Back

Theories of Money Supply

The Classical Theory (Quantity Theory of Money):
  • The classical theory, largely associated with economists like Irving Fisher, posits that the demand for money is determined by the level of income and the price level. According to this theory, there is a direct relationship between money demand and transactions (money is primarily demanded to carry out transactions).

Summarized by the equation MV=PY , where:

  • M is the money supply,
  • V is the velocity of money (how quickly money circulates in the economy),
  • P is the price level,
  • Y is real output (GDP).

According to this theory, if the money supply increases and output remains constant, it will lead to an increase in prices (inflation). Monetarists, led by Milton Friedman, emphasize the importance of controlling the money supply to control inflation.

Assumptions of Fisher’s Quantity Theory of Money

1. Velocity of Money (V) is Constant

Fisher assumed that the velocity of circulation of money remains stable over time.
 This means that people’s spending habits, payment systems, and banking practices do not change frequently, keeping VVV constant.

 Why important?
 If V fluctuated, it would also affect the price level, making it harder to isolate the impact of money supply changes.

2. Volume of Transactions (T) is Constant or Predetermined

It is assumed that the total number of transactions or output of goods and services in the economy is fixed in the short run.

 Why important?
 This implies that changes in the money supply do not affect output, only prices. If output could vary freely, changes in money supply might lead to real growth rather than inflation.

3. Money is Only a Medium of Exchange

In Fisher’s view, money serves purely as a medium of exchange and not as a store of value.
 It is assumed that people do not hoard money; they spend it quickly, which supports the constancy of VVV.

Why important?
 If people started hoarding money, velocity would decrease, undermining the direct relationship between money supply and price level.

4. Price Level is a Passive Factor

The theory assumes that the price level adjusts automatically and proportionately to changes in the money supply.

 Why important?
 There is no time lag or friction assumed in price adjustments—if money supply doubles, prices instantly double.

5. No Time Lags in Adjustment

Fisher assumed that changes in the money supply immediately and proportionately affect the price level, without any delays.

Why important?
 In reality, price changes often take time, but Fisher’s theory neglects such frictions for simplicity.

6. Full Employment of Resources

It is assumed that the economy is operating at full employment—meaning all available resources are being fully utilized.

Why important?
 If there is unemployment, an increase in money supply could lead to more output (real growth) rather than just higher prices (inflation).

7. Closed Economy (No Foreign Trade)

The model implicitly assumes that there are no imports or exports influencing the domestic money supply or transactions.

Why important?
 In an open economy, international trade flows could alter the domestic money supply, complicating the theory’s simple relationship.

The Keynesian Theory:
  • The Keynesian theory, as described by John Maynard Keynes, emphasizes the speculative and precautionary motives for holding money, in addition to the transactional motive.
  • Keynes argued that the demand for money is a function of income and interest rates, where higher income leads to higher transaction demand and higher interest rates lead to lower speculative demand for money.
  • Keynes introduced the concept of the liquidity preference theory, which posits that individuals demand money for liquidity reasons—preferring the ease of transactions and the security of holding cash.
    The liquidity preference function can be represented as:
    L(Y,i)
    Where:
    • L = Liquidity preference (demand for money)
    • Y = Income
    • i = Interest rate
Reasons Why People Demand Money

In economics, demand for money means the desire to hold liquid cash instead of spending or investing it immediately.
 John Maynard Keynes, in his famous work “The General Theory of Employment, Interest and Money” (1936), classified the motives for holding money into three main categories:

1. Transactions Motive

Definition: People demand money to carry out their day-to-day transactions—buying goods and services, paying bills, salaries, etc.

Explanation:

  • Money facilitates the exchange of goods and services in the economy.
  • Since there is often a gap between receipt of income and expenditure, people hold a portion of their wealth in liquid form (cash or demand deposits).
  • The transactions demand for money depends largely on:
    • The level of income: Higher income → more transactions → greater demand for money.
    • Frequency of income receipts: Salaried individuals might hold more cash near the end of the month.
    • Payment systems: In economies with advanced banking facilities (credit cards, online transfers), transaction demand may be lower.

Key point:

  • Directly proportional to income.
  • Less sensitive to interest rates because people need to transact regardless of the return they could earn elsewhere.

2. Precautionary Motive

Definition: People also hold money to meet unforeseen contingencies—such as sudden illnesses, accidents, emergencies, or unexpected opportunities.

Explanation:

  • The future is uncertain, and individuals as well as businesses like to maintain a reserve of cash to feel financially secure. 
  • For example:
    • An individual may keep extra cash for unexpected medical bills.
    • A business may hold liquid funds to handle sudden machinery breakdowns.

Factors influencing precautionary demand:

  • Income levels: Higher income → greater precautionary balances.
  • Economic uncertainty: In times of recession or war, people tend to increase precautionary holdings.
  • Availability of credit: Easier access to credit (loans, credit cards) may reduce the need to hold precautionary money.

Key point:

  • Positively related to income, but like transaction motive, not very sensitive to interest rates.

3. Speculative Motive

Definition: People demand money to take advantage of future investment opportunities or to avoid potential losses from holding non-liquid assets.

Explanation:

  • Money is demanded to speculate on bonds, stocks, or other assets whose prices may fluctuate.
  • If people expect interest rates to rise (which would cause bond prices to fall), they prefer holding money instead of bonds to avoid losses.
  • Alternatively, if they expect interest rates to fall (bond prices to rise), they will use their money to buy bonds later and profit.

Thus, speculative motive reflects the link between:

  • Expectations about future interest rates and asset prices, and
  • Current decision to hold money instead of investing.

Key characteristics:

  • Highly sensitive to interest rates.
  • Inverse relationship between interest rates and speculative demand for money:
    • Low interest rates → High speculative demand (people hold cash anticipating rates to rise).
    • High interest rates → Low speculative demand (people invest in bonds
The Quantity Theory of Money (Friedman’s Revision):

Milton Friedman’s revision of the Quantity Theory of Money builds on the classical equation of exchange (MV=PY) but with key modifications. In the classical theory, changes in the money supply (M) directly affect prices (P) and output (Y). However, Friedman argued that the demand for money is more stable and predictable than the classical model suggested.

Key Points of Friedman’s Revision:
  1. Stable Money Demand: Friedman emphasized that the demand for money is stable and depends on factors like income, wealth, and interest rates. Unlike the classical view, it is not only influenced by prices.
  2. Money Supply Control: He believed that controlling the money supply is the most effective way to control inflation. Central banks should target a steady, predictable growth rate for the money supply to maintain price stability.
  3. Long-Term Focus: In the long run, changes in the money supply affect only the price level, not real output, which is determined by real factors like labor and capital.
  4. Velocity of Money: While classical theory assumes velocity is constant, Friedman argued that it fluctuates in the short term but remains stable in the long run, helping make the relationship between money supply and prices predictable.

In essence, Friedman’s revision of the quantity theory emphasizes that inflation is primarily driven by excessive growth in the money supply and that monetary policy should focus on controlling it for stable prices.

Cambridge Cash Balance Approach 

The Cambridge Cash Balance Approach is a refinement of the Quantity Theory of Money that focuses on the demand for money rather than just the supply side. This approach was developed by economists from Cambridge University such as Alfred Marshall, A.C. Pigou, and later expanded by John Maynard Keynes.

Basic Equation

The Cambridge economists formulated the money demand equation as:

M=kPY

Where:

  • M = Money held by the public (nominal money balances)
  • k = Fraction of nominal income (PY) that people wish to hold as cash
  • P = Price level
  • Y = Real national income or output
  • PY = Nominal income
Key Concepts
  1. Emphasis on Money as a Store of Value:
     Unlike Fisher’s version, which saw money mainly as a medium of exchange, the Cambridge approach views money primarily as a store of value. People hold money not only for transactions but also to maintain liquidity.
  2. The Role of k:
    • The parameter k reflects people’s preferences for liquidity.
    • It indicates the proportion of income individuals choose to hold in the form of money balances rather than spending or investing it.
    • kkk is influenced by factors such as payment habits, interest rates, and financial institutions’ efficiency.
  3. Stability Assumption:
    • If k and Y are stable, the money demand is stable.
    • The equation implies that money supply M should be adjusted to maintain price stability, assuming velocity (the inverse of k) is constant.
The Demand for Money Curve:

The demand for money can be graphically represented as a downward sloping curve, where:

  • On the horizontal axis, we plot the quantity of money.
  • On the vertical axis, we plot the interest rate or the opportunity cost of holding money.
  • At higher interest rates, the demand for money is lower because people prefer to invest in interest-bearing assets.
  • At lower interest rates, the demand for money is higher as people forgo the opportunity cost of holding non-interest bearing money.
Need Help?
error: Content is protected !!