Demand for Money Essay Example | Topics and Well Written Essays - 1000 words

Demand for Money - Essay Example Defining M as the money supply, P as the price level, Y as the real aggregate output and V as the Velocity of money, the average frequency of spending of a unit of money across all transactions in a given time period, the focal representation of the theory is through the equation of exchange: MV=PY. This equation simply states that the amount of money supplied multiplied by the number of times a single unit is circulated equals the nominal value of aggregate output or income. This is more or less a tautological identity. The equation of exchange however can be translated into a theory of money demand by noting that in equilibrium, money supplied is equal to money demand and therefore, M=MD and rewriting the equation of exchange as: (1) Thus, evidently, this theory implies that given a constant velocity in the short run and the price level, the demand for money is a function of Y only. Additionally, if Y is fixed at its full employment level and V is fixed in the short run then note t hat an increase in the money demand will lead to a proportional increase in the price level implying inflation. The assumption of a constant velocity in the short run follows from the belief that velocity is determined through technological and institutional factors of the economy and these factors undergo changes at very slow paces or are altered in discrete jumps over large intervals of time. Thus velocity remains unaltered over shorter time horizons. Therefore, to summarize Fischer's theory of money demand, money demand is determined by the magnitude of transactions generated by any particular level of nominal income PY and institutional and technological factors that determine the velocity of money. Rate of interest has no significance in the determination of the demand for money in an economy. The Baumol-Tobin approach to money demand is essentially an extension of Keynesian ideas regarding the demand for money. Keynes argued that interest rate has a substantial role to play in the determination of money demand. Particularly, Keynes noted that money demand has three components: the transactions demand for money, the precautionary demand for money and the speculative demand for money. Transactions demand for money is the demand that is generated due to the fact that receipts of money and expenses occur at different points in time and therefore, people have to maintain a reserve of money for transaction purposes at points in time when receipts do not occur but expenses must be made. Precautionary demand for money is the demand for cash that results due to people maintaining reserves for unforeseen contingencies. These two types of money demand, in Keynes' theory are functions of the income only. These were clubbed together by Keynes as L1(Y). The last part of money demand is the speculative demand for money which derives from the fact that people hold money since it is a store of value. According to Keynes' theory, people can either invest in bonds or hold cash money. The opportunity cost of holding cash as opposed to bonds is the forsaken interest payments or capital gains. The interest rate therefore has an inverse relationship with the speculative demand for cash. The idea was that if people expect a particular interest rate to prevail then if interest rates were above this, people would expect a decline in interest rates in future. This implies that bond