Read this article to learn about the demand for money: the classical and the Keynesian approach towards money:

The demand for money arises from two important functions of money. The first is that money acts as a medium of exchange and the second is that it is a store of value. Thus individuals and businesses wish to hold money partly in cash and partly in the form of assets.

Deeper definition. GDP is the most important way to take a country’s economic temperature. It totals the monetary value of all goods and services produced in a given time period, less the value. Equation (ix) shows that the demand for real money balances, depends on: (i) Level of real income: demand for money depends on the level of income (real income) because people hold money to purchase goods and services. Higher is the level of income, greater will be the demand for real balances. It is also known as transaction demand for money. Define Real economy. Real economy synonyms, Real economy pronunciation, Real economy translation, English dictionary definition of Real economy. The social science that deals with the production, distribution, and consumption of goods and services and with the theory and management of economies.

Image Courtesy : yourmoney.com/IMG/495/248495/stacked-money.png

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 rates, people prefer to keep their assets 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:

Real Money Balances Definition Economics

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”.

ADVERTISEMENTS:

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 equation becomes

Md = PT

Current Account Balance Economics Definition

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.

Money Definition Economics Quizlet

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.

ADVERTISEMENTS:

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:

ADVERTISEMENTS:

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 transacti

Real Money Balances Definition Economics