Shortly Money Demand Theories

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It is still a phenomenon that has not been fully resolved by both economists and policy makers how the demand for money, which is the most important factor in the functioning of the economy, is affected.

This article will examine the development process of money demand theories and try to explain the theories. Starting with the theories of Irving Fisher and classical economists, Friedman’s theories until the “Modern Quantity Theory” will be examined.

Quantity Theory of Money

The quantity theory of money was developed by classical economists in the 19th and 20th centuries. The most important feature of the theory is that it argues that interest rates do not affect the demand for money.

Rate of Circulation of Money and Equation of Exchange

Classical quantity theory is most clearly laid out in economist Irving Fisher’s famous work The Purchasing Power of Money. In his work, Fisher wanted to examine the relationship between the money supply M and the total goods and services produced P*Y. The relationship between M and P*Y is explained by the concept of “Velocity of Money”, that is, the velocity of circulation of money. The formula for the velocity of circulation of money is as follows;

V=P*Y/M

The velocity of money shows how many times a dollar is used to purchase goods and services in a year. When both sides of the equation are multiplied by M, the money supply, the formula for the equation of exchange is obtained;

M*V=P*Y

This shows us that the money supply times the velocity of circulation of money is equal to the total goods and services produced, that is, it is equal to GDP. The main mistake in Fisher’s theory is our economist’s wrong idea that the velocity of money is constant in the short run. But the velocity of circulation of money fluctuates very frequently. Today, the “Classical Quantity Theory of Money” is not a widely accepted theory.

Keynes’ Theory of Liquidity Preference

John Maynard Keynes is one of the economists who most influenced economic theories. In his famous work The General Theory of Employment Interest and Money, which he published in 1936, he abandoned the classical theory, which states that the velocity of circulation is constant, and developed the “Liquidity Preference Theory”, in which interest rates greatly affect the demand for money. The theory of liquidity preference essentially seeks to answer the question of why individuals hold money, and according to Keynes, there are three motives that push individuals to hold money. These; transaction motive, precautionary motive and speculation motive.

Action Motive

As you may remember, money has three functions in the economy, and one of them is the most used function of money as a medium of exchange. Keynes also stated this when he said this motive. Transaction motive assumes that people hold money to carry out day-to-day transactions.

Prudence

Suppose you want to buy a product and you see in a brochure that the product is on sale in a store. In this case, if you decide to buy that product and you have money to buy that product outside of daily transactions, it means that your precautionary instinct has worked and has led you to demand money outside of daily transactions.

Speculation motive

Keynes’ main contribution to the theory of money demand was by adding the speculation motive to the theory. The speculation motive tells us that people are likely to demand money as well as a means of hiding wealth. According to Keynes, there are two types of wealth storage. These; money and bonds. If the expected return on money exceeds the expected return on the bond, people’s demand for money increases. In other words, according to Keynes, when interest rates rise, the demand for money falls.

There were serious criticisms of the speculation motive. The primary criticism is due to Keynes’ belief that people do not diversify portfolios. But people often diversify their portfolio to avoid risks. Keynesian economist James Tobin improved Keynes’ speculation motive by adding risk sharing and revealed a more reliable money demand model, but another problem is that according to some economists there is no speculation motive at all because people hold both money and bonds for investment purposes in their portfolio to avoid risk. even there are always real returns and zero risk instruments (like US treasury bills). So why would people keep money as a means of hiding wealth?

In short, Keynes is important in showing that there is a relationship between interest rates and money demand, but whether there is a speculation motive among the motives that determine the money demand is still a question mark.

Friedman’s Modern Quantity Theory

Milton Friedman developed a theory of demand for money in his 1956 article The Quantity Theory of Money: A Restatement. According to Friedman, the demand for money is a function of the expected returns on other assets relative to the expected return on money. Friedman formulated the demand for money as follows:

Md/P = f(Yp,rb-rm,re-rm,πe-rm)

Here

Md/P = real money balance

Yp = Friedman’s measure of wealth known as permanent income

rm = expected return on money

rb = expected return of the bond

re = expected return of the stock

πe = expected rate of inflation

According to Friedman, people do not keep their wealth in money alone. Apart from money, Friedman identified three means of accumulation of wealth. These; bonds, stocks and commodities. The terms rb-rm and re-rm represent the difference between the expected returns on bonds and stocks and the expected return on money. When these increase, the demand for money also increases. Πe-rm, on the other hand, compares the expected return of goods relative to money. The expected rate of inflation determines the expected return on goods.

Differences Between Friedman and Keynesian Theories

There are some fundamental differences between Friedman’s modern quantity theory and Keynes’s theory of liquidity preference. First of all, unlike Friedman Keynes, he added many assets to his analysis as an alternative to money and developed a theory on the relationship between money and expected returns between assets. However, Keynes only included the bond in his analysis because he thought that the expected returns of all assets and bonds would be the same.

Contrary to Keynes, who said that interest rates are an important determinant of money demand, Friedman thinks that a change in interest rates does not have a significant effect on money demand. Also, contrary to Friedman Keynes, he thinks that the velocity of money and money supply are not predictable and volatile.

In this study, we have briefly examined the demand for money and the theories related to the demand for money.