The Keynesian Theory of Demand for Money is an important theory that explains why people hold money and how much money they want to hold. The theory was developed by John Maynard Keynes, a British economist, during the Great Depression of the 1930s. It is an alternative to the classical theory of the quantity of money, which argues that people hold money only for transactions purposes and that the quantity of money in an economy is determined by the supply of money.
According to Keynes, the demand for money has two components: transactions demand and speculative demand. The transactions demand for money is the amount of money that people hold to carry out their day-to-day transactions, such as buying goods and services, paying bills, and so on. The speculative demand for money is the amount of money that people hold as a store of value or as a hedge against uncertainty. In other words, people hold money because they want to be able to meet unexpected expenses or take advantage of investment opportunities.
The Keynesian theory of demand for money is based on the following assumptions:
- People are rational and they make decisions based on their expectations of the future.
- People have a preference for liquidity and they prefer to hold assets that can be easily converted into cash.
- The interest rate is the opportunity cost of holding money. When the interest rate is high, people are more likely to hold assets that earn interest, such as bonds, rather than holding money.
The Keynesian theory of demand for money can be expressed mathematically as:
Md = kPY
Where
Md is the demand for money
k is the fraction of income that people want to hold as money
P is the price level, and Y is real income.
The equation shows that the demand for money is proportional to real income (Y) and the price level (P). The coefficient k represents the fraction of income that people want to hold as money. It is assumed to be a constant, although it may vary depending on economic conditions.
The Keynesian theory of demand for money has several implications. First, an increase in real income leads to an increase in the demand for money. This is because people need more money to carry out their transactions as their income increases. Second, an increase in the price level leads to an increase in the demand for money. This is because people need more money to buy the same amount of goods and services at a higher price level. Finally, an increase in the interest rate leads to a decrease in the demand for money. This is because people are more likely to hold assets that earn interest rather than holding money.
The Keynesian theory of demand for money has important policy implications. It suggests that monetary policy can be used to influence the demand for money and, hence, the level of economic activity. For example, if the economy is in a recession and the demand for money is low, the central bank can increase the money supply to stimulate economic activity. On the other hand, if the economy is overheating and inflation is a concern, the central bank can reduce the money supply to slow down economic activity.
Baumol-Tobin Transaction approach
The Baumol-Tobin Transaction Approach is an alternative to the Keynesian theory of demand for money, which was developed by William Baumol and James Tobin in the 1950s. The approach considers the demand for money in terms of how much money is needed to make transactions, rather than how much money is needed for speculative purposes, as suggested by Keynes.
Baumol-Tobin Transaction Approach assumes that individuals need money for transactions, such as buying goods and services, paying bills, and making other payments. The approach argues that the demand for money is based on the need to reduce the cost of managing transactions. This means that people hold money to save on transaction costs rather than for speculative purposes.
According to the Baumol-Tobin Transaction Approach, people determine the amount of money to hold based on the following three factors:
- Income: People with higher incomes tend to have higher transaction costs because they tend to spend more, which requires more money to make transactions.
- Interest rates: People can earn interest on their money by investing it in interest-bearing assets. However, they must balance the interest earned against the cost of transaction. If interest rates are high, people may choose to hold less money and invest more. Conversely, if interest rates are low, people may choose to hold more money to avoid transaction costs.
- Cost of goods and services: When the prices of goods and services increase, people will require more money to make transactions. Therefore, inflation can affect the demand for money.
The Baumol-Tobin Transaction Approach provides insights into how individuals manage their money and how changes in economic conditions affect their demand for money. It also helps policymakers understand how changes in interest rates and inflation can affect the demand for money and, therefore, the economy.
Criticism
- Unrealistic assumptions: The Baumol-Tobin model is based on the assumption that the amount of money an individual holds is directly proportional to the number of transactions made. However, this is not always true as some individuals may choose to hold more money for precautionary reasons or for speculative purposes. Therefore, the model does not account for the diversity of individual preferences and motives for holding money.
- Ignores interest rates: The model assumes that there is no interest earned on the money held for transactions, which is not the case in reality. In fact, individuals are likely to hold less money if interest rates are high as they can earn more returns on other forms of investment. The model ignores the opportunity cost of holding money.
- Ignores uncertainty: The model assumes that individuals can predict their future transactions with certainty. However, this is not always the case, and individuals may hold more money as a buffer against unexpected events.
- Static model: The Baumol-Tobin model is a static model that assumes a constant level of income and price level. However, in reality, income and prices fluctuate over time, which can affect the demand for money.
- Narrow scope: The model only considers the demand for money for transactions purposes and does not account for the demand for money for other purposes such as speculation and precautionary motives.
Tobin’s Portfolio Balance approach
Tobin’s Portfolio Balance Theory of Demand for Money is an alternative approach to the Keynesian and Fisher’s Quantity Theory of Money. According to Tobin, the demand for money is determined by the need to hold a certain proportion of assets in the form of liquid money. Tobin’s theory of demand for money is based on the concept of portfolio choice, in which an investor chooses between different assets with varying degrees of liquidity and risk.
Tobin’s Portfolio Balance Theory assumes that individuals hold their wealth in two forms: money and non-money assets (such as bonds, stocks, and real estate). The demand for money is derived from the need to hold a certain proportion of assets in the form of liquid money, as opposed to non-money assets. In other words, individuals hold a certain proportion of their wealth in the form of money to provide liquidity and for transaction purposes. The proportion of wealth held in the form of money is determined by the investor’s portfolio preferences, including the level of wealth, the expected return on non-money assets, the expected return on money, and the risk of holding different assets.
Tobin’s Portfolio Balance Theory also takes into account the effect of changes in the interest rate on the demand for money. Tobin argues that an increase in interest rates will decrease the demand for money because individuals will shift their wealth from money to interest-bearing assets to take advantage of the higher rate of return. Conversely, a decrease in interest rates will increase the demand for money because individuals will shift their wealth from interest-bearing assets to money to take advantage of the increased liquidity.
Tobin’s Portfolio Balance Theory Criticism
- Oversimplified assumptions: The portfolio balance theory assumes that investors have only two assets to choose from, money and bonds. This is not a realistic assumption since investors have a wide range of assets available to them, including stocks, real estate, and commodities. Additionally, the theory assumes that investors only consider two factors when making investment decisions: the return on the investment and the risk involved. In reality, investors also consider other factors such as liquidity, taxation, and marketability.
- Fixed income assumption: The portfolio balance theory assumes that individuals have a fixed income, which they allocate between money and bonds. However, in reality, individuals’ incomes are not fixed and may vary over time.
- Narrow view of money demand: The portfolio balance theory focuses only on the demand for money as a store of value, ignoring the demand for money as a medium of exchange. This is a significant limitation since the demand for money as a medium of exchange can also impact the overall demand for money in an economy.
- Ignoring institutional factors: The portfolio balance theory ignores the impact of institutional factors such as regulations, taxes, and transaction costs on investors’ behavior. These factors can significantly affect the demand for money and bonds.
- Static analysis: The portfolio balance theory assumes that the demand for money and bonds remains constant over time. However, in reality, the demand for these assets can vary depending on changes in economic conditions such as inflation, interest rates, and income levels.