Demand for Money and Keynes’s Liquidity Preference Theory of Interest

INTRODUCTION

• Demand for money is a key macroeconomic issue because it influences interest rates, price levels, and national income in the economy.

• Classical economists viewed money mainly as a medium of exchange, with people holding it primarily for transaction purposes to purchase goods and services.

• Keynes expanded this view by emphasising money as a store of value and introduced the speculative motive, where people hold money to benefit from future changes in interest rates or bond prices.

• People demand real money balances, not just nominal holdings, meaning they care about purchasing power rather than the number of currency notes or deposits.

• If nominal money increases in proportion to rising prices, real balances remain unchanged; ignoring this effect is known as money illusion.

• The demand for money has been widely debated because of its crucial role in determining prices, interest rates, and income levels.

• Major theoretical approaches include Fisher’s transactions approach, Cambridge cash-balance approach, Keynes’s liquidity preference theory, and modern contributions by Baumol, Tobin, and Friedman.

FISHER’S TRANSACTIONS APPROACH TO DEMAND FOR MONEY

• Fisher’s theory of demand for money emphasises money’s role as a medium of exchange used to buy goods, services, and assets in all economic transactions.

• The total value of transactions in a period equals the number of transactions multiplied by the average price level, expressed as PT.

• The value of money used in transactions equals the money supply multiplied by its velocity of circulation (V), the average number of times a unit of money is used.

• Fisher’s equation of exchange is MV = PT, where M is money supply, V is velocity, P is average price level, and T is total transactions.

• Fisher treated money supply as fixed by the central bank and considered transactions volume determined by national income under full employment.

• A key assumption is that velocity is constant in the short run, as it depends on institutional and technological factors that change slowly.

• With these assumptions, the equation becomes a theory of money demand, showing that money required for transactions is proportional to price level and transaction volume.

• In equilibrium, money supply equals money demand, implying Md = PT / V, meaning demand for money depends on prices, transaction levels, and velocity.

Thus, according to Fisher’s transactions approach, demand for money depends on the following three factors:

1. The number of transactions (T)
2. The average price of transactions (P)
3. The transaction velocity of circulation of money

• Fisher’s transactions approach is criticised for presenting a mechanical relationship between money demand (Md) and total transaction value (PT), treating money demand as a technical requirement rather than a behavioural choice.

• It assumes money is needed solely to perform transaction “work,” ignoring motives, preferences, and expectations that influence actual money holding behaviour.

• A major empirical limitation is that the approach includes transactions in both current goods and capital assets such as shares, securities, and land, whose values fluctuate frequently.

• Because capital asset prices vary widely, the assumption that total transactions (T) remain constant under full employment becomes unrealistic.

• Another difficulty is defining a general price level that includes both current goods and services and diverse capital assets, making measurement and analysis problematic.

The Cambridge Cash-Balance Theory of Demand for Money

• The Cambridge cash-balance theory, developed by Marshall and Pigou, emphasises money as a store of value rather than merely a medium of exchange as in Fisher’s approach.

• It focuses on individuals holding money as purchasing power between receiving income and making future expenditures.

• Cambridge economists analysed factors influencing demand for cash balances but assumed they remain constant or proportional to income, making money demand mainly a function of nominal income.

• The demand for money is expressed as Md = kPY, where k is the proportion of nominal income people wish to hold as cash, P is price level, and Y is real income.

• This formulation makes money demand a behavioural function of income, unlike Fisher’s mechanical transactions approach.

• Other factors such as interest rates, wealth, and expectations affect money demand indirectly by influencing k, though they were not formally incorporated.

• Keynes later improved the theory by explicitly including interest rates and expectations in money demand analysis.

• The Cambridge function implies unit income elasticity and unit price elasticity of demand for money, meaning demand changes proportionately with income and price level.