Keynesian version on money demand

Keynesian version / Theory on money demand

Definition of money demand

According to J.M. Keynes, money performs both functions of medium of exchange and store in value. Under the medium of exchange, M^d (where M^d= money demand) is for transaction of various goods and services. Similarly under store in value, M^d is for securing purchasing power in the market, to be wealthy in the society, to take precaution in the future rainy days and further income generation by investing it on various financial assets that can easily be converted into cash at any time.

Hence, money is demanded by people with three different motives like:

          a.     Transaction motive (M^dt)… for goods and services

          b.     Precautionary motive (M^dp)

          c.      Speculative motive (M^ds)… for bills and bonds

So, the total money demand (M^dT) = (M^dt + M^dp + M^ds)

a. Transaction money demand (M^dt)

For consumers it depends upon size of income accumulation of wealth, frequency of receiving income in a given period of time, spending habit of people, social custom and tradition, taste and preference of cash holding etc.

Similarly, by business firms, it depends upon nature of business, scale of business, level of investment, gestation period (time period between input and output or return on investment), condition of money market, interest rate, etc. However, according to Keynes M^dt is the direct and functional relationship with the level of income and interest rate.

i. Relationship between transaction money demand (M^dt) and size of income

According to Keynes, M^dt is a positive, linear and proportional function of the size of income that can be shown as;

M^dt = k(y)     Where, M^dt increases by increasing the value of k with constant y and also increases by increasing the size of y with constant value of k as shown in given figure.

 ii. Relationship between M^dt and interest rate

According to Keynes, M^dt is generally interest inelastic at lower interest rate. But it will be negatively affected with higher interest rate with the given size of income as shown in given figure:

b. Precautionary money demand (M^dp)

Precautionary money demand is associated with store in value function of money which is for unexpected and expected future expenses. By consumers, it depends upon sudden accident, future illness, future unemployment, retirement, purchase of land, house, vehicle, computer, mobiles, etc. Similarly, by business firms, it depends upon opportunity for borrowing cash, condition of money market, interest rate, etc. For unexpected needs to spend in business and to come over unfavorable market situation.

The M^dp depends upon the size of income, availability of borrowing cash, condition of money market, opportunity cost of holding money, desire of getting physical assets and interest rate.

However, the size of M^dp is the positive, linear and proportional function of the size of income. But it is interest inelastic in the beginning at lower interest rate and negatively affected by the higher interest rate like the transaction money demand as shown in the given figures of M^dt.

c. Speculative money demand (M^ds)

Speculative money demand is for further income generation by investing it on various income earning financial assets specially on government bills/bonds. And it depends upon given interest rate (r) and expected interest rate (r^e). Where,

M^ds = - f (r) and

M^ds = f (r^e)

i.e.

M^ds↑ = f (r↓, r^e↑)

it happens due to the strong desires of speculators for making more profit as much as possible and the speculators hold their speculative wealth either in cash or bonds but not both at a time. So, at very lower interest rate, the size of speculative money demand is perfectly elastic as the market price of bills and bonds becomes maximum at very lower interest rate.

i.e. r↓ => P_b/b↑ => M^ds↑

Which is known as “Liquidity Trap” in Keynesian term.

It can be shown with the help of given following figure

The figure shows that there is an inverse relationship between an interest rate and speculative money demand which is perfect elastic at very lower interest rate. But expected interest rate is only the adaptive observation.

Therefore, the total money demand is the sum of transaction, precautionary and speculative money demand, which is affected by the size of income and interest rate.

i.e.

↑M^dT = M^dt + M^dp + M^ds = k↑(y↑) + (r↓, r^e↑)

M^dT = M^dtp + M^ds = k↑(y↑) + (r↓, r^e↑)