Monetary Notes Topic3

II.
Keynes Liquidity Preference Theory

Keynes believed there were 3 motives to holding money:
Transactions motive
Individuals are assumed to hold money because it is a medium of exchange that can be used
to carry out everyday transactions. The transactions demand for money is positively related to
real incomes and inflation. As an individual's income rises or as prices in the shops increase,
he will have to hold more cash to carry out his everyday transactions. Transaction costs can
also be an opportunity cost such as the time it takes to go to a bank to withdraw money from
a savings account.
Precautionary demand
People hold money as a cushion against an unexpected expenses e.g car repair,
hospitalization. Demand for money is positively correlated with real incomes and inflation.
The benefit of holding money under the precautionary motive is being able to maximize
utility by making all the transactions you can afford and are willing to make. Money
shortages result in the lost opportunity to spend. It may be cab fare in a heavy rain or a one-
time only sale.
Speculative demand for money

Money is also a way for people to store wealth. Keynes assumed that people stored wealth
either in money or bonds. When interest rates are high, rate would then be expected to fall
and bond prices would be expected to rise. So bonds are more attractive than money when
interest rates are high. When interest rates are low, they then would be expected to rise in the
future and thus bond prices would be expected to fall. So money is more attractive than bonds
when interest rates are low. So under the speculative motive, money demand is negatively
related to the interest rate.
Putting the 3 motives together

Keynes also modelled money demand as the demand for the real quantity of money (real
balances) or M/P. In other words, if prices double, you must hold twice the amount of M to
buy the same amount of stuff, but your real balances stay the same. So people chose a certain
amount of real balances based on the interest rate, and income:
d
M
= f (i, Y)
P
This is known as the liquidity preference
The importance of interest rates in the Keynesian approach is the big difference between
Keynes and Fisher. With this difference also come different implications about the behaviour
of velocity. Consider the two equations:
MV = PY
d
M
= f(i, Y)
P
Thus M = PY/V in the first equation. Substituting in the second equation:
Y
Y/V = f (i, Y) or V =
f (i , Y )
This means that under Keynes' theory, velocity fluctuates with the interest rate. Since interest
rates fluctuate quite a bit, then velocity must too. In fact, velocity and interest rates will move
in the same direction. Both are procyclical, rising with expansions and falling during
recessions.
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The demand for money and the rate of interest
There is an inverse relationship between the rate of interest and the speculative demand for
money. The total demand for money is obtained by summating the transactions,
precautionary and speculative demands. Represented graphically, it is sometimes called the
liquidity preference curve and is inversely related to the rate of interest.
Money demand and increases in real GDP

Consider a period of sustained economic growth in the economy. Rising real incomes and
increasing numbers of people employed will increase the demand for money at each rate of
interest. Therefore higher real national income causes an outward shift in the demand for
money. This is shown in the diagram below
Financial innovation and the demand for money

The pace of change in financial markets is rapid and this affects our demand for money
balances in order to finance our purchases. Most people can finance their purchases using
debit cards and credit cards rather than carrying around large amounts of cash. Financial
innovation has reduced the demand for cash balances at each rate of interest-represented by
an inward shift in the money demand curve.
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III Baumol-Tobin portfolio choice
The theory relies on the trade-off between the liquidity provided by holding money (the
ability to carry out transactions) and the interest foregone by holding one’s assets in the form
of non-interest bearing money.
Transaction demand for money

Baumol-Tobin argued that even money balances held for transactions purposes are sensitive
to the level of interest rates. As interest rates rise, the opportunity cost of holding cash for
transactions will also rise, so the transactions part of money demand is negatively related to
the interest rate. There are two costs involved: the opportunity cost of interest not earned on
cash holdings plus transaction costs (the cost of trips to the bank):
Total Cost = Foregone Interest + Cost of Trips
Precautionary demand
Similarly, people will hold fewer precautionary balances when interest rates are high. As
interest rates rise, the opportunity cost of holding precautionary balances rises. The
precautionary demand for money is therefore negatively related to interest rates. Holding
money prevents you from earning interest on other investments.
Speculative demand
Tobin criticized Keynes analysis of the speculative demand. Tobin assumed that most people
are risk averse. That they would be willing to hold an asset with a lower expected return if it
is less risky. Tobin assumed a zero return on money although money has certainty. Bonds can
have volatile returns but what if there are assets that have no risk but have higher returns?
Still one problem with money demand remains. There are other low risk interest bearing
assets: money market mutual funds, Treasury Bills, and others. So why would anyone hold
money (M1) as a store of wealth? Economists today still try to develop models of investor
behaviour to solve this "rate of return dominance" puzzle.
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IV. Friedman’s Modern Quantity Theory of Money
Milton Friedman (another Nobel Prize winner) developed a model for money demand based
on the general theory of asset demand. Money demand, like the demand for any other asset,
should be a function of wealth and the returns of other assets relative to money. His money
demand function is as follows:
Where Yp = permanent income (the expected long-run average of current and future income)
rb = the expected return on bonds
rm = the expected return on money
re = the expected return on stocks
pi(e) = the expected inflation rate (the expected return on goods, since inflation is the increase
in the price/value of goods)
Money demand is positively related to permanent income. Since permanent income is a long-
run average, it is more stable than current income, so this will not be the source of a lot of
fluctuation in money demand.
The other terms in Friedman's money demand function are the expected returns on bonds,
stocks and goods relative to the expected return on money. These items are negatively related
to money demand: the higher the returns of bonds, equity and goods relative to the return on
money, the lower the quantity of money demanded. Friedman did not assume the return of
money to be zero.
Friedman vs. Keynes

When comparing the money demand frameworks of Friedman and Keynes, several
differences arise
 Friedman considers multiple rates of return and considers the relative returns to be
important
 Friedman viewed money and goods as substitutes.
 Friedman viewed permanent income as more important than current income in
determining money demand
Friedman's money demand function is much more stable than Keynes'. Why? Consider the
terms in Friedman's money demand function:
 Permanent income is very stable, and
 The spread between returns will also be stable since returns would tend to rise or fall
all at once, causing the spreads to stay the same. So in Friedman's model changes in
interest rates have little or no impact on money demand. This is not true in Keynes'
model.
If the terms affecting money demand are stable, then money demand itself will be stable.
Also, velocity will be fairly predictable.
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II.

Keynes Liquidity Preference Theory

Speculative demand for money

Putting the 3 motives together

Money demand and increases in real GDP

Financial innovation and the demand for money

Transaction demand for money

Friedman vs. Keynes

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