and constant for purposes of determination of price level.
It follows from equations (3) and (4) above that with income velocity (V) and national output (F) remaining constant, price level (P) is determined by the quantity of money (M).
Classical quantity theory of money is illustrated in Fig. 20.1 through aggregate demand and aggregate supply model. It is worth noting that the quantity of money (A/) multiplied by the income velocity of circulation (V), that is, MV gives us aggregate expenditure in the quantity theory of money. Now with a given quantity of money, say M1 and constant velocity of money V, we have a given amount of monetary expenditure (M1 V).
Given this aggregate expenditure, at a lower price level more quantities of goods can be purchased and at a higher price level, less quantities of goods can be purchased. Therefore, in accordance with classical quantity theory of money aggregate demand representing M1 slopes downward as shown by the aggregate demand curve AD1 in Fig. 20.1. If now the quantity of money is increased, say to M2, aggregate demand curve representing new aggregate monetary expenditure M2 V will shift upward.
As regards, aggregate supply curve, due to the assumption of wage-price flexibility, it is perfectly inelastic at full-employment level of output as is shown by the vertical aggregate supply curve AS in Fig. 20.1. Now, with a given quantity of money equal to M1, aggregate demand curve AD1 cuts the aggregate supply curve AS at point E and determines price level OP1.
Now, if the quantity of money is increased to M2, the aggregate demand curve shifts upward to AD2. It will be seen from Fig. 20.1 that with the increase in aggregate demand to AD2 consequent to the expansion in money supply to M2, excess demand equal to EB emerges at the current price level OP1. This excess demand for goods and services will lead to the rise in price level to OP2 at which again aggregate quantity demanded equals the aggregate supply which remains unchanged at OY due to the existence of full employment in the economy.
2. Quantity Theory of Money: The Cambridge Cash Balance Approach:
The equation of exchange has been stated by Cambridge economists, Marshall and Pigou, in a form different from Irving Fisher. Cambridge economists explained the determination of value of money in line with the determination of value in general.
Value of a commodity is determined by demand for and supply of it and likewise, according to them, the value of money (i.e., its purchasing power) is determined by the demand for and supply of money. As studied in cash-balance approach to demand for money Cambridge economists laid stress on the store of value function of money in sharp contrast to the medium of exchange function of money emphasised by in Fisher’s transactions approach to demand for money.
According to cash balance approach, the public likes to hold a proportion of nominal income in the form of money (i.e., cash balances). Let us call this proportion of nominal income that people want to hold in money as k.
Then cash balance approach can be written as:
Md =kPY ….(1)
Y = real national income (i.e., aggregate output)
P = the price level PY = nominal national income
k = the proportion of nominal income that people want to hold in money
Md = the amount of money which public want to hold
Now, for the achievement of money-market equilibrium, demand for money must equal worth the supply of money which we denote by M. It is important to note that the supply of money M is exogenously given and is determined by the monetary policies of the central bank of a country. Thus, for equilibrium in the money market.
M = Md
As Md =kPY
Therefore, in equilibrium M = kPY …(2)
Monetary equilibrium Cambridge cash balance approach is shown in Fig. 20.2 where demand for money is shown by a rising straight line kPY which indicates that with k and Y being held constant demand for money increases proportionately to the rise in price level. As price level rises people demand more money for transaction purposes.
Dia 20.2
purposes.Determination of Price Level:Cambridge Cash Balance ApproachNow, if supply of money fixed by the Government (or the Central Bank) is equal to M0, the demand for money APK equals the supply of money, M0 at price level P0. Thus, with supply of money equal to M0 equilibrium price level P0 is determined. If money supply is increased, how the monetary equilibrium will change? Suppose money supply is increased to M1 at the initial price level P0 the people will be holding more money than they demand at it.
Therefore, they would want to reduce their money holding. In order to reduce their money holding they would increase their spending on goods and services. In response to the increase in money spending by the households the firms will increase prices of their goods and services.
C
As prices rise, the households will need and demand more money to hold for transaction purposes (i.e., for buying goods and services). It will be seen from Fig. 20.2 that with the increase in money supply to M1 new equilibrium between demand for money and supply of money is attained at point E1 on the demand for money curve kPY and price level has risen to P1.
It is worth mentioning that k in the equations (1) and (2) is related to velocity of circulation of money V in Fisher’s transactions approach. Thus, when a greater proportion of nominal income is held in the form of money (i.e., when k is higher), V falls. On the other hand, when less proportion of nominal income is held in money, K rises. In the words of Crowther, “The higher the proportion of their real incomes that people decide to keep in money, the lower will be the velocity of circulation, and vice versa.
It follows from above that k = 1/V. Now, rearranging equation (2) we have cash balance approach in which P appears as dependent variable. Thus, on rearranging equation (2) we have
P = 1/k.M/Y…………(3)
Like Fisher’s equation, cash balance equation is also an accounting identity because k is defined as:
Quantity of Money Supply/National Income, that is, M/PY
Now, Cambridge economists also assumed that k remains constant. Further, due to their belief that wage-price flexibility ensures full employment of resources, the level of real national income was also fixed corresponding to the level of aggregate output produced by full employment of resources.
Thus, from equation (3) it follows that with k and Y remaining constant price level (P) is determined by the quantity of money (M); changes in the quantity of money will cause proportionate changes in the price level.
Some economists have pointed out similarity between Cambridge cash-balance approach and
Fisher’s transactions approach. According to them, k is reciprocal of V (k = 1/V or V = 1/k). Thus in equation (2) if we replace k by , we have
M = 1/PY
Or MV=PY
Which is income version of Fisher’s quantity theory of money? However, in spite of the formal similarity between the cash balance and transactions approaches, there are important conceptual differences between the two which makes cash balance approach superior to the transactions approach. First, as mentioned above.
Fisher’s transactions approach lays stress on the medium of exchange function of money, that is, according to its people want money to use it as a means of payment for buying goods and services. On the other hand, cash balance approach emphasizes the store-of-value function of money. They hold money so that some value is stored for spending on goods and services after some lapse of time.
Further, in explaining the factors which determine velocity of circulation, transactions approach points to the mechanical aspects of payment methods and practices such as frequency of wages and other factor payments, the speed with which funds can be sent from one place to another, the extent to which bank deposits and cheques are used in dealing with others and so on.
On the other hand, k in the cash balance approach is behavioural in nature. Thus, according to Prof S.B. Gupta, ”Cash- balance approach is behavioural in nature: it is build around the demand for money, however simple. Unlike Fisher s V, k is a behavioural ratio. As such it can easily lead to stress being placed on the relative usefulness of money as an asset.”
Thirdly, cash balance approach explains determination of value of money in a framework of general demand-supply analysis of value. Thus, according to this approach value of money (that is, its purchasing power is determined by the demand for and supply of money).
To sum up cash balance approach has made some improvements over Fisher’s transactions approach in explaining the relation between money and prices. However it is essentially the same as the Fisher’s transactions approach. Like Fisher’s approach if considers substitution between money and commodities.
That is, if they decide to hold less money, they spend more on commodities rather than on other assets such as bonds, shares real property, and durable consumer goods. Further, like Fisher’s transactions approach it visualises changes in the quantity of money causes proportional changes in the price level.
Like Fisher’s approach, cash balance approach also assumes that full- employment of resources will prevail due to the wage-price flexibility. Hence, it also believes the aggregate supply curve as perfectly inelastic at full-employment level of output.
An important limitation of cash balance approach is that it also assumes that the proportion to income that people want to hold in money, that is, k, remains constant. Note that. In practice it has been found that proportionality factor k or- velocity of circulation has not remained constant but has been fluctuating, especially in the short run.
Besides, cash-balance approach falls short of considering demand for money as an asset. If demand for money as an asset were considered, it would have a determining influence on the rate of interest on which amount of investment in the economy depends. Investment plays an important role in the determination of/level of real income in the economy.
It was left to J.M. Keynes who later emphasised the role of demand for money as an asset which was one of the alternative assets in which individuals can keep their income or wealth. Finally, it may be mentioned that other criticisms of Fisher’s transactions approach to quantity theory of money discussed above equally apply to the Cambridge cash balance approach.
Keynes’s Critique of the Quantity Theory of Money:
The quantity theory of money has been widely criticised.
The following criticisms have been levelled against the quantity theory of money lay by Keynes and his followers:
1. Useless truism:
With the qualification that velocity of money (V) and the total output (T) remain the same, the equation of exchange (MV= PT) is a useless truism. The real trouble is that these things seldom remain the same. They change not only in the long run but also in a short period. Fisher’s equation of exchange simply tells us that expenditure made on goods (MV) is equal to the value of output of goods and services sold (PT).
2. Velocity of money is not stable:
Keynesian economists have challenged the assumption that velocity of money remains stable. According to them, velocity of money changes inversely with the change in money supply. They argue that increase in money supply, demand for money remaining constant, leads to the fall in the rate of interest.
At a lower rate of interest, people will be induced to hold more money as idle cash balances (under speculative motive). This means velocity of circulation of money will be reduced. Thus, if a decline in interest rate reduces velocity, then increase in the money supply will be offset by reduction in velocity, with the result that price level, need not rise when money supply is increased.
3. Increase in quantity of money may not always lead to the increase in aggregate spending or demand:
Further, according to Keynes’ the quantity theory of money is based upon two more wrong assumptions.
Basically, for, the quantity theory to be true, the following two assumptions must hold:
(i) An increase is money supply must lead to an increase in spending, that is, aggregate demand i.e., no part of additional money created should be kept in idle hoards.
(ii) The resulting increase in spending or aggregate demand must face a totally inelastic output.
Both the assumptions according to Keynes, lack generality and, therefore, it either of them does not hold, the quantity theory cannot be accepted as a valid explanation of the changes in price level.
Let us take the first assumption. Under this assumption, the entire increase in the quantity of money must express itself in the form of increased spending. If spending does not increase, there is no question of a change in prices or output. But, is it valid to make such an assumption?
Obviously, there is no such direct link between the increase in the quantity of money and the increase in the volume of total spending or aggregate demand. No one is going to increase his expenditure simply because the government is printing more notes or the banks are more liberal in their lending policies. Thus, if the demand for money is highly interest-elastic, the increase in money supply will not lead to any appreciable fall in the rate of interest.
With no significant fall in rate of interest, the investment expenditure and expenditure on durable consumer goods will not increase much. As a result, increase in money supply may not lead to increase in expenditure or aggregate demand and therefore price level may remain unaffected.
This is not to say, however, that changes in the quantity of money have no influence whatsoever on the volume of aggregate spending. As we shall show below, changes in the quantity of money are often capable of inducing changes in the volume of aggregate spending. What Keynes and his followers deny is the assertion that there exists a direct, simple, and more or less a proportional relation between variation in money supply and variation in the level of total spending.
4. Assumption of constant volume of transactions or constant level of aggregate output is not valid:
Keys asserted that the assumption of constant aggregate output valid only under conditions of full employment. It is only then that we can assume a totally inelastic supply of output, for all the available resources are being already fully utilised. In conditions of less than full employment, the supply curve of output will be elastic.
Now, if we assume that aggregate spending or demand increases with an increase in the quantity of money, it does not follow that prices must necessarily rise. If the supply curve of output is fairly elastic, D
, it is more likely that effect of an increase in spending will be more to raise production rather than prices.
Of course, at full-employment level every further increase in spending or aggregate demand must lead to the rise in the price level as output is inelastic in supply at full-employment level. Since full-employment cannot be assumed to be a normal affair, we cannot accept the quantity theory of money as a valid explanation of changes in the price level in the short run.
The Demand for Money: The Classical and keynes approach towards demand of money..
The demand fo two important function Money exchange and the second is that it is a store of value. Thus individuals and businesses
What explains changes in the demand for money? There are two views on this issue. The first is the “scale” view which is related to the impact of the income or wealth level upon the demand for money. The demand for money is directly related to the income level. The higher the income level, the greater will be the demand for money.
The second is the “substitution” view which is related to relative attractiveness of assets that can be substituted for money. According to this view, when alternative assets like bonds become unattractive due to fall in interest ssets in cash, and the demand for money increases, and vice versa.
The scale and substitution view combined together have been used to explain the nature of the demand for money which has been split into the transactions demand, the precautionary demand and the speculative demand. There are three approaches to the demand for money: the classical, the Keynesian, and the post-Keynesian. We discuss these approaches below.
The Classical Approach:
The classical economists did not explicitly formulate demand for money theory but their views are inherent in the quantity theory of money. They emphasized the transactions demand for money in terms of the velocity of circulation of money. This is because money acts as a medium of exchange and facilitates the exchange of goods and services. In Fisher’s “Equation of Exchange”
MV=PT
Where M is the total quantity of money, V is its velocity of circulation, P is the price level, and T is the total amount of goods and services exchanged for money.
The right hand side of this equation PT represents the demand for money which, in fact, “depends upon the value of the transactions to be undertaken in the economy, and is equal to a constant fraction of those transactions.” MV represents the supply of money which is given and in equilibrium equals the demand for money. Thus the
Md = PT
This transactions demand for money, in turn, is determined by the level of full employment income. This is because the classicists believed in Say’s Law whereby supply created its own demand, assuming the full employment level of income. Thus the demand for money in Fisher’s approach is a constant proportion of the level of transactions, which in turn, bears a constant relationship to the level of national income. Further, the demand for money is linked to the volume of trade going on in an economy at any time.
Thus its underlying assumption is that people hold money to buy goods.
But people also hold money for other reasons, such as to earn interest and to provide against unforeseen events. It is therefore, not possible to say that V will remain constant when M is changed. The most important thing about money in Fisher’s theory is that it is transferable. But it does not explain fully why people hold money. It does not clarify whether to include as money such items as time deposits or savings deposits that are not immediately available to pay debts without first being converted into currency.
It was the Cambridge cash balance approach which raised a further question: Why do people actually want to hold their assets in the form of money? With larger incomes, people want to make larger volumes of transactions and that larger cash balances will, therefore, be demanded.
The Cambridge demand equation for money is
Md=kPY
where Md is the demand for money which must equal the supply to money (Md=Ms) in equilibrium in the economy, k is the fraction of the real money income (PY) which people wish to hold in cash and demand deposits or the ratio of money stock to income, P is the price level, and Y is the aggregate real income. This equation tells us that “other things being equal, the demand for money in normal terms would be proportional to the nominal level of income for each individual, and hence for the aggregate economy as well.”
Its Critical Evaluation:
This approach includes time and saving deposits and other convertible funds in the demand for money. It also stresses the importance of factors that make money more or less useful, such as the costs of holding it, uncertainty about the future and so on. But it says little about the nature of the relationship that one expects to prevail between its variables, and it does not say too much about which ones might be important.
One of its major criticisms arises from the neglect of store of value function of money. The classicists emphasized only the medium of exchange function of money which simply acted as a go-between to facilitate buying and selling. For them, money performed a neutral role in the economy. It was barren and would not multiply, if stored in the form of wealth.
This was an erroneous view because money performed the “asset” function when it is transformed into other forms of assets like bills, equities, debentures, real assets (houses, cars, TVs, and so on), etc. Thus the neglect of the asset function of money was the major weakness of classical approach to the demand for money which Keynes remedied.
The Keynesian Approach: Liquidity Preference:
Keynes in his General Theory used a new term “liquidity preference” for the demand for money. Keynes suggested three motives which led to the demand for money in an economy: (1) the transactions demand, (2) the precautionary demand, and (3) the speculative demand.
The Transactions Demand for Money:
The transactions demand for money arises from the medium of exchange function of money in making regular payments for goods and services. According to Keynes, it relates to “the need of cash for the current transactions of personal and business exchange” It is further divided into income and business motives. The income motive is meant “to bridge the interval between the receipt of income and its disbursement.”
Similarly, the business motive is meant “to bridge the interval between the time of incurring business costs and that of the receipt of the sale proceeds.” If the time between the incurring of expenditure and receipt of income is small, less cash will be held by the people for current transactions, and vice versa. There will, however, be changes in the transactions demand for money depending upon the expectations of income recipients and businessmen. They depend upon the level of income, the interest rate, the business turnover, the normal period between the receipt and disbursement of income, etc.
Given these factors, the transactions demand for money is a direct proportional and positive function of the level of income, and is expressed as
L1 = kY
Where L1 is the transactions demand for money, k is the proportion of income which is kept for transactions purposes, and Y is the income.
This equation is illustrated in Figure 70.1 where the line kY represents a linear and proportional relation between transactions demand and the level of income. Assuming k= 1/4 and income Rs 1000 crores, the demand for transactions balances would be Rs 250 crores, at point A. With the increase in income to Rs 1200 crores, the transactions demand would be Rs 300 crores at point Ð’ on the curve kY.
Fig70.1
If the transactions demand falls due to a change in the institutional and structural conditions of the economy, the value of к is reduced to say, 1/5, and the new transactions demand curve is kY. It shows that for income of Rs 1000 and 1200 crores, transactions balances would Rs 200 and 240 crores at points С and D respectively in the figure. “Thus we conclude that the chief determinant of changes in the actual amount of the transactions balances held is changes in income. Changes in the transactions balances are the result of movements along a line like kY rather than changes in the slope of the line. In the equation, changes in transactions balances are the result of changes in Y rather than changes in k.”
Interest Rate and Transactions Demand:
Regarding the rate of interest as the determinant of the transactions demand for money Keynes made the LT function interest inelastic. But the pointed out that the “demand for money in the active circulation is also the some extent a function of the rate of interest, since a higher rate of interest may lead to a more economical use of active balances.” “However, he did not stress the role of the rate of interest in this part of his analysis, and many of his popularizes ignored it altogether.” In recent years, two post-Keynesian economists William J. Baumol and James Tobin have shown that the rate of interest is an important determinant of transactions demand for money.
They have also pointed out the relationship, between transactions demand for money and income is not linear and proportional. Rather, changes in income lead to proportionately smaller changes in transactions demand.
E
Transactions balances are held because income received once a month is not spent on the same day. In fact, an individual spreads his expenditure evenly over the month. Thus a portion of money meant for transactions purposes can be spent on short-term interest-yielding securities. It is possible to “put funds to work for a matter of days, weeks, or months in interest-bearing securities such as U.S. Treasury bills or commercial paper and other short-term money market instruments.
The problem here is that there is a cost involved in buying and selling. One must weigh the financial cost and inconvenience of frequent entry to and exit from the market for securities against the apparent advantage of holding interest-bearing securities in place of idle transactions balances.
Among other things, the cost per purchase and sale, the rate of interest, and the frequency of purchases and sales determine the profitability of switching from ideal transactions balances to earning assets. Nonetheless, with the cost per purchase and sale given, there is clearly some rate of interest at which it becomes profitable to switch what otherwise would be transactions balances into interest-bearing securities, even if the period for which these funds may be spared from transactions needs is measured only in weeks. The higher the interest rate, the larger will be the fraction of any given amount of transactions balances that can be profitably diverted into securities.”
The structure of cash and short-term bond holdings is shown in Figure 70.2 (A), (B) and (C). Suppose an individual receives Rs 1200 as income on the first of every month and spends it evenly over the month. The month has four weeks. His saving is zero.
Accordingly, his transactions demand for money in each week is Rs 300. So he has Rs 900 idle money in the first week, Rs 600 in the second week, and Rs 300 in the third week. He will, therefore, convert this idle money into interest bearing bonds, as illustrated in Panel (B) and (C) of Figure 70.2. He keeps and spends Rs 300 during the first week (shown in Panel B), and invests Rs 900 in interest-bearing bonds (shown in Panel C). On the first day of the second week he sells bonds worth Rs. 300 to cover cash transactions of the second week and his bond holdings are reduced to Rs 600.
Similarly, he will sell bonds worth Rs 300 in the beginning of the third and keep the remaining bonds amounting to Rs 300 which he will sell on the first day of the fourth week to meet his expenses for the last week of the month. The amount of cash held for transactions purposes by the individual during each week is shown in saw-tooth pattern in Panel (B), and the bond holdings in each week are shown in blocks in Panel (C) of Figure 70.2
The modern view is that the transactions demand for money is a function of both income and interest rates which can be expressed as
L1 = f (Y, r).
This relationship between income and interest rate and the transactions demand for money for the economy as a whole is illustrated in Figure 3. We saw above that LT = kY. If y=Rs 1200 crores and k= 1/4, then LT = Rs 300 crores.
This is shown as Y1 curve in Figure 70.3. If the income level rises to Rs 1600 crores, the transactions demand also increases to Rs 400 crores, given k = 1/4. Consequently, the transactions demand curve shifts to Y2. The transactions demand curves Y1, and Y2 are interest- inelastic so long as the rate of interest does not rise above r8 per cent.
As the rate of interest starts rising above r8, the transactions demand for money becomes interest elastic. It indicates that “given the cost of switching into and out of securities, an interest rate above 8 per cent is sufficiently high to attract some amount of transaction balances into securities.” The backward slope of the K, curve shows that at still higher rates, the transaction demand for money declines.
Thus when the rate of interest rises to r12, the transactions demand declines to Rs 250 crores with an income level of Rs 1200 crores. Similarly, when the national income is Rs 1600 crores the transactions demand would decline to Rs 350 crores at r12 interest rate. Thus the transactions demand for money varies directly with the level of income and inversely with the rate of interest.
The Precautionary Demand for Money:
The Precautionary motive relates to “the desire to provide for contingencies requiring sudden expenditures and for unforeseen opportunities of advantageous purchases.” Both individuals and businessmen keep cash in reserve to meet unexpected needs. Individuals hold some cash to provide for illness, accidents, unemployment and other unforeseen contingencies.
Similarly, businessmen keep cash in reserve to tide over unfavourable conditions or to gain from unexpected deals. Therefore, “money held under the precautionary motive is rather like water kept in reserve in a water tank.” The precautionary demand for money depends upon the level of income, and business activity, opportunities for unexpected profitable deals, availability of cash, the cost of holding liquid assets in bank reserves, etc.
Keynes held that the precautionary demand for money, like transactions demand, was a function of the level of income. But the post-Keynesian economists believe that like transactions demand, it is inversely related to high interest rates. The transactions and precautionary demand for money will be unstable, particularly if the economy is not at full employment level and transactions are, therefore, less than the maximum, and are liable to fluctuate up or down.
Since precautionary demand, like transactions demand is a function of income and interest rates, the demand for money for these two purposes is expressed in the single equation LT=f(Y, r)9. Thus the precautionary demand for money can also be explained diagrammatically in terms of Figures 2 and 3.
F
The Speculative Demand for Money:
The speculative (or asset or liquidity preference) demand for money is for securing profit from knowing better than the market what the future will bring forth”. Individuals and businessmen having funds, after keeping enough for transactions and precautionary purposes, like to make a speculative gain by investing in bonds. Money held for speculative purposes is a liquid store of value which can be invested at an opportune moment in interest-bearing bonds or securities.
Bond prices and the rate of interest are inversely related to each other. Low bond prices are indicative of high interest rates, and high bond prices reflect low interest rates. A bond carries a fixed rate of interest. For instance, if a bond of the value of Rs 100 carries 4 per cent interest and the market rate of interest rises to 8 per cent, the value of this bond falls to Rs 50 in the market. If the market rate of interest falls to 2 per cent, the value of the bond will rise to Rs 200 in the market.
This can be worked out with the help of the equation
V = R/r
Where V is the current market value of a bond, R is the annual return on the bond, and r is the rate of return currently earned or the market rate of interest. So a bond worth Rs 100 (V) and carrying a 4 per cent rate of interest (r), gets an annual return (R) of Rs 4, that is,
V=Rs 4/0.04=Rs 100. When the market rate of interest rises to 8 per cent, then V=Rs 4/0.08=Rs50; when it fall to 2 per cent, then V=Rs 4/0.02=Rs 200.
Thus individuals and businessmen can gain by buying bonds worth Rs 100 each at the market price of Rs 50 each when the rate of interest is high (8 per cent), and sell them again when they are dearer (Rs 200 each when the rate of interest falls (to 2 per cent).
According to Keynes, it is expectations about changes in bond prices or in the current market rate of interest that determine the speculative demand for money. In explaining the speculative demand for money, Keynes had a normal or critical rate of interest (rc) in mind. If the current rate of interest (r) is above the “critical” rate of interest, businessmen expect it to fall and bond price to rise. They will, therefore, buy bonds to sell them in future when their prices rise in order to gain thereby. At such times, the speculative demand for money would fall. Conversely, if the current rate of interest happens to be below the critical rate, businessmen expect it to rise and bond prices to fall. They will, therefore, sell bonds in the present if they have any, and the speculative demand for money would increase.
Thus when r > r0, an investor holds all his liquid assets in bonds, and when r < r0 his entire holdings go into money. But when r = r0, he becomes indifferent to hold bonds or money.
Thus relationship between an individual’s demand for money and the rate of interest is shown in Figure 70.4 where the horizontal axis shows the individual’s demand for money for speculative purposes and the current and critical interest rates on the vertical axis. The figure shows that when r is greater than r0, the asset holder puts all his cash balances in bonds and his demand for money is zero.
This is illustrated by the LM portion of the vertical axis. When r falls below r0, the individual expects more capital losses on bonds as against the interest yield. He, therefore, converts his entire holdings into money, as shown by OW in the figure. This relationship between an individual asset holder’s demand for money and the current rate of interest gives the discontinuous step demand for money curve LMSW.
For the economy as a whole the individual demand curve can be aggregated on this presumption that individual asset-holders differ in their critical rates r0. It is smooth curve which slopes downward from left to right, as shown in Figure 70.5.
Thus the speculative demand for money is a decreasing function of the rate of interest. The higher the rate of interest, the lower the speculative demand for money and the lower the rate of interest, the higher the speculative demand for money. It can be expressed algebraically as Ls = f (r), where Ls is the speculative demand for money and r is the rate of interest.
Geometrically, it is shows in Figure 70.5. The figure shows that at a very high rate of interest rJ2, the speculative demand for money is zero and businessmen invest their cash holdings in bonds because they believe that the interest rate cannot rise further. As the rate of interest falls to say, r8 the speculative demand for money is OS. With a further fall in the interest rate to r6, it rises to OS’. Thus the shape of the Ls curve shows that as the interest rate rises, the speculative demand for money declines; and with the fall in the interest rate, it increases. Thus the Keynesian speculative demand for money function is highly volatile, depending upon the behaviour of interest rates.
Liquidity Trap:
Keynes visualised conditions in which the speculative demand for money would be highly or even totally elastic so that changes in the quantity of money would be fully absorbed into speculative balances. This is the famous Keynesian liquidity trap. In this case, changes in the quantity of money have no effects at all on prices or income. According to Keynes, this is likely to happen when the market interest rate is very low so that yields on bond, equities and other securities will also be low.
At a very low rate of interest, such as r2, the Ls curve becomes perfectly elastic and the speculative demand for money is infinitely elastic. This portion of the Ls curve is known as the liquidity trap. At such a low rate, people prefer to keep money in cash rather than invest in bonds because purchasing bonds will mean a definite loss. People will not buy bonds so long as the interest rate remain at the low level and they will be waiting for the rate of interest to return to the “normal” level and bond prices to fall.
According to Keynes, as the rate of interest approaches zero, the risk of loss in holding bonds becomes greater. “When the price of bonds has been bid up so high that the rate of interest is, say, only 2 per cent or less, a very small decline in the price of bonds will wipe out the yield entirely and a slightly further decline would result in loss of the part of the principal.” Thus the lower the interest rate, the smaller the earnings from bonds. Therefore, the greater the demand for cash holdings. Consequently, the Ls curve will become perfectly elastic.
Further, according to Keynes, “a long-term rate of interest of 2 per cent leaves more to fear than to hope, and offers, at the same time, a running yield which is only sufficient to offset a very small measure of fear.” This makes the Ls curve “virtually absolute in the sense that almost everybody prefers cash to holding a debt which yields so low a rate of interest.”
Prof. Modigliani believes that an infinitely elastic Ls curve is possible in a period of great uncertainty when price reductions are anticipated and the tendency to invest in bonds decreases, or if there prevails “a real scarcity of investment outlets that are profitable at rates of interest higher than the institutional minimum.”
The phenomenon of liquidity trap possesses certain important implications.
First, the monetary authority cannot influence the rate of interest even by following a cheap money policy. An increase in the quantity of money cannot lead to a further decline in the rate of interest in a liquidity-trap situation. Second, the rate of interest cannot fall to zero.
Third, the policy of a general wage cut cannot be efficacious in the face of a perfectly elastic liquidity preference curve, such as Ls in Figure 70.5. No doubt, a policy of general wage cut would lower wages and prices, and thus release money from transactions to speculative purpose, the rate of interest would remain unaffected because people would hold money due to the prevalent uncertainty in the money market. Last, if new money is created, it instantly goes into speculative balances and is put into bank vaults or cash boxes instead of being invested. Thus there is no effect on income. Income can change without any change in the quantity of money. Thus monetary changes have a weak effect on economic activity under conditions of absolute liquidity preference.
The Total Demand for Money:
According to Keynes, money held for transactions and precautionary purposes is primarily a function of the level of income, LT=f (F), and the speculative demand for money is a function of the rate of interest, Ls = f (r). Thus the total demand for money is a function of both income and the interest rate:
LT + LS = f (Y) + f (r)
or L = f (Y) + f (r)
or L=f (Y, r)
Where L represents the total demand for money.
Thus the total demand for money can be derived by the lateral summation of the demand function for transactions and precautionary purposes and the demand function for speculative purposes, as illustrated in Figure 70.6 (A), (B) and (C). Panel (A) of the Figure shows ОТ, the transactions and precautionary demand for money at Y level of income and different rates of interest. Panel (B) shows the speculative demand for money at various rates of interest. It is an inverse function of the rate of interest.
For instance, at r6 rate of interest it is OS and as the rate of interest falls to r the Ls curve becomes perfectly elastic. Panel (C) shows the total demand curve for money L which is a lateral summation of LT and Ls curves: L=LT+LS. For example, at rb rate of interest, the total demand for money is OD which is the sum of transactions and precautionary demand ОТ plus the speculative demand TD, OD=OT+TD. At r2 interest rate, the total demand for money curve also becomes perfectly elastic, showing the position of liquidity trap
G
Friedman’s Theory of the Demand for Money (Theory and Criticisms)
Following the publication of Keynes’s the General Theory of Employment, Interest and Money in 1936 economists discarded the traditional quantity theory of money. But at the University of Chicago “the quantity theory continued to be a central and vigorous part of the oral tradition throughout the 1930s and 1940s.”
At Chicago, Milton Friedman, Henry Simons, Lloyd Mints, Frank Knight and Jacob Viner taught and developed ‘a more subtle and relevant version’ of the quantity theory of money in its theoretical form “in which the quantity theory was connected and integrated with general price theory.” The foremost exponent of the Chicago version of the quantity theory of money who led to the so-called “Monetarist Revolution” is Professor Friedman. He, in his essay “The Quantity Theory of Money—A Restatement” published in 1956′, set down a particular model of quantity theory of money. This is discussed below.
Friedman’s Theory:
In his reformulation of the quantity theory, Friedman asserts that “the quantity theory is in the first instance a theory of the demand for money. It is not a theory of output, or of money income, or of the price level.” The demand for money on the part of ultimate wealth holders is formally identical with that of the demand for a consumption service. He regards the amount of real cash balances (M/P) as a commodity which is demanded because it yields services to the person who holds it. Thus money is an asset or capital good. Hence the demand for money forms part of capital or wealth theory.
2 ) Total wealth
For ultimate wealth holders, the demand for money, in real terms, may be expected to be a function primarily of t
The total wealth is the analogue of the budget constraint. It is the total that must be divided among various forms of assets. In practice, estimates of total wealth are seldom available. Instead, income may serve as an index of wealth. Thus, according to Friedman, income is a surrogate of wealth.
2. The Division of Wealth between Human and Non-Human Forms:
The major source of wealth is the productive capacity of human beings which is human wealth. But the conversion of human wealth into non-human wealth or the reverse is subject to institutional constraints. This can be done by using current earnings to purchase non-human wealth or by using non-human wealth to finance the acquisition of skills. Thus the fraction of total wealth in the form of non-human wealth is an additional important variable. Friedman calls the ratio of non-human to human wealth or the ratio of wealth to income as w.
3. The Expected Rates of Return on Money and Other Assets:
These rates of return are the counterparts of the prices of a commodity and its substitutes and complements in the theory of consumer demand. The nominal rate of return may be zero as it generally is on currency, or negative as it sometimes is on demand deposits, subject to net service charges, or positive as it is on demand deposits on which interest is paid, and generally on time deposits. The nominal rate of return on other assets consists of two parts: first, any currently paid yield or cost, such as interest on bonds, dividends on equities, and costs of storage on physical assets, and second, changes in the prices of these assets which become especially important under conditions of inflation or deflation.
4. Other Variables:
Variables other than income may affect the utility attached to the services of money which determine liquidity proper. Besides liquidity, variables are the tastes and preferences of wealth holders. Another variable is trading in existing capital goods by ultimate wealth holders. These variables also determine the demand function for money along-with other forms of wealth. Such variables are noted as u by Friedman.
Broadly, total wealth includes all sources of income or consumable services. It is capitalised income. By income, Friedman means “permanent income” which is the average expected yield on wealth during its life time.
Wealth can be held in five different forms: money, bonds, equities, physical goods, and human capital. Each form of wealth has a unique characteristic of its own and a different yield.
1. Money is taken in the broadest sense to include currency, demand deposits and time deposits which yield interest on deposits. Thus money is luxury good. It also yields real return in the form of convenience, security, etc. to the holder which is measured in terms of the general price level (P).
2. Bonds are defined as claim to a time stream of payments that are fixed in nominal units
3. Equities are defined as a claim to a time stream of payments that are fixed in real units.
4. Physical goods or non-human goods are inventories of producer and consumer durable.
5. Human capital is the productive capacity of human beings. Thus each form of wealth has a unique characteristic of its own and a different yield either explicitly in the form of interest, dividends, labour income, etc., or implicitly in the form of services of money measured in terms of P, and inventories. The present discounted value of these expected income flows from these five forms of wealth constitutes the current value of wealth which can be expressed as:
W = y/r
Where W is the current value of total wealth, Y is the total flow of expected income from the five forms of wealth, and r is the interest rate. This equation shows that wealth is capitalised income. Friedman in his latest empirical study Monetary Trends in the United States and the United Kingdom (1982) gives the following demand function for money for an individual wealth holder with slightly different notations from his original study of 1956 as:
M/P = f (y, w; Rm, Rb, Re, gp, u)
Where M is the total stock of money demanded; P is the price level; у is the real income; w is the fraction of wealth in non-human form: Rm is the expected nominal rate of return on money; Rb is the expected rate of return on bonds, including expected changes in their prices; Re is the expected nominal rate of return on equities, including expected changes in their prices; gp=(1/P) (dP/dt) is the expected rate of change of prices of goods and hence the expected nominal rate of return on physical assets; and и stands for variables other than income that may affect the utility attached to the services of money.
The demand function for business is roughly similar, although the division of total wealth and human wealth is not very useful since a firm can buy and sell in the market place and hire its human wealth at will. But the other factors are important.
The aggregate demand function for money is the summation of individual demand functions with M and у referring to per capita money holdings and per capita real income respectively, and w to the fraction of aggregate wealth in nonhuman form.
The demand function for money leads to the conclusion that a rise in expected yields on different assets (Rb, Re and gp) reduces the amount of money demanded by a wealth holder, and that an increase in wealth raises the demand for money. The income to which cash balances (M/P) are adjusted is the expected long term level of income rather than current income being received.
Empirical evidence suggests that the income elasticity of demand for money is greater than unity which means that income velocity is falling over the long run. This means that the long run demand for money function is stable and is relatively interest inelastic, as shown in fig. 68.1. where MD is the demand for money curve. If there is change in the interest rate, the long-run demand for money is negligible.
Friedman’s restatement of the quantity theory of money, the supply of money is independent of the demand for money. The supply of money is unstable due to the actions of monetary authorities. On the other hand, the demand for money is stable. It means that money which people want to hold in cash or bank deposits is related in a fixed way to their permanent income.
If the central bank increases the supply of money by purchasing securities, people who sell securities will find their holdings of money have increased in relation to their permanent income. They will, therefore, spend their excess holdings of money partly on assets and partly on consumer goods and services.
This spending will reduce their money balances and at the same time raise the nominal income. On the contrary, a reduction in the money supply by selling securities on the part of the central bank will reduce the holdings of money of the buyers of securities in relation to their permanent income.
They will, therefore, raise their money holdings partly by selling their assets and partly by reducing their consumption expenditure on goods and services. This will tend to reduce nominal income. Thus, on both counts, the demand for money remains stable. According to Friedman, a change in the supply of money causes a proportionate change in the price level or income or in both. Given the demand for money, it is possible to predict the effects of changes in the supply of money on total expenditure and income.
If the economy is operating at less than full employment level, an increase in the supply of money will raise output and employment with a rise in total expenditure. But this is only possible in the short run. Friedman’s quantity theory of money is explained in terms of Figure 68.2. Where income (Y) is measured on the vertical axis and the demand for the supply of H
money are measured on the horizontal axis. MD is the demand for money curve which varies with income. MS is the money supply curve which is perfectly inelastic to changes in income. The two curves intersect at E and determine the equilibrium income OY. If the money supply rises, the MS curve shifts to the right to M1S1. As a result, the money supply is greater than the demand for money which raises total expenditure until new equilibrium is established at E1 between MD and M1S1, curves. The income rises to OY1.
Thus Friedman presents the quantity theory as the theory of the demand for money and the demand for money is assumed to depend on asset prices or relative returns and wealth or income. He shows how a theory of the stable demand for money becomes a theory of prices and output. A discrepancy between the nominal quantity of money demanded and the nominal quantity of money supplied will be evident primarily in attempted spending. As the demand for money changes in response to changes in its determinants, it follows that substantial changes in prices or nominal income are almost invariably the result of changes in the nominal supply of money.
Its Criticisms:
Friedman’s reformulation of the quantity theory of money has evoked much controversy and has led to empirical verification on the part of the Keynesians and the Monetarists. Some of the criticisms levelled against the theory are discussed as under.
1. Very Broad Definition of Money:
Friedman has been criticised for using the broad definition of money which not only includes currency and demand deposits (М1) but also time deposits with commercial banks (M2). This broad definition leads to the obvious conclusion that the interest elasticity of the demand for money is negligible. If the rate of interest increases on time deposits, the demand for them (M2) rises. But the demand for currency and demand deposits (M1) falls.
So the overall effect of the rate of interest will be negligible on the demand for money. But Friedman’s analysis is weak in that he does not make a choice between long-term and short-term interest rates. In fact, if demand deposits (M1) are used a short-term rate is preferable, while a long-term rate is better with time deposits (M2). Such an interest rate structure is bound to influence the demand for money.
2. Money not a Luxury Good:
Friedman regards money as a luxury good because of the inclusion of time deposits in money. This is based on his finding that there is higher trend rate of the money supply than income in the United States. But no such ‘luxury effect’ has been found in the case of England.
3. More Importance to Wealth Variables:
In Friedman’s demand for money function, wealth variables are preferable to income and the operation of wealth and income variables simultaneously does not seem to be justified. As pointed out by Johnson, income is the return on wealth, and wealth is the present value of income. The presence of the rate of interest and one of these variables in the demand for money function would appear to make the other superfluous.
4. Money Supply not Exogenous:
Friedman takes the supply of money to be unstable. The supply of money is varied by the monetary authorities in an exogenous manner in Friedman’s system. But the fact is that in the United States the money supply consists of bank deposits created by changes in bank lending. Bank lending, in turn, is based upon bank reserves which expand and contract with (a) deposits and withdrawals of currency by non-bank financial intermediaries; (b) borrowings by commercial banks from the Federal Reserve System; (c) inflows and outflows of money from and to abroad: and (d) purchase and sale of securities by the Federal Reserve System. The first three items definitely impart an endogenous element to the money supply. Thus the money supply is not exclusively exogenous, as assumed by Friedman. It is mostly endogenous.
5. Ignores the Effect of Other Variables on Money Supply:
Friedman also ignores the effect of prices, output or interest rates on the money supply. But there is considerable empirical evidence that the money supply can be expressed as a function of the above variables.
6. Does not consider Time Factor:
Friedman does not tell about the timing and speed of adjustment or the length of time to which his theory applies.
7. No Positive Correlation between Money Supply and Money GNP:
Money supply and money GNP have been found to be positively correlated in Friedman’s findings. But, according to Kaldor, in Britain the best correlation is to be found between the quarterly variations in the amount of cash held in the form of notes and coins by the public and corresponding variations in personal consumption at market prices, and not between money supply and the GNP.
8. Conclusion:
Despite these criticisms, “Friedman’s application to monetary theory of the basic principle of capital theory—that is the yield on capital, and capital the present value of income—is probably the most important development in monetary theory since Keynes’s General Theory. Its theoretical significance lies in the conceptual integration of wealth and income as influences on behaviour.”
Friedman Vs Keynes:
Friedman’s demand for money function differs from that of Keynes’s in many ways which are discussed as under.
First, Friedman uses a broader definition of money than that of Keynes in order to explain his demand for money function. He treats money as an asset or capital good capable of serving as a temporary abode of purchasing power. It is held for the stream of income or consumable services which it renders. On the other hand, the Keynesian definition of money consists of demand deposits and non-interest bearing debt of the government.
Second, Friedman postulates a demand for money function quite different from that of Keynes. The demand for money on the part of wealth holders is a function of many variables. These are Rm, the yield on money; Rb, the yield on bonds; Re, the yield on securities; gp, the yield on physical assets; and u referring to other variables. In the Keynesian theory, the demand for money as an asset is confined to just bonds where interest rates are the relevant cost of holding money.
Third, there is also the difference between the monetary mechanisms of Keynes and Friedman as to how changes in the quantity of money affect economic activity. According to Keynes, monetary changes affect economic activity indirectly through bond prices and interest rates.
The monetary authorities increase the money supply by purchasing bonds which raises their prices and reduces the yield on them. Lower yield on bonds induces people to put their money elsewhere, such as investment in new productive capital that will increase output and income. On the other hand, in Friedman’s theory monetary disturbances will directly affect prices and production of all types of goods since people will buy or sell any asset held by them. Friedman emphasises that the market interest rates play only a small part of the total spectrum of rates that are relevant.
Fourth, there is the difference between the two approaches with regard to the motives for holding money balances. Keynes divides money balances into “active” and “idle” categories. The former consist of transactions and precautionary motives, and the latter consist of the speculative motive for holding money. On the other hand, Friedman makes no suchdivision of money balances.
According to him, money is held for a variety of different purposes which determine the total volume of assets held such as money, physical assets, total wealth, human wealth, and general preferences, tastes and anticipations.
Fifth, in his analysis, Friedman introduces permanent income and nominal income to explain his theory. Permanent income is the amount a wealth holder can consume while maintaining his wealth intact. Nominal income is measured in the prevailing units of currency. It depends on both prices and quantities of goods traded. Keynes, on the other hand, does not make such a distinction.
I
Patinkin’s monetary model of quantity theory of money.
Introduction:
In 1956 there appeared a monumental work by Don Patinkin which, inter alia, demonstrated the rigid conditions required for the strict proportionality rule of the quantity theory whilst simultaneously launching a severe attack upon the Cambridge analysis.
Patinkin’s main point of contention was that the advocates of the cash balance approach had failed to understand the true nature of the quantity theory.
Their failure was revealed in the dichotomy which they maintained between the goods market and the money market. Far from integrating the two, as had been claimed, Patinkin held that the neo-classical economists had kept the two rigidly apart.
An increase in the stock of money was assumed to generate an increase in the absolute price level but to exercise no real influence upon the market for commodities. One purpose of Patinkin’s analysis was that only by exerting an influence upon the market for commodities, via the real balance effect, could the strict quantity theory be maintained.
Part of Patinkin’s attack revolved round the nature of the demand curve for money, which according to Patinkin, Cambridge School had generally assumed to be a rectangular hyperbola with constant unit elasticity of the demand for money. As a matter of fact, such a demand curve was implicit in the argument that a doubling of the money stock would induce a doubling of the price level.
Patinkin used the ‘real balance effect’ to demonstrate that the demand curve for money could not be of the shape of a rectangular hyperbola (i.e., the elasticity of demand for money cannot be assumed to be unity except in a stationary state), and moreover, such a demand curve would contradict the strict quantity theory assertion which the Cambridge quantity theorists were trying to establish Patinkin’s main point is that cash balance approach ignored the real balance effect and assumed the absence of money illusion under the assumption of ‘homogeneity postulate’ and, therefore, failed to bring about a correct relation between the theory of money and the theory of value.
The homogeneity postulate implies that the demand functions in the real sectors are assumed to be insensitive to the changes in the absolute level of money prices (i.e., with changes in the quantity of money there will be equi-proportional changes in all money prices), which indicates absence of money illusion and the real balance effect. But this is valid only in a pure barter economy, where there are no money holdings and as such the concept of absolute price level has no or little meaning. The money economy in reality, cannot be without money illusion.
Assumptions:
Patinkin has been able to show the validity and the rehabilitation of the classical quantity theory of money through Keynesian tools with the help of and on the basis of certain basic assumptions: for example, it is assumed that an initial equilibrium exists in the economy, that the system is stable, that there are no destabilizing expectations and finally there are no other factors except those which are specially assumed during the analysis. Again, consumption functions remains stable [the ratio of the flow of consumption expenditure on goods to the stock of money (income velocity) must also be stable.
Further, it is assumed that there are no distribution effects, that is, the level and composition of aggregate expenditures are not affected by the way in which the newly injected money is distributed amongst initial recipients and the reaction of creditors and debtors to a changing price level offset each other. It is also assumed that there is no money illusion. Thus, Patinkin has discussed the validity of the quantity theory only under conditions of full employment, as according to him Keynes questioned its validity even under conditions of full employment.
In Patinkin’s approach we reach the same conclusion as in the old quantity theory of money but we employ modern analytical framework of income-expenditure approach or what is called the Keynesian approach. In other words, Patinkin has rehabilitated the truth contained in the old quantity theory of money with modern Keynesian model
Let us be clear that Patinkin first criticised the so called classical dichotomy of money and then rehabilitated it through a different route. The classical dichotomy which treated relative prices as being determined by real demands (tastes) and real supplies (production conditions), and the money price level as depending on the quantity of money in relation to the demand for money.
In such classical dichotomy there is a real theory of relative prices and a monetary theory of the level of prices, and these are treated as being separate problems, so that in analysing what determines relative prices one does not have to introduce money; whereas in analysing what determines the level of money prices, one does not have to introduce the theory of relative prices. The problem here is (before Patinkin has been) how these two theories can be reconciled—once this has been done, the other problem is— whether the reconciliation permits one to arrive at the classical proposition that an increase in the quantity of money will increase all prices in the same proportion, so that relative prices are not dependent on the quantity of money.
This particular property is described technically as neutrality of money. If money is neutral, an increase in the quantity of money will merely raise the level of money prices without changing relative prices and the rate of interest (which is a particular relative price). In Pigou’s terminology, money will be simply a ‘veil’ covering the underlying operations of the real system.
According to Patinkin this contradiction could be removed and classical theory reconstituted by making the demand and supply functions depend on real cash balances as well as relative prices. While this would eliminate the dichotomy, it would preserve the basic features of the classical monetary theory and particularly the invariance of the real equilibrium of the economy (relative prices and the rate of interest) with respect to changes in the quantity of money.
The real balance effect has been one of the most important innovations in thought concerning the quantity theory of money. This is also called ‘Pigou Effect’, because it was developed by him but Don Patinkin criticized the narrow sense in which the term real balance effect was used by Pigou and he used it in a wider sense.
Suppose a person holds certain money balances and price level falls, the result will be an increase in the real value of these balances. The person will have a larger stock of money than previously, in real terms, though not in nominal units. Similarly, if the private sector of the economy, taken as a whole, has money balances larger than its net debts, than a fall in the price level will lead to increased spending and the quantity theory of money to that extent stands modified, the important variable to watch is not M, but M/P, that is, real money balances. The real balance effect and the demand for money substitutes go to constitute important modifications of the quantity theory of money.
Thus, we find that the solution to this problem, as Patinkin develops it, is to introduce the stock of real balances held by individuals as an influence on their demand for goods. The real balance effect, therefore, is an essential element of the mechanism which works to produce equilibrium in the money market. Suppose, for example, that for some reason prices fall below their equilibrium level—this will increase the real wealth of the cash-holders—lead them to spend more money—and that in turn will drive prices back towards equilibrium.
Thus, the real balance effect is the force behind the working of the quantity theory. Similarly if there is a chance to increase in the price level, this will reduce people’s real balances and therefore lead them to rebuild their balances by spending less, this in turn will force prices back down, so that the presence of real balances as an influence on demands ensures the stability of the price level. Thus, the introduction of the real balance effect disposed of classical dichotomy, that is, it makes it impossible to talk about relative prices without introducing money; but it nevertheless preserve the classical proposition that the real equilibrium of the system will not be affected by the amount of money, all that will be affected will be the level of prices.
“Once the real and monetary data of an economy with outside money are specified”, says Patinkin, “the equilibrium value of relative prices, the rate of interest, and the absolute price level are simultaneously determined by all the markets of the economy.”
According to Patinkin, “The dynamic grouping of the absolute price level towards its equilibrium value will—through the real balance effect—react back on the commodity markets and hence the relative prices.” Hence, the integration of monetary and value theory through the explicit introduction of real balances as a determinant of the behaviour and the reconstitution of classical monetary theory, is the main theme and contribution of Patinkin’s monumentally scholarly work—Money, Interest and Prices.
Keynes criticized the old quantity theory of money on two grounds: that velocity of circulation is not a constant of economic behaviour and that the theory was valid only under highly rigid assumptions. Don Patinkin agrees in his approach to the problem that the Keynesia J
analysis and economic variables provide more dependable interrelationships than does the velocity of circulation. In other words, a breakdown of expenditure into the sum of C and I is more useful analytical device than the breakdown into the product of the stock of money and the velocity of circulation.
Patinkin assumes full employment and deals with the above-mentioned criticism of Keynes that even under rigid assumptions the quantity theory is not valid unless certain other conditions are also fulfilled. According to Patinkin, these other conditions mentioned by Keynes (besides, full employment) are that the propensity to hoard [that part of the demand for money which depends upon the rate of interest—M2(r)] should always be zero in equilibrium and that the effective demand (AD) should increase in the same proportion as the quantity of money—this will depend on the shapes of LP, MEC, CF functions.
Don Patinkin has shown that irrespective of the values of the marginal propensities to consume and invest and the existence of a non-zero propensity to hoard; an increase in the quantity of money must ultimately bring about a proportional increase in prices (leaving the interest rate unaffected) once the real balance effects are brought into the picture. Thus, Keynes’ argument that the above conditions must be fulfilled has been proved incorrect by Patinkin
Further, with the help of real balance effect Patinkin shows that the quantity theory will hold good even in the extreme Keynesian case where the initial increase in the quantity of money directly affects only the demand for bonds (M2) and finally Patinkin has shown that a change in the quantity of money does not ultimately affect the rate of interest—even though a change in the rate of interest does affect the amount of money demanded.
Real Balance Effect:
The term ‘real balance effect’ was coined by Patinkin to denote the influence of changes in the real stock of money on consumption expenditure, that is, a change in consumption expenditure as a result of changes in the real value of the stock of money in circulation. This influence was taken into consideration by Pigou also under what we call ‘Pigou Effect’, which Patinkin described as a bad terminological choice. Pigou effect was used in a narrow sense to denote the influence on consumption only, but the term real balance effect, has been made more meaningful and useful by including in it all likely influences of changes in the stock of real balances.
In other words it considers the behavioural effects of changes in the real stock of money. The term has been used by Patinkin in a wider sense so as to include the net wealth, effect, portfolio effect, Cambridge effect, as well as any other effect one might think of. Patinkin used the term real balance effect to include all the aspects of real balances in the first edition of his book. It is in the second edition of his book that Patinkin emphasises the net wealth aspect of real balances though he does not completely exclude other aspects as detailed above.
Unless the term is used in a wider sense so as to include all the aspects of real balances, its use is likely to be misleading and may fail to describe a generalized theory of people’s reactions to changes in the stock of real balances. The use of the term in the wider sense as enunciated above also helps us to resolve the paradox—that income is the main determinant of expenditure on the micro level and wealth is a significant determinant of income on the macro level.
The analysis of the real balance effect listed three motives why people would alter their spending and, therefore, demand for money in response to a change in the aggregate stock of money. First, the demand for money is a function of the level of wealth. The wealthier the people, the more the expenditure on goods; second, they hold money for security as a part of their diversified portfolios; third, just as the demand for every superior good increases with a rise in income, so does the demand for money. Individuals usually desire that their cash balances should bear a given relation to their yearly income.
Therefore, other things being equal—wealth, portfolio structure and income determine the demand for money as also the spending decisions. Hence, corresponding to these three motives of the demand for money, there are three different aspects of the real balance effect—each of which may operate either directly on the demand for commodities or may operate indirectly by stimulating the demand for financial assets (securities etc.), raising their prices, lowering the interest rate, stimulating investments, increasing incomes, resulting in a rise in demand for commodities.
Net Wealth Effect:
Net wealth effect is the first and important aspect of the real balance effect. According to this interpretation, an increase in real balances produces an increase in spending because it changes one’s net wealth holding, which by definition includes currency, net claims of the private domestic sector on foreigners and net claims of the private sector on the government sector. Hence, consumption is a function of net wealth, rising or falling as real balances increase or decrease.
An increase in real balances results in individuals increasing their spending on goods because they are wealthier, or they have come to hold too much money in their portfolios, or because their balances have become too large in relation to their incomes.
Clearly, the direct net wealth aspect has become identified primarily with the term real balance effect. Besides, there is an indirect process also through which changes in real balances affect expenditures—an increase in real balances stimulates initially the demand for financial assets (securities), which in turn, reduces interest rates making investments more attractive, stimulating incomes and expenditures. Some writers simply emphasize the direct net wealth aspect.
They include, G. Ackley, Fellner, Mishan, Collery. These authors primarily associate the term real balance effect with the net wealth aspect, to the exclusion of all others. Other economists point out to the indirect operation of the real balance effect. Harrod and later on Mishan supported the view that there is an indirect effect of real balance phenomenon. Therefore, the real balance effect in its most general sense covers both the direct and indirect methods by which changes in real balances affect consumer spending.
Portfolio Aspect:
James Tobin is the chief exponent of this view, who is supported by Metzler. According to the portfolio aspect of the real balance effect, a decrease in price level causes investor’s portfolios to consist of more money than desired in proportion to the portfolio. Accordingly, they spend more and their effort to restore the actual to the desired amount of money changes the price level until equilibrium is restored. In their attempt to remedy the situation, individuals spend their excess supply of money directly on the physical assets or indirectly in the financial market (for securities etc.).
Equilibrium is restored when prices change (rise or fall) to such an extent that real balances once again come to bear the desired relation to the value of the portfolios. A distinguishing feature of the portfolio aspect is that people increase or decrease their expenditures in order to restore their stock of money to the optimum level with respect to their asset portfolio.
Cambridge Aspect:
This is the third aspect of the real balance effect. It differs from others in that it views the demand for money primarily as a function of income. According to Cambridge aspect, an increase in the stock of real balances increases real balances relative to income. If previously one held cash balances equal to 1/10th of the yearly income; then after an increase in real balances one would, for example, hold cash balances equal to 1/5th of the yearly income. Finding themselves with more than optimal fraction of income in money terms, people begin to spend more.
If they spend for commodities the price level increases in accordance with the direct aspect; if they spend on bonds (securities) the equilibrium will be restored through indirect process or operation. In other words, equilibrium will be restored, when other things being equal, the price level has risen in proportion to the increase in the money supply.
However, let us be clear that spending is influenced by, how wealthy people feel they are their portfolio balance and the relation of cash balances to income. The wealth effect, the portfolio effect and the Cambridge aspect of the real balance effect are all interrelated and it is merely for the sake of convenience that a division amongst the three aspects of the real balance effect is made.
Critical Evaluation:
This is Patinkin’s solution to the problem but it has not been accepted. The basic disagreements centre on whether or not it is necessary to retain this real balance effect in the real analysis. Patinkin’s model may be considered as an elegant refinement of the traditional quantity theory and its value lies in specifying precisely the necessary conditions for the strict proportionality of the quantity theory to hold and in analysing in detail the mechanism by which the change in the stock of money takes effect—the real balance effect.
Although Patinkin’s analysis is said to be the formally incomplete because it fails to provide an explanation of full long run equilibrium, yet the integration of product and monetary markets through the real balance effect represented a significant improvement over earlier treatments. For the first time, the nature of the wealth effect is made explicit. What, however, is not analysed is the manner in which the increase in monetary wealth comes about. A doubling of money balances is simply assumed and the analysis rests entirely on the resultant effects.
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The Patinkin effect fails to take into account the long-run equilibrium effect as has been pointed out by Archibald and Lipsey and conceded by Patinkin in the second edition of his work. They show that Patinkin’s analysis of the real balance effect is inadequate inasmuch as he confines himself to the impact effect of a change in a price and does not work the analysis through to the long-run equilibrium. The result of the debate is that the real balance effect must be considered not as a necessary part of the general equilibrium theory but as a part of the analysis of monetary stability, in that context it performs the functions of ensuring stability of the price level.
What one needs the real balance effect for is to ensure the stability of the price level; one does not need it to determine the real equilibrium of the system; so long as one confines oneself to equilibrium positions. The equilibrium obtained is no doubt a short-term equilibrium only because further changes will be induced for income recipients in future time periods. Moreover, it is very interesting to point out that if the analysis is extended to an infinite number of periods, general long-run equilibrium is found to be perfectly consistent with – a unit elastic demand curve for money—the real balance effect disappears. Therefore, this again raises a thorny question of whether the quantity theory is a theory of short-run or long-run equilibrium or indeed whether it should be considered a theory of equilibrium at all?
Even otherwise, it has been pointed out that if some kind of monetary effect has got to be present, it need not necessarily be a real balance effect as the presence of real balance effect implies that people do not suffer from money illusion—they hold money for what it will buy.
This assumption yields the classical monetary proposition that a doubling of the money supply will lead to a doubling of prices and no change in real equilibrium. But a recent article by Cliff Lloyd has shown that stability of price level can be attained without assuming simply that there is a definite quantity of money which people want to hold. The mere fact that they want to hold money and that the available quantity is fixed will ensure the stability of price level—but it will not produce the neutrality of the money of the classical theory.
Further, G.L.S. Shackle has criticised Patinkin’s analysis. He feels that Keynes analysis took account of money and uncertainties, whereas in Patinkin’ analysis the objective is to understand the functioning of money economy under perfect interest and price certainty. He accepts that once the ‘Pandora Box’ of expectations and interest and price uncertainty is opened on the world of economic analysis, anything may happen and this makes all the difference between two approaches. Patinkin’s treatment is a long-term equilibrium of pure choice, while Keynes treatment is of short-term equilibrium of impure choice.
J.G. Gurley and E.S. Shaw have also criticised the static assumptions of Patinkin and have enumerated and elucidated the conditions to show under which money will not be neutral. They bring back into the analysis, the overall liquidity of the monetary and financial structure and differing liquidity characteristics of different assets,’ which were excluded by the assumptions made in Patinkin’s analysis, in which money is not itself a government debt but is issued by the monetary authority against private debt (inside money as contrasted with the outside money).
They show that money cannot be neutral in a system containing inside and outside money. Outside money is the money which comes from outside the private sector and simply exists. One can think of outside money being gold coins in circulation or paper currency printed by the government. Outside money represents wealth to which there corresponds no debt. Inside money is the money created against private debt. It is typified by the bank deposits created by a private banking system. These writers have shown that if the money supply consists of a combination of inside and outside money, the classical neutrality of money does not hold good as claimed by Patinkin. The main difference between Keynes and Patinkin
approaches is that Keynes assumed the price level given does not assume full employment, whereas Patinkin has tried to establish the validity of the quantity theory by assuming full employment but not the price level. Patinkin discussed the validity of the quantity theory under full employment because Keynes questioned its validity even under conditions of full employment.
Patinkin’s Monetary Model and Neutrality of Money:
The mechanism of Patinkin’s monetary model can be elaborated as follows:
Suppose there are four markets in the economy—goods, labour, bonds and money. In each of these markets there is a demand function, there is a supply function and a statement of the equilibrium condition, namely, a statement that prices, wages and interest rate are such that the amount demanded in the market equals the amount supplied. By virtue of what we call ‘Walras law’, we know that if equilibrium exists in any three of these markets, it must also exist in the fourth.
Considering the markets for finished goods Keynes’ aggregate demand function would comprise of consumption plus investment plus government demand. Following Keynes, we assume that the real amount demanded of finished goods (E) varies directly with the level of national income (K), and inversely, with the rate of interest (r).
Assume further that E also depends directly on the real value of cash balances held by the community M0/P (where Mo is the amount of money in circulation assumed constant, and p is an index of the prices of finished goods). In other words, a decrease in the price level, which increases these real cash balances, is assumed to cause an increase in the aggregate amount of goods demanded and vice versa.
Thus, the real aggregate demand function for goods is shown:
E = Æ’(Y, r, M0/P) …… (i)
Since, there exists full employment, therefore, the supply function of finished goods can be written as:
Y – Y0 …(ii)
where, Y0 is the level of real national product (equal by definition to the level of real national income) corresponding to full employment condition.
The statement of equilibrium in the goods market is then that the goods demanded equal the goods supplied that is:
E = Y …(iii)
In the labour market let us assume that the demand for labour (Nd) is equal to the supply of labour (Ns) at the real wage rate (W/p) Therefore,
Nd = g (W/p) …..(iv)
and Ns = h (W/p) …(v)
Therefore, Nd = Ns …….. (vi)
Thus, the full employment level of real national income Y0 (in the market for finished goods) is directly related to the full employment level of employment No in the labour market.
In the money market, let us assume that the individual is concerned with the real value of cash balances and that he holds or his demand for money is denoted by Md/P, and assume further as Keynes, that this total demand is divided into transactions and precautionary demand varying with the level of income (Y) and speculative demand varying inversely with the rate of interest (r). Thus,
To complete the analysis we must examine the model from the viewpoint of general equilibrium analysis. The above-mentioned nine equations and nine variables (E, Y, p, Nd, Ns w/p, Md, Ms, r) can be reduced to the following three equations and three variables p, w and r and we get the following equations for the initial period:
These are the conditions for equilibrium in the markets for goods, labour market and money market. Further, assume that there exists a price level p0, a wage level w0, and interest rate r0, whose joint existence (at p0, w0, r0), simultaneously satisfies the equilibrium conditions for all the three markets.
In other words, the same set of values—P0, w0, and r0, simultaneously cause:
(a) The formation of an aggregate function showing that the aggregate amount demanded (AD) is equal to the full employment output,
(b) Equalizes the amount demanded of labour with the supply,
(c) Equates the amount demanded for money with the supply of money. Under certain simple assumptions, the equilibrium position described here must be a stable one.
For example, suppose an excess demand for the goods raises the absolute price level and an excess demand for money raises the rate of interest and the labour market is always in equilibrium (because there is very little lag between money, wages and prices). Also assume that there are no destabilising expectations then, the above assumptions made about the forms and slopes of the various demand and supply functions ensure the stability of the system.
The Effect of an Increase in the Quantity of Money:
The equilibrium position as described above prevails during a certain initial period (t). Now, let us assume that there is a new injection of additional quantity of money into circulation which disturbs the initial equilibrium position. We shall see how a new equilibrium position is established (comparative statics) and how does the system converge to the new equilibrium position over time (dynamics).
Suppose the amount of money in circulation increases from M0 to (1 + t) M0, where t is a positive constant. It will be seen that a new equilibrium position will come to exist in which prices and wages have risen in the same proportion as the amount of money and the rate of interest has remained unchanged.
Thus, when the amount of money in circulation was M0, the equilibrium of the economy was attained by p0, w0 and r0. But when the money increases to (I + t) M0 the new equilibrium is attained at the price level (I + t) P0, wage rate (I + t) w0 and interest rate remaining unchanged at ro. Now, when the prices rise in the same proportion as the amount of money, the real value of cash balances is exactly the same as it was in the beginning or L
in the initial period t and the rate of interest remains unchanged.
Hence, the new aggregate demand (function) must be identical with the aggregate demand (function) of the initial period and as the market for goods was in equilibrium in the initial period it must be in equilibrium now. Similarly, if wages and prices rise in the same proportion then the real wage rate remains the same as it was in the initial period and, therefore, the labour market which was in equilibrium at the initial real wage rate (w0) must be in equilibrium now.
The position in money market is slightly different. When the amount of money supplied has increased from M0 to (I + t) M0, it is clear that the demand function (schedule) for money must also change and if the demand schedule for money does not change and remains in its original position, then it is obvious that the equilibrium cannot be attained at the initial rate of interest ro. We know that the demand schedule for money cannot remain in its original position because the nominal amount of money demanded depends upon the price level and if the price level increases, so must also the demand for money.
In other words, in the initial period when the price level is p0 and the rate of interest is r0, people wish to hold M0 (amount of money)—but when the price level has increased from p0 to (I + t) P0, people must wish to hold the larger amount of money; say, (I + t) M0. Hence, when the amount of money in circulation is (I + t) M0, the money market, too, is or becomes in equilibrium at the price level (I + t) p0 because the demand for money has gone up to (I + t) M0 but the rate of interest will remain unchanged at r0 as shown in the Fig. 29.1.
Patinkin has shown that the same kind of equilibrium is possible even when the analysis is dynamic, that is, through different time periods. The typical time paths of the variables would be such as to generate equilibrating forces e.g., the quantity theorists assert that in the initial stages after an increase in the amount of money the rate of interest would decline (from Or0 to Or1 in Fig. 29.1); but that when prices begin to rise due to increase in money supply, the interest rate, too, would rise again to its original level (from Or0 to Or1). In other words, with an increase in the quantity of money the price level no doubt rises continuously towards the new equilibrium level and the same will be true of the wage rates. Under these circumstances, Patinkin’s analysis has shown that the interest rate may decline first but rises once again to its original value.
Equilibrium in the market can be established only at a rate of interest lower than r0, for only by such reduction could individuals be induced to hold additional money available. But prices, on the other hand, have also changed by now. Since the excess supply in money market shows excess demand in the commodity market, this excess demand must result in raising the prices.
This, in turn, reacts back on the money market (through the multiplicative p in the demand for money equation). In particular when the price level has finally doubled, the demand for money must also double, bringing back the original rate of interest r0.
This is the crucial and central point of Patinkin’s analysis. It is true that during the process the system may, at limes, ‘over-compensate’ and the price level and the interest rate may be at some stage rise above their equilibrium values but, it cannot be denied, as claimed by Patinkin that an increase in the quantity of money would raise the price level proportionately at the invariance (un-alterability) of the rate of interest.
The whole process is bound to generate equilibrating forces which will lower the values of various variables to their equilibrium positions. Thus, we see that once we keep in mind Patinkin’s influence of the real cash balances in mind and an increase in the quantity of money will cause an equi-proportionate increase in price level and money wages while leaving the rate of interest unaffected (thereby maintaining the neutrality of money). Although we have reached this conclusion, as does Patinkin, through modern analytical framework of income-expenditure approach or the Keynesian approach but the result that emerges is that of the traditional quantity theory of money.
Neutrality of Money:
The above analysis of Patinkin’s monetary model brings to light very clearly one of the salient features of money or the quantity of money called the ‘neutrality of money’. If money is neutral, an increase in the quantity of money will merely raise the level of money prices without changing the relative prices and the interest rate. Patinkin (with the help of Keynesian framework) arrives at the classical conclusion that relative prices and the rate of interest are independent of the quantity of money.
The significance of his approach lies mainly in establishing the neutrality of money. However, it is this neutrality of money, which has been the main object of attack by Gurley and Shaw in their— ‘Money in a Theory of Finance’—the main purpose of this book is to elaborate conditions under which money cannot be neutral. Gurley and Shaw severely criticized this feature of neutrality of money, for establishing which Patinkin had taken so much pain. Gurley and Shaw distinguished between outside money and inside money to show that the money will not be neutral.
Gurley and Shaw with the help of different mathematical and monetary models show that if the money supply consists of a combination of inside and outside money, the classical neutrality of money does not hold good. A money supply consisting of a combination of inside and outside money implies that changes in the quantity of money will not simply produce a movement up or down in the general price level but will also produce changes in relative prices.
This conclusion is easy enough to understand—whenever the public holds a combination of these kinds of money, a change in the quantity of one of them without a change in the other will change the ratios in which people are obliged to hold assets and owe liabilities. If there is a change in the amount of outside money alone without a change in the amount of inside money, there must be a change in the ratios of the debt that backs the inside money to the outside money, so that a change in the quantity of money involves a change in the real variables of the economic system, as a whole.
For example, suppose there is only outside money in an economic system like gold coins and let us suppose that the quantity of this money (gold coins) is doubled which simultaneously doubles the price level, then we get back to the initial real situation—that is, all the relative prices are the same and the ratio of real balances to everything else is the same as it was before.
Let us suppose, now that there are two kinds of money gold coins and bank deposits—suppose, we double the amount of gold coins but do not change the amount of bank deposits-—then, if we double the price level we can restore the real value of gold coins, but we will reduce the real value of bank deposits and the assets backing them, so that the community cannot get back to the situation, it started from.
Consequently, there must be some change somewhere else in the economic system to reconcile people’s desires for assets and liabilities with the changed amounts that are available. This analysis takes Gurley and Shaw several hundred pages to develop, but the key to it is, the devising of a situation in which the ratios of assets change. The whole purpose of their analysis is to show that money is not neutral. H.G. Johnson also endorses these views expressed by Gurley and Shaw on the non-neutrality of money.
Lloyd Metzler has also repudiated the neutrality of money theory with the help of general equilibrium model through IS and LM curves as shown in Fig. 29.2. In this diagram, we measure income along OY and rate of interest along vertical Or. The initial equilibrium income and the rate of interest corresponding to full employment are simultaneously determined by the intersection of IS0 and LM0 curves at income Y0 and interest r0 respectively.
Now, if the central bank follows a policy of open market operations and begins purchasing securities and bonds, the nominal stock of money will increase; this, in turn, will cause a shift in the LM function from LM1 to LM2 which will determine equilibrium at a lower rate of interest r1 and the income Y1 .There is, now, an excess of income over the full employment income.
This excess of income is shown by Y0 Y1 .This represents the inflationary gap. This will initiate a process of inflation. The real balance effect will now become operative and the LM function will shift to LM1. The IS function will also shift at the same time from IS0 to IS1, on account of a reduction in consumption spending owing to a decline in the value of real balances.
The shifting of the LM curve to LM1 and IS0 curve to IS1 will restore the equilibrium again at full employment income Y0 but the rate of interest has declined from r0 to r2. Hence, the money is not neutral (because the rate of interest cannot be considered to remain unaffected).
Unless a few conditions are fulfilled the money cannot be neutral, for example, there must be an absence of money illusion, wage-price flexibility, absence of distribution effects, absence of government borrowing and open market operations and there is no combination of inside-outside money. According to Patinkin, an individual suffering from money illusion reacts to the change in money prices.
Money illusion constitutes a friction in the economic system and as such it makes it imperative for the monetary authority to create just the right amount of nominal balances if the neutrality of money is to be achieved. Similarly, flexibility of wages and prices is an important condition of the neutrality of money. Rigidity of wages M
and prices will prevent the real balance effect from making itself felt and hence it will become difficult to abolish inflationary pressures.
Money will, as a result, be non-neutral. The distribution effects imply the redistribution of real incomes, goods balances and bond amongst the individuals and institutions following changes in prices and stock of money. For example, a price increase may reduce the demand for consumer goods and increase the demand for money and bonds bringing about a redistribution against high consuming groups and in favour of high saving and lending groups.
Such a redistribution will mean a lowering in the rate of interest in case the quantity of money is doubled. Money, under these circumstances (unless distribution effects are absent), cannot be neutral. Again, the government borrowings and central banking open market operations have non-neutral effects on the system. Money will be non-neutral, as already seen, if there is a combination of inside-outside varieties of money.
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Theories of Demand of Money: Tobin’s Portfolio and Baumol’s Inventory Approaches!
By introducing speculative demand for money, Keynes made a significant departure from the classical theory of money demand which emphasized only the transactions demand for money. However, as seen above, Keynes’ theory of speculative demand for money has been challenged.
The main drawback of Keynes’ speculative demand for money is that it visualises that people hold their assets in either all money or all bonds. This seems quite unrealistic as individuals hold their financial wealth in some combination of both money and bonds.
This gave rise to portfolio approach to demand for money put forward by Tobin, Baumol and Freidman. The portfolio of wealth consists of money, interest-bearing bonds, shares, physical assets etc. Further, while according to Keynes’ theory, demand for money for transaction purposes is insensitive to interest rate, the modem theories of money demand put forward by Baumol and Tobin show that money held for transaction purposes is interest elastic.
We discuss below the Post-Keynesian theories of demand for money put forward by Tobin, Baumol and Friedman.
1. Tobin’s Portfolio Approach to Demand for Money:
An American economist James Tobin, in his important contribution explained that rational behaviour on the part of the individuals is that they should keep a portfolio of assets which consists of both bonds and money. In his analysis he makes a valid assumption that people prefer more wealth to less.
According to him, an investor is faced with a problem of what proportion of his portfolio of financial assets he should keep in the form of money (which earns no interest) and interest-bearing bonds. The portfolio of individuals may also consist of more risky assets such as shares.
According to Tobin, faced with various safe and risky assets, individuals diversify their portfolio by holding a balanced combination of safe and risky assets.
According to Tobin, individual’s behaviour shows risk aversion. That is, they prefer less risk to more risk at a given rate of return. In the Keynes’ analysis an individual holds his wealth in either all money or all bonds depending upon his estimate of the future rate of interest.
But, according to Tobin, individuals are uncertain about future rate of interest. If a wealth holder chooses to hold a greater proportion of risky assets such as bonds in his portfolio, he will be earning a high average return but will bear a higher degree of risk. Tobin argues that a risk averter will not opt for such a portfolio with all risky bonds or a greater proportion of them.
On the other hand, a person who, in his portfolio of wealth, holds only safe and riskless assets such as money (in the form of currency and demand deposits in banks) he will be taking almost zero risk but will also be having no return and as a result there will be no growth of his wealth. Therefore, people generally prefer a mixed diversified portfolio of money, bonds and shares, with each person opting for a little different balance between riskiness and return.
It is important to note that a person will be unwilling to hold all risky assets such as bonds unless he obtains a higher average return on them. In view of the desire of individuals to have both safety and reasonable return, they strike a balance between them and hold a mixed and balanced portfolio consisting of money (which is a safe and riskless asset) and risky assets such as bonds and shares though this balance or mix varies between various individuals depending on their attitude towards risk and hence their trade-off between risk and return.
Tobin‘s Liquidity Preference Function:
Tobin derived his liquidity preference function depicting relationship between rate of interest and demand for money (that is, preference for holding wealth in money form which is a safe and “riskless” asset. He argues that with the increase in the rate of interest (i.e. rate of return on bonds), wealth holders will be generally attracted to hold a greater fraction of their wealth in bonds and thus reduce their holding of money.
That is, at a higher rate of interest, their demand for holding money (i.e., liquidity) will be less and therefore they will hold more bonds in their portfolio. On the other hand, at a lower rate of interest they will hold more money and less bonds in their portfolio.
This means, like the Keynes’s speculative demand for money, in Tobin’s portfolio approach demand function for money as an asset (i.e. his liquidity preference function curve) slopes downwards as is shown in Fig. 19.1, where on the horizontal axis asset demand for money is shown. This downward-sloping liquidity preference function curve shows that the asset demand for money in the portfolio increases as the rate of interest on bonds falls.
In this way Tobin derives the aggregate liquidity preference curve by determining the effects of changes in interest rate on the asset demand for money in the portfolio of individuals. Tobin’s liquidity preference theory has been found to be true by the empirical studies conducted to measure interest elasticity of the demand for money.
As shown by Tobin through his portfolio approach, these empirical studies reveal that aggregate liquidity preference curve is negatively sloped. This means that most of the people in the economy have liquidity preference function similar to the one shown by curve Md in Fig. 19.1.
Tobin's Liquidity Preference CurveEvaluation:
Tobin’s approach has done away with the limitation of Keynes’ theory of liquidity preference for speculative motive, namely, individuals hold their wealth in either all money or all bonds. Thus, Tobin’s approach, according to which individuals simultaneously hold both money and bonds but in different proportion at different rates of interest yields a continuous liquidity preference curve.
Further, Tobin’s analysis of simultaneous holding of money and bonds is not based on the erroneous Keynes’s assumption that interest rate will move only in one direction but on a simple fact that individuals do not know with certainty which way the interest rate will change.
It is worth mentioning that Tobin’s portfolio approach, according to which liquidity preference (i.e. demand for money) is determined by the individual’s attitude towards risk, can be extended to the problem of asset choice when there are several alternative assets, not just two, of money and bonds.
2. Baumol’s Inventory Approach to Transactions Demand for Money:
Instead of Keynes’s speculative demand for money, Baumol concentrated on transactions demand for money and put forward a new approach to explain it. Baumol explains the transaction demand for money from the viewpoint of the inventory control or inventory management similar to the inventory management of goods and materials by business firms.
As businessmen keep inventories of goods and materials to facilitate transactions or exchange in the context of changes in demand for them, Baumol asserts that individuals also hold inventory of money because this facilitates transactions (i.e. purchases) of goods and services.
In view of the cost incurred on holding inventories of goods there is need for keeping optimal inventory of goods to reduce cost. Similarly, individuals have to keep optimum inventory of money for transaction purposes. Individuals also incur cost when they hold inventories of money for transactions purposes.
They incur cost on these inventories as they have to forgone interest which they could have earned if they had kept their wealth in saving deposits or fixed deposits or invested in bonds. This interest income forgone is the cost of holding money for transactions purposes. In this way Baumol and Tobin emphasised that transaction demand for money is not independent of the rate of interest.
It may be noted that by money we mean currency and demand deposits which are quite safe and riskless but carry no interest. On the other hand, bonds yield interest or return but are risky and may involve capital loss if wealth holders invest in them.
However, saving deposits in banks, according to Baumol, are quite free from risk and also yield some interest. Therefore, Baumol asks the question why an individual holds money (i.e. currency and demand deposits) instead of keeping his wealth in saving deposits which are quite safe and earn some interest as well.
According to him, it is for convenience and capability of it being easily used for transactions of goods that people hold money with them in preference to the saving deposits. Unlike Keynes both Baumol and Tobin argue that transactions demand for money depends on the rate of interest.
People hold money for transaction purposes “to bridge the gap between the receipt of income and its spending.” As interest rate on saving deposits goes up people will tend to shift a part of their money holdings to the interest-bearing saving deposits.
Individuals compare the costs and benefits of funds in the form of money with the interest- bearing saving deposits. According to Baumol, the cost which people incur when they hold funds in money is the opportunity cost of these funds, that is, interest income forgone by not putting them in saving deposits.
Baumol’s Analysis of Transactions Demand:
A Baumol analysis the transactions demand for money of an individual who receives income at a specified interval, say every month, and spends it gradually at a steady rate. This is illustrated in Fig. 19.2. It is assumed that individual is paid Rs. 12000 salary cheque on the first day of each month.
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Suppose he gets it cashed (i.e. converted into money) on the very first day and gradually spends it daily throughout the month. (Rs. 400 per day) so that at the end of the month he is left with no money. It can be easily seen that his average money holding in the month will be Rs. = 12000/2 = Rs. 6,000 (before 15th of a month he will be having more than Rs. 6,000 and after 15th day he will have less than Rs. 6,000)
6,000).Stream of Cash Payments and Transactions Demand for MoneyAverage holding of money equal to Rs. 6,000 has been shown by the dotted line. Now, the question arises whether it is the optimal strategy of managing money or what is called optimal cash management. The simple answer is no. This is because the individual is losing interest which he could have earned if he had deposited some funds in interest-bearing saving deposits instead of withdrawing all his salary in cash on the first day.
He can manage his money balances so as to earn some interest income as well. Suppose, instead of withdrawing his entire salary on the first day of a month, he withdraws only half of it i.e. (Rs. 6,000 in cash and deposits the remaining amount of Rs. 6,000 in saving account which gives him interest of 5 per cent, his expenditure per day remaining constant at Rs. 400.
This is illustrated in Fig. 19.3. It will be seen that his money holdings of Rs. 6,000 will be reduced to zero at the end of the 15th day of each month. Now, he can withdraw Rs. 6,000 on the morning of 16th of each month and then spends it gradually, at a steady rate of 400 per day for the next 15 days of a month. This is a better method of managing funds as he will be earning interest on Rs. 6,000 for 15 days in each month. Average money holdings in this money management scheme is Rs. 6000/2 = 3000
Transactions Demand for Money and Stream of Cash PaymentsLikewise, the individual may decide to withdraw Rs. 4,000 (i.e., 1/3rd of his salary) on the first day of each month and deposits Rs. 8,000 in the saving deposits. His Rs. 4,000 will be reduced to zero, as he spends his money on transactions, (that is, buying of goods and services) at the end of the 10th day and on the morning of 11th of each month he again withdraws Rs. 4,000 to spend on goods and services till the end of the 20th day and on 21st day of the month he again withdraws Rs. 4,000 to spend steadily till the end of the month. In this scheme on an average he will be holding Rs. 4000/2 = 2000 and will be investing remaining funds in saving deposits and earn interest on them. Thus, in this scheme he will be earning more interest income.
Now, which scheme will he decide to adopt? It may be noted that investing in saving deposits and then withdrawing cash from it to meet the transactions demand involves cost also. Cost on brokerage fee is incurred when one invests in interest-bearing bonds and sells them.
Even in case of saving deposits, the asset which we are taking for illustration, one has to spend on transportation costs for making extra trips to the bank for withdrawing money from the Savings Account. Besides, one has to spend time in the waiting line in the bank to withdraw cash each time from the saving deposits.
Thus, the greater the number of times an individual makes trips to the bank for withdrawing money, the greater the broker’s fee he will incur. If he withdraws more cash, he will be avoiding some costs on account of brokerage fee.
Thus, individual faces a trade-off problem-, the greater the amount of pay cheque he withdraws in cash, less the cost on account of broker’s fee but the greater the opportunity cost of forgoing interest income. The problem is therefore to determine an optimum amount of money to hold. Baumol has shown that optimal amount of money holding is determined by minimising the cost of interest income forgone and broker’s fee. Let us elaborate it further.
Let the size of the pay cheque (i.e. salary) be denoted by Y, the average amount of the cash he withdraws each time the individual goes to the bank by C, the number of times he goes to the bank to withdraw cash by T, broker’s fee which he has to bear each time he makes a trip to the bank by b. In the first scheme of money management when he gets his whole pay-cheque cashed on the first day of every month he incurs broker’s fee only once since he makes only a single trip to the bank.
Thus T in our first case is equal to one T = Y/C = 12000/12000 = 1 because in this case C = Y. In the second, case, T = 12000/6000 =2 and in the third case T = 12000/4000 =3.
Interest income lost by holding money is the average amount of money holding multiplied by the interest rate. As seen above, average money held is one half of cash withdrawn each time (i.e., C/2).
Thus, interest income lost in the first case is rC/2 = 5/100 x 1200/2 = Rs. 300, in the second case interest lost =r.C/2 = 5/100 x 6000/2 = 150 and m the third case it is 5/100 x 4000/2 = 100.
Thus the total cost incurred on broker’s fee and interest income forgone is given by
Total Cost =bT + r.C/2
Where b stands for broker’s fee
As seen above, T = Y/C
Therefore, Total Cost = Y/Cb + r.C/2
Baumol has shown that average amount of cash withdrawal which minimises cost is given by
C = √2bY/r
This means that average amount of cash withdrawal which minimise cost is the square root of the two times broker’s fee multiplied by the size of individual’s income (Y) and divided by the interest rate. This is generally referred to as Square Root Rule.
For this rule, it follows that a higher broker’s fee will raise the money holdings as it will discourage the individuals to make more trips to the bank. On the other hand, a higher interest rate will induce them to reduce their money holdings for transaction purposes as they will be induced to keep more funds in saving deposits to earn higher interest income. That is, at a higher rate of interest transactions demand for money holdings will decline.
Keynes thought that transactions demand for money was independent of rate of interest. According to him, transactions demand for money depends on the level of income. However, Baumol and Tobin have shown that transactions demand for money is sensitive to rate of interest.
As explained above, interest represents the opportunity cost of holding money instead of bonds, saving and fixed deposits. The higher the rate of interest, the greater the opportunity cost of holding money (i.e. the greater the interest income forgone for holding money for transactions).
Therefore, at a higher rate of interest people will try to economise the use of money and will demand less money for transactions. At a lower interest rate on bonds, saving and fixed deposits, the opportunity cost of holding money will be less which will prompt people to hold more money for transactions.
Therefore, according to Baumol and Tobin, transactions demand curve for money slopes downward as shown in Fig. 19.4. At higher interest rates, bonds, savings and fixed deposits are more attractive relative to money holding for transactions.
Therefore, at higher interest rates people tend to hold less money for transaction purposes. On the other hand, when the rates of interest are low, opportunity cost of holding money will be less and, as a consequence, people will hold more money for transactions. Therefore, the curve of transaction demand for money slopes downward.
downward.Transaction Demand for Money: Baumoltobin ApproachIt will be observed from the square root rule given above that transactions demand for money varies directly with the income (Y) of the individuals. Therefore, the higher the level of income, the greater the transactions demand for money at a given rate of interest.
In Fig. 19.4. the three transactions demand curves for money Md, Md‘ and Md“, for three different income levels, Y1, Y2, Y3 are shown. It will be known from the square root rule that optimum money holding for transactions will increase less than proportionately to the increase in income. Thus, transactions demand for money, according to Baumol and Tobin, is function of both rate of interest and the level of income.
Mtd = f(r, Y)
Where Mtd stands for transactions demand for money, r for rate of interest and Y for the level of income.
3. Friedman’s Theory of Demand for Money:
A noted monetarist economist Friedman put forward demand for money function which plays an important role in his restatement of the quantity theory of money and prices.
Friedman believes that money demand function is most important stable function of macroeconomics. He treats money as one type of asset in which wealth holders can keep a part of their wealth. Business firms view money as a capital good or a factor of production which they combine with the services of other productive assets or labour to produce goods and services.
Thus, according to Friedman, individuals hold money for the services it provides to them. It may be noted that the service rendered by money is that it serves as a general purchasing power so that it can be conveniently used for buying goods and services.
His approach to demand for money does not consider any motives for holding money, nor does it distinguishes between speculative and transactions demand for money. Friedman considers the demand for money merely as an application of a general theory of demand for capital assets.
Like other capital assets, money also yields return and provides services. He analyses the various factors that determine the demand for money and from this analysis derives demand for money function. Note that the value of goods and services which money can buy represents the real yield on money. Obviously, this real yield of money in terms of goods and services which it can purchase will depend on the price level of goods and services.
Besides money, bonds are another type of asset in which people can hold their wealth. Bonds are securities P
money and prices.
Friedman believes that money demand function is most important stable function of macroeconomics. He treats money as one type of asset in which wealth holders can keep a part of their wealth. Business firms view money as a capital good or a factor of production which they combine with the services of other productive assets or labour to produce goods and services.
Thus, according to Friedman, individuals hold money for the services it provides to them. It may be noted that the service rendered by money is that it serves as a general purchasing power so that it can be conveniently used for buying goods and services.
His approach to demand for money does not consider any motives for holding money, nor does it distinguishes between speculative and transactions demand for money. Friedman considers the demand for money merely as an application of a general theory of demand for capital assets.
Like other capital assets, money also yields return and provides services. He analyses the various factors that determine the demand for money and from this analysis derives demand for money function. Note that the value of goods and services which money can buy represents the real yield on money. Obviously, this real yield of money in terms of goods and services which it can purchase will depend on the price level of goods and services.
Besides money, bonds are another type of asset in which people can hold their wealth. Bonds are securities which yield a stream of interest income, fixed in nominal terms. Yield on bond is the coupon rate of interest and also anticipated capital gain or loss due to expected changes in the market rate of interest.
Equities or Shares are another form of asset in which wealth can be held. The yield from equity is determined by the dividend rate, expected capital gain or loss and expected changes in the price level. The fourth form in which people can hold their wealth is the stock of producer and durable consumer commodities.
These commodities also yield a stream of income but in kind rather than in money. Thus, the basic yield from commodities is implicit one. However, Friedman also considers an explicit yield from commodities in the form of expected rate of change in their price per unit of time.
Friedman’s nominal demand function (Md) for money can be written as
Md=f (W, h, rm, rb, re, P, ∆P/P, U)
As demand for real money balances is nominal demand for money divided by the price level, demand for real money balances can be written as
Md/P = f(W, h, rm, rb, re, P, ∆P/P, U)
Where Md stands for nominal demand for money and Md/P for demand for real money balances, W stands for wealth of the individuals, h for the proportion of human wealth to the total wealth held by the individuals, rm for rate of return or interest on money, rb for rate of interest on bonds, re for rate of return on equities, P for the price level, ∆P/P for the change in price level {i.e. rate of inflation), and U for the institutional factors.
1. Wealth (W):
The major factor determining the demand for money is the wealth of the individual (W) In wealth Friedman includes not only non-human wealth such as bonds, shares, money which yield various rates of return but also human wealth or human capital. By human wealth Friedman means the value of an individual’s present and future earnings.
Whereas non-human wealth can be easily converted into money, that is, can be made liquid. Such substitution of human wealth is not easily possible. Thus human wealth represents illiquid component of wealth and, therefore, the proportion of human wealth to the non-human wealth has been included in the demand for money function as an independent variable.
Individual’s demand for money directly depends on his total wealth. Indeed, the total wealth of an individual represents an upper limit of holding money by an individual and is similar to the budget constraint of the consumer in the theory of demand.
The greater the wealth of an individual, the more money he will demand for transactions and other purposes. As a country, becomes richer, its demand for money for transaction and other purposes will increase.
Since as compared to non- human wealth, human wealth is much less liquid, Friedman has argued that as the proportion of human wealth in the total wealth increases, there will be a greater demand for money to make up for the illiquidity of human wealth.
2. Rates of Interest or Return (rm, rb, re):
Friedman considers three rates of interest, namely, rb, re and which determine the demand for money, rm is the own rate of interest on money. Note that money kept in the form of currency and demand deposits does not earn any interest.
But money held as saving deposits and fixed deposits earns certain rates of interest and it is this rate of interest which is designated by rm in the money demand function. Given the other rates of interest or return, the higher the own rate of interest, the greater the demand for money.
In deciding how large a part of his wealth to hold in the form of money the individual will compare the rate of interest on money with rates of interest (or return) on bonds and other assets. As mentioned earlier, the opportunity cost of holding money is the interest or return given up by not holding these other forms of assets.
As rates of return on bond (rb) and equities (re) rise, the opportunity cost of holding money will increase which will reduce the demand for money holdings. Thus, the demand for money is negatively related to the rate of interest (or return) on bonds, equities and other such non-money assets.
3. Price Level (P):
Price level also determines the demand for money balances. A higher price level means people will require a larger nominal money balances in order to do the same amount of transactions, that is, to purchase the same amount of goods and services.
If income (Y) is used as proxy for wealth (W) which, as stated above, is the most important determinant of demand for money, then nominal income is given by Y.P which becomes a crucial determinant of demand for money.
Here Y stands for real income (i.e. in terms of goods and services) and P for price level. As the price level goes up, the demand for money will rise and, on the other hand, if price level falls, the demand for money will decline. As a matter of fact, people adjust the nominal money balances (M) to achieve their desired level of real money balances (M/P).
4. The Expected Rate of Inflation (∆P/P):
If people expect a higher rate of inflation, they will reduce their demand for money holdings. This is because inflation reduces the value of their money balances in terms of its power to purchase goods and services.
If the rate of inflation exceeds the nominal rate of interest, there will be negative rate of return on money. Therefore, when people expect a higher rate of inflation they will tend to convert their money holdings into goods or other assets which are not affected by inflation.
On the other hand, if people expect a fall in the price level, their demand for money holdings will increase.
5. Institutional Factors (U):
Institutional factors such as mode of wage payments and bill payments also affect the demand for money. Several other factors which influence the overall economic environment affect the demand for money. For example, if recession or war is anticipated, the demand for money balances will increase.
Besides, instability in capital markets, which erodes the confidence of the people in making profits from investment in bonds and equity shares will also raise the demand for money. Even political instability in the country influences the demand for money. To account for these institutional factors Friedman includes the variable U in his demand for money function.
Simplifying Friedman’s Demand for Money Function:
A major problem faced in using Friedman’s demand for money function has been that due to the non-existence of reliable data about the value of wealth (W), it is difficult to estimate the demand for money. To overcome this difficulty Friedman suggested that since the present value of wealth or W = YP/r (where Yp is the permanent income and r is the rate of interest on money.), permanent income Yp can be used as a proxy variable for wealth.
Incorporating this in Friedman’s demand for money function we have:
Md = (Yp,h,rm,rb,re ∆P/P,U)
If, we assume that no price change is anticipated and institutional factors such as h and U remain fixed in the short run and also all the three rates of interest return are clubbed into one, Friedman’s demand for money function is simplified to
Md = f(Ypr)
