Money Demand and its determinants in Nepal

1.1 Introduction

According to Keynesian money demand theory considers money as a store in value in addition to a medium of exchange. The store in value function of money signifies that money is an asset in which a person can hold wealth i.e. money is a part of wealth. Keynes combined all assets that were alternatives to money into one category, which he terms ‘bond’. According to him, people either hold money in cash or purchase bonds. Selling or purchasing of bonds depends on the market rate of interest. Thus Keynes introduced a new demand function in which demand for money depends on the market rate of interest. This is popularly known as speculative demand for money. On the other hand, he also believes classical money demand function and he says that people hold money for three motives. They are:  

1. Transaction motive
2. Precautionary motive
3. Speculative motive

1. Transaction demand for money

The first motive Keynes considered was transaction motive. According to this motive, money is a medium of exchange and individuals hold money for the use in the transaction of goods and services. The amount of money held for transactions would very positively with the volume of transactions in which the individual engaged. Income was assumed to be a good measure of this volume of transaction and thus transaction demand for money is positively related to the level of income. Symbolically, transaction demand for money is written as;

M^dt = f(Y)…………. (i) and f’ > 0

Where, M^dt = transaction demand for money and Y = level of income.

Equation (i) clearly shows that transaction demand for money is an increasing function of income in the Keynesian system. Graphically, it is shown in the figure below;

Figure 1.1: Keynesian transaction demand for money and income

Figure 1.1 shows an upward sloping transaction demand for money. The meaning of upward sloping transaction demand for money curve is that there is a positive relationship between income and transaction demand for money. It implies that transaction demand for money increases with the increase in income and decreases with the decrease in income.

Some of the key determinants of demand for money specified by Friedman is: 
1. Total wealth, 
2. the division of wealth between human and non-human forms, 
3. The expected rates of return on money and other assets and 
4. Other variables.

The ultimate wealth-holders are households. To them, money appears as a durable consumer good. As such the standard theory of demand for consumer goods can be applied to the demand for money. Also, this demand will be a demand for a quantity of real (and not “Merely nominal) money as the wealth-holders are basically interested a certain command over real goods and services through money and not in the nominal amount of it (money) per se.

Money demand and its determinants in Nepal

Major determinants of money demand are stated below:

1. Total wealth:

This is the analogue of the budget constraint in the usual theory of consumer choice. It is the total that must be divided among various forms of assets. In practice, estimates of total wealth are rarely available, more so when the total wealth is defined to include not merely non-human or physical wealth but also human wealth, that is, the present value of the expected flow of labor income. So income is generally used as a surrogate for wealth. Income, as we know, includes both property income and labor income.

But to serve as a good proxy for wealth, a longer-term concept of income, like Friedman’s concept of ‘permanent income’, should be used in place of the current income. The emphasis on income as a surrogate for wealth, rather than as a measure of the ‘work’ to be done by money, has been claimed by Friedman as the basic conceptual difference between his formulation of the demand for money and the earlier formulations, both neoclassical and Keynesian, concerned with the transactions approach to the demand for money.   

2. The division of wealth between human and non-human forms:

Since total wealth is assumed to include human wealth and institu­tional constraints limit narrowly the conversion of human into non-human wealth or the reverse, Friedman hypothesizes the fraction of total wealth that is in the form of non-human wealth to be an additional important variable. In particular, he hypothesizes the demand for money to be a declining function of the aforesaid fraction, as it is much easier to sell or purchase non-human than human wealth.

3. The expected rates of return on money and other assets:

This is the analogue of the prices of a commodity and its substitutes and complements in the theory of consumer demand. The nominal rate of return on money may be zero as on currency or positive as it is on savings deposits, a large part of which is counted as demand deposits, or even negative, if current-account deposits are subject to net service charges. 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 storage costs on physical assets, and second, expected changes in their nominal prices.

It is through the second part (of expected capital gains or losses) that Keynes had introduced his speculative demand for money. Keynes, however, had considered only bonds as the competing non-money asset. Or, more correctly speaking, he had treated bonds as representing all long-term financial assets. Thus interpreted, the really novel and important feature of Friedman’s formulation is the extension of the margin of substitution for money to stocks of (durable) goods. Obviously, for them the expected rate of change of prices (adjusted for storage costs) gives the appropriate rate of return, and this becomes especially important under conditions of inflation or deflation:

4. Other variables:

Besides the above, there may be other variables that affect the utility attached to the services of money relative to those rendered by other assets, and so should be included in the demand function for money. One such variable suggested by Friedman is ‘the degree of economic stability expected to prevail in the future’.

According to him, wealth-holders are likely to attach considerably more value to liquidity when they expect economic conditions to be unstable than when they expect them to be highly stable. However, it is difficult to express this variable quantitatively.

Friedman’s theory of the demand function for money for an individual wealth-holder is summed up symbolically below:

(M/p)d =f(y,w;rm,rb,repe;u)

where M, P, and y have the same meaning as in the foregoing except that they relate to a single wealth-holder; w is the fraction of wealth in a non-human form (or, alternatively, the fraction of income derived from the property); rm is the expected rate of return on money; rb is the rate of return on fixed-value securities, including expected changes in their prices; re is the expected rate of return on equities, including expected changes in their price; pe is the expected rate of change in prices of goods and hence the expected rate of return on real assets (unadjusted for storage costs); and u is a symbol for whatever variables other than income that may affect the utility attached to the services of money.

Equation (11.5) can be regarded as giving the aggregate demand function for money, with, M, y, and w referring to aggregate magnitudes if we are willing to assume that the amount of money demanded depends merely on the aggregate or average value of y and w and not their distribution among households (and firms). The assumption is commonly made in deriving almost all macro relations from their micro counterparts.