keynesian money demand
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Keynesian Money Demand Theory
Traditional View
Money is medium of exchangeHas no intrinsic valuePeople hold money for transactions
Keynes Money Holding Motives
Transactions motivePrecautions motiveSpeculative motive
Transaction Motive
Holding money to carry on day to day transactions
Higher Income More Transactions More Money Demand
Mdt =f (y)
Precautions Motive
Holding money for emergencies
Expected transactions in futureMoney demand expected, rises
with incomeMdp =f (y)
Speculative motive
Way for people to store wealthSavings in banks for gaining interest Major idea is to increase profitsIncrease in interest rates, decrease
the money demandHigher Interest Rate Higher
Opportunity Cost of Money Lower Money Demand
Mds = f (i)
Keynes Money Demand Function
Md = Mdt + Mdp + Mds
Mdt =f (y) ----------------------K1Y
Mdp =f (y) ---------------------K2Y
Mds = f (i) --------------------- -miMd = Mdt + Mdp + Mds
= K1Y + K2Y – mi
= KY- mi
The Keynesian demand for money function
An increase in household income shifts the money demand function to the right.
Money Market Equilibrium
Money demand = Money SupplyMoney Supply is exogenous
controlled by Central Bankms=mo
md = ms
Ky-mi = mo
KY-mo = mi
Equilibrium in the money market
Increase in Money supply
Bond Holding Motives
Annual Return ARAR= PB x i
Capital Gains = expected price of bond – actual price of bond
Pe-Pa
Expected Yield E(y) = AR + Pe-Pa
As
Pe = AR ie
Pa = AR i
Expected Yield E(y) = AR + Pe-Pa
= AR + AR - AR ie i
AR + AR = AR ie i
AR( 1+ 1/ ie ) = AR / i1+ 1/ ie = 1 / i(1+ ie ) / ie = 1 / i
Critical Rate of Interest
i = ie / (1+ ie )
The Liquidity Trap
X = critical interest rate
Quantity Theory of Money
The Quantity Theory of Money states that there is a direct relationship between the quantity of money in an economy and the level of prices of goods and services sold.
According to QTM, if the amount of money in an economy doubles, price levels also double, causing inflation (the percentage rate at which the level of prices is rising in an economy). The consumer therefore pays twice as much for the same amount of the good or service.
The Theory’s Calculations
Irving Fisher, in his Purchasing Power of Money (1911), stated this theory by referring it to the infamous “equation of exchange”.
MV = PT
Each variable denotes the following:M = Money SupplyV = Velocity of Circulation (the number of times
money changes hands)P = Average Price LevelT = Volume of Transactions of Goods and Services
QTM Assumptions
1. The theory assumes that V (velocity of circulation) and T (volume of transactions) are constant in the short term.
According to Fisher V depends on the institutional and technical conditions of the economy. Institutional and technical conditions mean frequency of payments and credit availability. These are constant over a certain time period. Therefore V is also constant.
2. The theory also assumes that the quantity of money supplied, is exogenous i.e. determined by the outside forces, and is the main influence of economic activity in a society. A change in money supply results in changes in price levels and/or a change in supply of goods and services.
3. Finally, the number of transactions (T) is determined by labor, capital, natural resources (i.e. the factors of production), knowledge and organization. The theory assumes an economy in equilibrium and at full employment. T is the constant proportion of income. Within a year the number of transactions is of constant proportion.
4. Also, price level is the determinate not the determinant. Price level is determined by the other 3 variables, but it does not determine anything itself.
MV = PT income expenditure
In the above equation, V and T are constant.MV = PT
MV / T = PAssume that V / T =
M = PMoney Supply can change the Price Level but the Price level cannot change the Money Supply. Now, if there is a change in Money Supply, then
M / P = P / P
Now, P = M
M / M = P / PM / M = P / P
Proportionate change in Money will cause proportionate change in Price Level.
Summing up Keynesian Demand Money Theory
Interest is purely a monetarist phenomenon
Change in i/ change in Md > 0Change in i /change in Ms < 0 Interest is used to activate the economy
Implications Of Quantity Theory Of Money
Implications
The monetary theory of price levelProportionality thesisCausality thesisExogenity thesisNeutrality thesis
The Monetary Theory of Price Level
Price level is determined by the money market.
Price level cannot affect the Money Supply but the Money Supply can effect the price level.
Md,Ms P
Proportionality thesis
Change in the price level will be proportionate to the change in money supply.
It is the assertion which needs to be proved. Assume Md is unitary elastic Md E = 1 Ms is independent of price level. 1/p is used to show proportionate change
with Ms and to keep Md curve downward slope
E1 = equilibrium
E2 = new equilibrium
New equilibrium shows increase in price level
As Money supply is independent of price level.
If Ms is doubled Price increases by the same proportion.
Causality Thesis
There is one way causality, meaning causality runs from one side.
It is a cause and effect relationship.
P/P = M/M
Exogenity Thesis
Ms is exogenous and Md is a positive function of income level.
According to classical, Future is certain and there is no Mds or Mdp.
Only Mdt exists
Thus where Md=Ms we can determine income Y.
According to classical, Money can effect the variables in Nominal terms but not in Real terms.
Neutrality Thesis
According to neutrality thesis Money can be divided into two parts:
1. Real2. Monetary or Nominal
Money is neutral as far as the real variables are concerned.
It can only change the nominal values of real variables.
Real variables are determined in the real sector and money has no influence on them.
DL = f(w/p)
SL = f(w/p)
Where DL = SL w/p determinedWe know Y= f(L,K)Assume K is constant
Loanable Funds Market
The loanable funds market balances the demand for funds generated by borrowers & the supply of funds provided by lenders.
Interest rate - the price charged by a lender to a borrower for use of lender's savings for one year.
There is an inverse relationship between the quantity of loanable funds demanded and the interest rate.
There is a direct relationship between the quantity of loanable funds supplied and the interest rate.
How to determine interest rate
I = f (i)If i I When S = I Md = Ms
Lfd = Lfs
Bd = Bs
Choices Of Income Earners
Spending on Goods and Services. SavingInvestment
Players of Credit Market
LendersBorrowers
Supply Of Loanable Funds
SavingsDishoardingBank moneyDisinvestment
Now, if we add up all these factors we come to an equation:
Lfs = S + Dishoardings + Disinvestment + Bank Credit
Lfs = S + Other Factors
Lfs = f(S)
Demand Of Loanable Funds
Households/HoardingsGovernmentProfitability of the loan takenForeign firmsDemand to spend on rituals
Now, if we add up all these factors we come to an equation
Lfd = f(I)
Equilibrium of Market
Lfs = Lfd