Unit-1 Course Objectives

• To introduce students with the concept of money

and its value for functioning of economic system.
• To elucidate students about the various classical
theories showing reasons for demand for and
supply of money in an economy.
• To enlighten the students with the situations
affecting demand and supply of money in an
economy and how this change affects the
economy as whole.
 UNIT -1
• The Nature of Money,
• Defining money by its functions.
• Advantages of monetary economy over the barter economy.
• Types of money.
• Demand for Money- Quantity theory of demand for money.
Keynes’ speculative demand for money. Transaction based
theories of demand for money. Friedman’s Restatement of
quantity Theory
 MICROECONOMICS
MONETARY
ECONOMICS
MACROECONOMICS
 MONETARY ECONOMICS
MEANING
• Monetary economics is the economics of the money supply,
prices and interest rates, and their repercussions on the
economy.
• It focuses on the monetary and other financial markets, the
determination of the interest rate, the extent to which these
influence the behavior of the economic units and the
implications of that influence in the macroeconomic context.
• It also studies the formulation of monetary policy, usually by the
central bank or “the monetary authority,” with respect to the
supply of money and manipulation of interest rates, in terms
both of what is actually done and what would be optimal.
 Microeconomics part of monetary
economics
• The microeconomics part of monetary
economics focuses on the study of the demand
and supply of money and their equilibrium.
• No study of monetary economics can be even
minimally adequate without a study of the
behavior of those financial institutions whose
behavior determines the money stock and its
close substitutes, as well as determining the
interest rates in the economy.
 Macroeconomics part of monetary economics:
money in the macro economy
• The macroeconomics part of monetary
economics is closely integrated into the
standard short run macroeconomic theory.
The reason for such closeness is that
monetary phenomena are pervasive in their
influence on virtually all the major
macroeconomic variables in the short run.
 MEANING OF MONEY
Money is any item or verifiable record that is
generally accepted as payment for good and
services and repayment of debts , such
as taxes , in a particular country or socio-
economic context.
 Definition of money
• Traditional Definition: This view is defined as
currency and demand deposits, and its most
important function is to act as a medium of
exchange. However, there are other assets
which are equally acceptable as a medium of
exchange. By ignoring these assets, the
traditional view does not analyze their
influence in increasing their velocity.
• Friedman’s Definition: He defined money as
the sum of currency plus all adjusted
deposits in commercial banks. This is the
broader view as it includes bank deposits,
non bank deposits and any other type of
assets through which the monetary authority
influence the level of income, prices,
employment or any other macro economic
variable.
• Gurley – Shaw: Money which was defined as
equal to currency plus demand deposits is
only one liquid asset. Thus a wider definition
was formulated which was based upon
liquidity which includes bonds, insurance
reserves, pension funds, savings and loan
shares.
• Pesek and Saving definition: According to
them Money should include demand
deposits as well as money issued by
government. Time and Savings deposits
from banks are excluded. Thus total
money which includes demand deposits is
termed as net wealth of society
 FUNCTIONS OF MONEY
At a theoretical level, money is defined in
terms of the functions that it performs.
Money performs a number of primary,
secondary, and contingent functions which
not only remove the difficulties of barter but
also oils the wheels of trade and industry in
the present day world. We discuss these
functions one by one.
 1. Primary Functions:

The two primary functions of money are to act as a medium of

exchange and as a unit of value.
• Money as a Medium of Exchange: This is the primary function
of money because it is out of this function that its other
functions developed. By serving as a medium of exchange,
money removes the need for double coincidence of wants and
the inconveniences and difficulties associated with barter.
• This function of money also separates the transactions in time
and place because the sellers and buyers of a commodity are
not required to perform the transactions at the same time and
place.
• Money as Unit of Value: The second primary function
of money is to act as a unit of value. Under barter one
would have to resort to some standard of measurement,
such as a length of string or a piece of wood. Since one
would have to use a standard to measure the length or
height of any object, it is only sensible that one
particular standard should be accepted as the standard.
Money as a unit of account helps in calculations of
economic importance such as the estimation of the
costs, and revenues of business firms, the relative costs
and profitability of various public enterprises and
projects under a planned economy, and the gross
national product.
 Secondary Functions

Money performs three secondary functions: as a

standard of deferred payments, as a store of value,
and as a transfer of value. They are discussed below.
(i) Money as a Standard of Deferred Payments:
The third function of money is that it acts as a
standard of deferred or postponed payments. All
debts are taken in money. It was easy under barter
to take loans in goats or grains but difficult to make
repayments in such perishable articles in the future.
• Money as a Transfer of Value: Since money is a
generally acceptable means of payment and acts as a
store of value, it keeps on transferring values from
person to person and place to place. A person who
holds money in cash or assets can transfer that to any
other person. Moreover, he can sell his assets at Delhi
and purchase fresh assets at Bangalore. Thus money
facilitates transfer of value between persons and
places.

• Money as Store of Value: money provides store of

value as it can be stored for longer periods of time for
future use in terms of paper currency and coins.
 Contingent Functions:

With the passage of time, the functions of money

got diversified. Contingent functions of money
include distribution of income, measurement and
maximization of utility, basis of credit, liquidity to
wealth etc.
• Distribution of Income: Without money it is
impossible to settle the share of each factor of
production from the national income. It is, in fact,
very difficult to calculate the factor income
without money.
• Measurement and Maximization of Utility:
Utility is measured in terms of money. A
consumer measures the utilities of different
consumer goods with the help of money.
Similarly, a producer measures the utilities of
different factors of production with the help
of money. A consumer tries to get maximum
satisfaction by adjusting his expenditure on
variety of commodities with the heap of
money.
• Basis of Credit : Money constitutes the
basis of credit. Banks create credit with
the help of money. Any increase or
decrease in money supply leads to a
commensurate increase or decrease in the
availability of credit money in the
economy.
• Liquidity to Wealth: money creates
liquidity of assets and capital for business
units, as it provides readiness of use and
ease of transaction in purchase and sale.
NATURE/CHARACTERSITICS OF MONEY

An item must have six key characteristics to be

considered as “Money”
1. Durability
2. Portability
3. Divisibility
4. Uniformity
5. Limited Supply
6. Acceptability
1. Durability: Durability means that the item
must be able to withstand being used
repeatedly. Items that are considered
Currency, coins and paper bills used as
money meet this requirement.
2. Portability : Portability means that
individuals are able to carry money with
them and transfer it easily to other
individuals. This is why coins and paper
money have historically proved popular.
3. Divisibility: Divisibility means that the
money can easily be divided into smaller
units of value. Today, different coins and
notes convey these fractional values.
4. Uniformity: Uniformity means that all
versions of the same denomination of
currency must have the purchasing power.
As an example, a 1928 $2 bill will still buy $2
worth of goods or services today.
5. Limited Supply : Limited Supply means that
restrictions on the amount of money in
circulation ensure that values remain relatively
constant for the currency. The responsibility
for maintaining an adequate money supply
falls on the Federal Reserve System.
6. Acceptability: Acceptability means that
everyone must be able to use the money for
transactions. In the United States this is
indicated on paper bills by the notation: “This
note is legal tender for all debts, public and
private”.
Advantages of monetary economy over the
barter economy
Currency has three major characteristics which will
prove the advantages of monetary economy over
the barter economy:
1. First, modern money is a store of value. Imagine
you own an apple orchard and wanted to save
some of your harvest to trade next year, you
would have to turn it into preserves or put in
some similar work to make sure they don’t spoil.
Currency, on the other hand, is a fairly reliable
store of value across time.
2. Second, currency is easily transferable. Say
you want to buy a dress, but your seamstress
is allergic to apples. In this case you would
have to trade your apples through one or
more intermediary goods to eventually trade
for your dress. Modern money is widely
accepted in its country of origin (and
sometimes others as well) and can be easily
exchanged for other currencies should the
need arise.
• Finally, modern money is portable. If you
wanted to buy anything with apples you
would have to first transport them to the
barter
 1. Commodity Money
• Commodity Money The most primitive type of
money is commodity money.
• Some useful commodity that is in general
demand is used as an exchange medium and
may serve both as a means of payment and a
measure of value.
• Ex: tea, sugar, shells, tobacco etc.
 2. Metallic Money
Throughout history, various metals, some of
which are considered precious today, appear
to have been used as a form of currency. The
Bretton Woods system, under which all major
currencies were theoretically exchangeable for
gold, was abolished in 1971.
 3. Paper Money
A country's official, paper currency that is
circulated for transaction-related purposes.
The printing of paper money is typically
regulated by a country's central bank in order
to keep the flow of money in line with
monetary policy
 4. Bank credit
A demand deposit or bank money refers to the
funds held in demand deposit accounts in
commercial banks. These account balances
are usually considered money and form the
greater part of the money supply of a country
 5. Electronic Money
• The money stored in certain electronic cash
cards.
• Transactions are made electronically.
• Examples are Credit Card, Debit card, Charge
card etc.
 LEGAL TENDER MONEY
Legal tender is a medium of payment recognized by a legal
system to be valid for meeting a financial obligation.
Paper currency and coins are common forms of legal tender
in many countries. Legal tender is variously defined in
different jurisdictions. Formally, it is anything which when
offered in payment extinguishes the debt. Thus,
personal cheques, credit cards , and similar non-cash
methods of payment are not usually legal tender. The law
does not relieve the debt obligation until payment is
tendered. Coins and banknotes are usually defined as legal
tender. Some jurisdictions may forbid or restrict payment
made other than by legal tender.
 Legal tender money is of two kinds:
1. Limited Legal Tender: It refers to that form of legal
tender money, which can be paid in discharge of a
debt up to a certain limit. Beyond this limit, a person
may refuse to accept the payment and no legal action
can be taken against him. In India, coins are limited
legal tender.
2. Unlimited Legal Tender: It refers to that form of legal
tender money, which can be paid in discharge of a
debt of any amount. Legal action can be taken against
a person who refuses to accept this money. In India,
paper notes are unlimited legal tender.
EVOLUTION OF MONEY
 Demand for money
• This refers to the quantity of money that individuals wish
to hold.
• Individuals have three motives for holding money:
1. Transactionary motives: Individuals are paid periodically
(weekly, bi weekly, monthly). However food has to be
bought, utilities have to be paid, and even bus fares.
Theses regular payments are made during the course of
the month but not at the same time that they are paid.
Consumers will hold money to make these purchases or
transactions. These transactions will not depend on
interest rates.
2. Precautionary motives: Unforeseen
circumstances happen in life. Individuals will
put money aside for these moments. The
precautionary demand for money does not
depend on the interest rate.
3. Speculative motives: This demand arises
because individuals hope to make gain from
changes in the price of bonds. A bond is a loan
to the government or a firm, with a maturity
date in the future. Bonds provide interest.
• If the price levels in a country are increasing
interest rates will increase to reduce spending.
• Bonds will be sold to take money out of
circulation.
• To make the bonds attractive the price paid to
purchase bonds will be lower.
• Investors will hold less money since they will be
purchasing the bonds.
• Generally, the higher the interest rate the smaller
the quantity of money held for speculation.
• The lower the interest rate the greater the money
held by investors (they are more liquid)
• The speculative demand for money depends on
the interest rate.
The total demand for money is the sum of
the transactionary, precautionary and
speculative demands (motives).
 Key factors affecting the demand for
money
• The rate of interest on loans
• The number / value of monetary transactions that we expect to carry
out
• The extent to which we also want to hold other financial assets, such
as bonds, property, saving (this is also influenced by the rate of
interest) – this is known as the speculative motive for holding money
• Changes in GDP
• The extent to which it is possible to use debit cards / credit cards i.e.
the pace of financial innovation
• The extent to which we might have to pay out large unexpected
payments, for example, for i.e. the precautionary motive
• The rate of anticipated inflation
 Theories of Demand for Money
• Definition of Demand For Money: In monetary economics, the demand
for money is the desired holding of financial assets in the form of money:
that is, cash or bank deposits rather than investments. It can refer to the
demand for money narrowly defined as M1, or for money in the broader
sense of M2 or M3.

• Theories of Demand for money:

Fisher’s quantity Cambridge’s Friedman’s Transaction

theory Quantity Theory Theory

Keynes's
Theory
 Quantity Theories
• How is the general price level determined? Why does price level
change? Classical or pre- Keynesian economists answered all these
questions in terms of quantity theory of money.
• In its simplest form, it states that the general price level (P) in an
economy is directly dependent on the money supply (M);
• P = f(M)
• If M doubles, P will double. If M is reduced to half, P will decline
by the same amount. This is the essence of the quantity theory of
money. Though the theory was first stated in 1586, it received its
full-fledged popularity at the hands of Irving Fisher in 1911. Later,
an alter­native approach was given by a group of Cam­bridge
economists. However, the basic conclu­sion of these two theories is
same price level varies directly with and proportionally to money
supply.
• Basic Concepts used in theory:
• Quantity of money: the total amount of money in circulation in an economy is
known quantity of money.
• Value of money/ value of currency: The value of money, then, is the quantity
of goods in general that will be exchanged for one unit of money. The value of
money is its purchasing power, i.e., the quantity of goods and services it can
purchase.
• Prices: rate of different goods and services prevailing in the economy is
known as prices.

• Relationship between quantity of money and Value of money: there is an

inverse relationship between the quantity of money (M) and value of money
(Vm), represented by following equation: M = 1/Vm . Therefore when
quantity of money increases value of money decreases and vice-versa.

• Relationship between quantity of money and prices: the theory says there is
direct relationship between quantity of money (M) and Prices, i.e. with
increase in quantity of money (M), prices will also increase and v ice-versa.
This is represented by the following equation: M ∞ P
 Fisher’s Transaction Theory of quantity of
money

• In the words of Irving Fisher, “Other things remaining unchanged,

as the quantity of money in circulation increases, the price level also
increases in direct proportion and the value of money decreases and
vice versa.” If the quantity of money is doubled, the price level will
also double and the value of money will be one half. On the other
hand, if the quantity of money is reduced by one half, the price level
will also be reduced by one half and the value of money will be
twice.
• Fisher has explained his theory in terms of his equation of exchange:
• PT=MV+ M’ V’
• Where P = price level, or IP = the value of money;
• M = the total quantity of legal tender money;
• V = the velocity of circulation of M;
• M’ – the total quantity of credit money; (amount of money available
with banks in form of deposits which banks uses further by providing
credit out of it)
• V’ = the velocity of circulation of M’; (velocity of banks)
• T = the total amount of goods and services exchanged for money or
transactions performed by money.

• Velocity: velocity can be defined as the no of hand through which money

travel in an economy, or it is the circulation process of money.
• This equation equates the demand for money (PT) to supply of money
(MV=M’V). The total volume of transactions multiplied by the price level
(PT) represents the demand for money.
• Fisher points out the price level (P) (M+M’) provided the volume of trade
remain unchanged. The truth of this proposition is evident from the fact that
if M and M’ are doubled, while V, V’ and T remain constant, P is also
doubled, but the value of money (1/P) is reduced to half.
• Fisher’s quantity theory of money is explained with the help of following
figure (A) and (B). Panel A of the figure shows the effect of changes in the
quantity of money on the price level. To begin with, when the quantity of
money is M, the price level is P.
• When the quantity of money is doubled to M 2, the price level is also
doubled to P2. Further, when the quantity of money is increased
four-fold to M4, the price level also increases by four times to P 4.
This relationship is expressed by the curve P = f (M) from the origin
at 45°.

• In panel В of the figure, the inverse relation between the quantity of

money and the value of money is depicted where the value of money
is taken on the vertical axis. When the quantity of money is M 1 the
value of money is HP. But with the doubling of the quantity of
money to M2, the value of money becomes one-half of what it was
before, 1/P2. And with the quantity of money increasing by four-fold
to M4, the value of money is reduced by 1/P4. This inverse
relationship between the quantity of money and the value of money
is shown by downward sloping curve 1/P = f (M).
• Fisher’s theory is based of the following assumptions:
1. Velocity of money (V) and velocity of banks (V’) is constant in economy: fisher
was of view that in an economy factors affecting velocity remains constant for longer
period of time, hence velocity or circulation of money also remains constant in an
economy. Factor affecting velocity are: (a) habits of consumers remains unchanged,
(b) population remains unchanged and (c) rate of interest remains constant.
2. Volume of Trade (T) is also constant in an economy: fisher also assumed trade to be
constant in an economy, because in his view any change in (a) Technology, (b)
population size and (c) supply of resources remains unchanged for longer period of
time, hence the Trade (T) also remains unchanged for long period.
3. Price Level (P) is a passive factor: fisher stated that price (P) is the passive factor,
i.e. prices are effect or result of change in quantity of money and not cause of any
change.
4. Money is used as a medium of exchange only: Fisher assumed that whatever money
is their in economy, it will either be consumed for basic necessities or will be used for
further investment, therefore money will be used as medium of exchange only and not
as store of value(savings).
5. Constant Relationship between M and M’: deposits in the bank are formed out of
the quantity of money issued in the market, therefore the relationship between M and
M’ is constant, i.e. if M is doubled, M’ will be doubled.
6. The theory is applicable in the long run.
7. It is based on the assumption of the existence of full employment in the economy.
 Criticism Of Fisher’s Theory
1. Fisher’s Theory is Simple Truism: According to Keynes, “The quantity theory of money
is a truism.” Fisher’s equation of exchange is a simple truism because it states that the
total quantity of money (MV+M’V’) paid for goods and services must equal their value
(PT). This is something factual in nature and hence nothing new or different was stated in
this theory.
2. Interdependence between Variable: The direct and proportionate relation between
quantity of money and price level in Fisher’s equation is based on the assumption that
“other things remain unchanged”. But in real life, V, V’ and T are not constant. Moreover,
they are not independent of M, M’ and P. Rather, all elements in Fisher’s equation are
interrelated and interdependent. For instance, a change in M may cause a change in V.
• Consequently, the price level may change more in proportion to a change in the quantity of
money. Similarly, a change in P may cause a change in M. Rise in the price level may
necessitate the issue of more money. Moreover, the volume of transactions T is also affected
by changes in P. When prices rise or fall, the volume of business transactions also rises or
falls. Further, the assumptions that the proportion M’ to M is constant, has not been borne
out by facts. Not only this, M and M’ are not independent of T. An increase in the volume of
business transactions requires an increase in the supply of money (M and M’).
3. Unrealistic assumption of Long Run: Keynes criticised fishers theory stating that
“in long run we all will be dead” therefore one should analyse and find solutions
for the current problems i,.e problem in short run, as long run is uncertain in nature.
4. Unrealistic Assumption of Full employment: Keynes criticised the fisher’s
theory stating that “full employment” situation is a special situation in an economy
which rarely exists, in normal economy there is generally “underemployment”
situation which is the bitter reality of all economies.
5. This theory Fails to explain Trade Cycle: Fisher’s theory fails to explain the
effects and relationship of M and P in case of different situation under trade cycle.
For e.g.: in case of depression prices (P) fall, and in order to revive the economy,
quantity of money (M) is increased, but still the prices (P) fall rather than
increasing in relation to increase in quantity of money (M) as explained in the
theory.
6. This theory ignores other determinants of Price Level: this theory did not
considered other determinants which affect the price level in the economy, these
determinants are: (a) Income, (b) Expenditure, (c) Savings, (d) Consumption etc.
Change in these determinants also bring about change in price level (P) which were
not studied by fisher in his theory.
7. Static Theory or Impractical Theory: Fisher’s theory is static in nature because
of its such unrealistic assumptions as long run, full employment, etc. It is,
therefore, not applicable to a modern dynamic economy.
 Quantity Theory of Money: Cambridge Version

• An alternative version, known as cash balance version, was developed by a group of

Cam­bridge economists like Pigou, Marshall, Robertson and Keynes in the early 1900s.
These economists argue that money acts both as a store of wealth and a medium of
exchange. Here, by cash balance and money balance we mean the amount of money that
people want to hold rather than savings.
• According to Cambridge economists, people wish to hold cash to finance transactions
and for security against unforeseen needs. They also sug­gested that an individual’s
demand for cash or money balances is proportional to his in­come. Obviously, larger the
incomes of the individual, greater is the demand for cash or money balances.

• Thus, the demand for cash balances is specified by:

• Md = kPY …(4.6)
• where Y is the real income, P is the average price and k is the proportion of national
output or income that people want to hold. Let us assume that the supply of money,
MS’ is determined by the monetary authority, i.e.,
• MS = M …(4.7)
• Now, for the achievement of money-market equilibrium, demand for
money must equal worth the supply of money which we denote by M. It is
important to note that the supply of money M is exogenously given and is
determined by the monetary policies of the central bank of a country. Thus,
for equilibrium in the money market.
• M = Md
• As Md =KPY
• Therefore, in equilibrium M = KPY

• Monetary equilibrium Cambridge cash balance approach is shown in

the following figure where demand for money is shown by a rising
straight line KPY which indicates that with k and Y being held
constant demand for money increases proportionately to the rise in
price level. As price level rises people demand more money for
transaction purposes.
• Now, if supply of money fixed by the Government (or the Central Bank) is
equal to M0, the demand for money KPY equals the supply of money, M0 at
price level P0. Thus, with supply of money equal to M0 equilibrium price
level P0 is determined. Suppose money supply is increased to M 1 at the
initial price level P0 the people will be holding more money than they
demand at it.
• Therefore, they would want to reduce their money holding. In order to
reduce their money holding they would increase their spending on goods
and services. In response to the increase in money spending by the
households the firms will increase prices of their goods and services.
• As prices rise, the households will need and demand more money to hold
for transaction purposes (i.e., for buying goods and services). It will be
seen from the figure that with the increase in money supply to M1 new
equilibrium between demand for money and supply of money is attained at
point E1 on the demand for money curve KPY and price level has risen to
P1.
• it is worth mentioning that k in the equations (1) and (2) is related to
velocity of circulation of money V in Fisher’s transactions
approach. Thus, when a greater proportion of nominal income is
held in the form of money (i.e., when k is higher), V falls. On the
other hand, when less proportion of nominal income is held in
money, K rises. In the words of Crowther, “The higher the
proportion of their real incomes that people decide to keep in
money, the lower will be the velocity of circulation, and vice versa.
• Now rearranging the equation we get that, P = M/KY, Now, Cambridge
economists also assumed that k remains constant. Further, due to their
belief that wage-price flexibility ensures full employment of resources, the
level of real national income was also fixed corresponding to the level of
aggregate output produced by full employment of resources.
• Thus, from above equation it follows that with k and Y remaining constant
price level (P) is deter­mined by the quantity of money (M); changes in the
quantity of money will cause proportionate changes in the price level.

• Assumptions of Cambridge Approach:

• This theory is based in short-run.
• Money is used as function of exchange and store of value both.
• K is the constant of money income public want to hold
• K (proportion of holdings) and Y (income level of people) remains
constant in an economy.
• Assumption of full employment situation in the economy.
 Criticism of Cambridge’s Theory
1. Ignored various motives to hold cash: Although this approach was
evolved and popularized by Keynes, the theory does not to take into
consideration various motives for holding money. Cambridge approach to
the quantity theory ignored the speculative demand for money which turned
out to be one of the most important determinants for holding money.
Ignoring the speculative demand for money meant that the linkage between
the theories of the rate of interest and the level of income through the
demand for money was not complete.
2. Although Cambridge equation brought into the picture the level of income,
yet it ignored other elements, like productivity, liquidity preference—all
necessary in a comprehensive theory of the value of money.
3. Cambridge approach like Fisher’s approach also assumes K and Y as
constant, thus, it becomes subject to those criticisms, which were leveled
against Fisher’s approach.
4. The Cambridge approach does not furnish an adequate monetary
theory which could be utilized to explain and analyze the dynamic
behavior of prices in the economy, as it does not tell us by how much
price and output shall change as a result of a given change in money
supply in short period.
5. The cash balances approach fails to assign an explicit role to the rate of
interest thereby creating an impression that changes in the supply of
money are directly related to the price level. A realistic theory of prices
can hardly ignore the vital role of the rate of interest.
6. The cash balance theory does not explain the real forces which account
for the price level. It ignores such important variables as income, saving
and investment. It explains that changes in the demand for money may
bring about changes in the value of money, but it does not explain clearly
the factors which cause change in the demand for money, which in turn,
are very many and more so in a complex dynamic economy.
7. This theory takes unrealistic assumption of full employment which
does not exist in real life.
 Superiority of Cash balance approach over
Fisher’s Approach
• Superiority of Cash Balances Version:

• Cash balances version of the quantity theory of money is superior to Fisher’s version of the
quantity theory of money on the following grounds:

• (i) The cash balances version lays stress on the subjective valuations and human motives which are the
basis of all economic activities in sharp contrast to the highly mechanical nature of the concept of
velocity in Fisher’s equation.

• (ii) The Cambridge version of the theory brings to light a new element, namely, the level of income,
changes therein and in its velocity. Instead of being concerned with the total transactions it is concerned
with the level of income, which, in turn, determines the level of economic development, employment
and price level. As a matter of fact, the problem of price level cannot be studied without a reference to
changes in income and output. Moreover, it is not the velocity of money which matters but the velocity
of circulation of money due to changes in income that matters.

• (iii) The cash balances equation brings to light the demand for money to hold. This emphasis on the
demand side is in sharp contrast with traditional emphasis on the supply side. Actually, the Cambridge
equation was put forward to validate the classical quantity theory of money according to which the
supply of money is the sole determinant of the price level.
• (iv) The cash balances approach links itself with the general theory of
value, since it explains the value to money in terms of the demand for
and supply of money. The equation P = M/KY is a more useful device
than the transaction equation P = MV/T , because it is easier to know
how large cash- balances individuals hold than to know how much they
spent on various types of transactions.

• (v) The cash balances approach has given rise to the famous liquidity
preference theory, which has become an integral part of the theory of
income, output and employment.

• (vi) Cash balances approach brings out the importance of k. An analysis

of the factors responsible for fluctuations in k offered scope for the study
of many important problems like uncertainty, expectations, rate of
interest etc. which are not considered in the transactions approach. The
symbol k reflects the desire for liquidity. A shift in k in the direction of an
increased desire for liquidity shows a fall in demand for goods, i.e., a
movement away from goods to money resulting in the revision of
production plans, curtailment of output and fall of income.
 Keynesian Liquidity Preference Theory or
Keynes speculative demand for money theory
• According to him, the rate of interest is determined by the demand for and supply of money.

• Demand for money: Liquidity preference means the desire of the public to hold cash. According
to Keynes, there are three motives behind the desire of the public to hold liquid cash: (1) the
transaction motive, (2) the precautionary motive, and (3) the speculative motive.
• Transactions Motive: The transactions motive relates to the demand for money or the need of
cash for the current transactions of individual and business exchanges. Individuals hold cash in
order to bridge the gap between the receipt of income and its expenditure. This is called the
income motive.
• The businessmen also need to hold ready cash in order to meet their current needs like payments
for raw materials, transport, wages etc. This is called the business motive.
• Precautionary motive: Precautionary motive for holding money refers to the desire to hold cash
balances for unforeseen contingencies. Individuals hold some cash to provide for illness,
accidents, unemployment and other unforeseen contingencies. Similarly, businessmen keep cash
in reserve to tide over unfavorable conditions or to gain from unexpected deals.
• Keynes holds that the transaction and precautionary motives are relatively interest inelastic, but
are highly income elastic. The amount of money held under these two motives (M1) is a function
(L1) of the level of income (Y) and is expressed as M1 = L1 (Y)
• Speculative Motive: The speculative motive relates to the desire to hold
one’s resources in liquid form to take advantage of future changes in the
rate of interest or bond prices. Bond prices and the rate of interest are
inversely related to each other. If bond prices are expected to rise, i.e.,
the rate of interest is expected to fall, people will buy bonds to sell when
the price later actually rises. If, however, bond prices are expected to fall,
i.e., the rate of interest is expected to rise, people will sell bonds to avoid
losses.

• According to Keynes, the higher the rate of interest, the lower the
speculative demand for money, and lower the rate of interest, the higher
the speculative demand for money. Algebraically, Keynes expressed the
speculative demand for money as
• M2 = L2 (r)
• Where, L2 is the speculative demand for money, and
• r is the rate of interest.
• Geometrically, it is a smooth curve which slopes downward from left to
right.
• Now, if the total liquid money is denoted by M, the transactions plus
precautionary motives by M1 and the speculative motive by M2,
then
• M = M1 + M2. Since M1 = L1 (Y) and M2 = L2 (r), the total liquidity
preference function is expressed as M = L (Y, r).
• Supply of Money: The supply of money refers to the total quantity
of money in the country. Though the supply of money is a function
of the rate of interest to a certain degree, yet it is considered to be
fixed by the monetary authorities. Hence the supply curve of money
is taken as perfectly inelastic represented by a vertical straight line.
• Determination of the Rate of Interest: Like the price of any product,
the rate of interest is determined at the level where the demand for
money equals the supply of money. In the following figure, the
vertical line QM represents the supply of money and L the total
demand for money curve. Both the curve intersect at E2 where the
equilibrium rate of interest OR is established.
• At the point E1 the supply of money OM is greater than the demand for
money OM1. Consequently, the rate of interest will start declining from
OR1 till the equilibrium rate of interest OR is reached. Similarly at OR2
level of interest rate, the demand for money OM2 is greater than the supply
of money OM. As a result, the rate of interest OR2 will start rising till it
reaches the equilibrium rate OR.
• Criticisms:

• 1. It has been pointed out that the rate of interest is not purely a monetary
phenomenon. Real forces like productivity of capital and thriftiness or
saving by the people also play an important role in the determination of
the rate of interest.
• 2. Liquidity preference is not the only factor governing the rate of interest.
There are several other environmental factors which influence the rate of
interest by affecting the demand for and supply of investible funds. These
factors are : rate of GDP in economy, inflation or deflation in economy,
trade cycle etc.
• 3. The liquidity preference theory does not explain the existence of
different rates of interest prevailing in the market at the same time.
• 4. Keynes ignores saving or waiting as a means or source of investible fund.
To part with liquidity without there being any saving is meaningless.
• 5. The Keynesian theory only explains interest in the short-run. It gives no
clue to the rates of interest in the long run.
Thank You