KYAMBOGO UNIVERSITY

FACULTY OF ARTS AND SOCIAL SCIENCES

DEPARTMENT OF ECONOMICS AND STATISTICS

COURSE UNIT: EC223 MONEY AND BANKING

DATE OF SUBMISSION:

NAME: KALULE RICHARD

REG NO: 10/U/66/BEK/GV

SIGNATURE

Money can be defined as any thing that is generally acceptable as a medium of exchange. It can also be defined as a third commodity that is introduced between two other commodities to facilitate exchange. Money can therefore be looked at as an instrument that helps in fulfillment of contracts, discharge of debts and as a standard of deferred payment. Due to the obligation of people to accept money in the discharge of debts, money is often referred to as legal tender.

The demand for money can be defined as the desire by the public to hold cash other than investing it in interest earning assets. it can also de defined as the desire by the individuals and businesses to hold their incomes partly in cash and partly in form of assets.

The question of why do people demand for money has been a great topic of discussion among the economists from the days of the classical economists to the monetarists but like many other economic phenomena, no common consensus has ever been reached. Unlike the goods and services, money has no intrinsic value that is to say does not provide direct utility. Instead, the existence of money helps in improving the transactions where we obtain goods that satisfy human wants. Money is therefore useful because it provides an improved alternative in transactions technology over barter trade.

The demand for money arises from the two important functions of money that is money acts as a medium of exchange and secondly it acts as a store of value. Premised on the above functions people demand for money in an economy but this also results into the question of what determines the demand for money in an economy. There are two views to this end and these are:

The scale view
This is related to the impact of income or wealth on the demand for money. This indicates a positive relationship between income and money demand that is to say an increase in an individuals wealth results into an increase in his the demand for money.

The substitution view
This is related to the relative attractiveness of assets that can be substituted for money. according to this view, when the alternative assets like bonds, treasury bills become unattractive due to a fall in the interest rates, people prefer to keep their assets in cash forms resulting into an increase in the demand for money but when the interest rates on the bonds increase, this results into increased investment in such assets hence resulting into a reduction in the demand for money.

The scale and substitution view have been jointly used to explain the nature of demand for money which has been split into transactions demand, precautionary demand, speculative demand and finance demand.
Due to the many contentious issues surrounding the demand for money, many theories have been developed to explain the demand for money and prominent among these are discussed below.
The classical theory
The classical economists did not explicitly formulate the theory of demand for money but their views are inherent in the Irving fisher’s quantity theory of money. they emphasized that the transactions demand for money in terms of velocity of circulation of money. this is because money serves the purpose as a medium of exchange of goods and services.
In the fisher’s “equation of exchange”,
MV=PT
Where ➢ M is the total quantity of money ➢ V is the velocity of money circulation that is to say the frequency with which money changes hands ➢ P is the price level ➢ T is the total amount of gods and services exchanged for money

The right hand of the equation PT represents the demand for money which in fact “depends upon the value of the transactions to be undertaken in the economy and is equal to a constant fraction of those transactions”.

MV represents the supply of money which is exogenously determined and for the economy to be in equilibrium, the demand for money should be equal to the supply of money. Therefore the equation of exchange becomes

Md = PT

Where Md is the demand for money in the economy

This transactions demand for money is in turn determined by the level of full employment income this is because the classical economists believe in Say’s law that “supply creates its own demand assuming a full level of employment of income in the economy” thus the demand for money in fisher’s approach is a constant proportion of the level of transactions which in turn bears a constant proportion in the level of national income. Further, the demand for money is linked to the volume of trade going on in the economy at a given time.

Criticisms of the classical theory
Its underlying assumption is that people only hold money to buy goods and services. People also hold money to for other reasons, such as to earn interest, and to provide against the unforeseen circumstances like sickness. It is therefore not possible to say that V will remain constant when M is changed.
The most important thing about money in the quantity theory of money is that money is transferable but it does not expeditiously explain why people demand or hold money.
The theory also fails to explain what makes up money. It does not clarify whether to include items like time deposits, or savings deposits that are not immediately available to pay debts as money without first converting them into cash.

Cambridge cash balance approach
It was the Cambridge cash balance approach which raised a further question of “why do people actually want to hold their assets in the form of money?” with larger incomes, people want to make bigger volumes of transactions and this results into demand for larger cash balances.
The Cambridge demand equation for money is

Md=kPY

Where ➢ Md is the demand for money in the economy ➢ k is the fraction of real money income (PY) that people want to hold in cash and demand deposits or the ratio of money stock to income ➢ P is the price level ➢ Y is the aggregate real income

For equilibrium, the demand for money must be equal to the supply of money (Md=Ms). This equation tells us that other things being equal, the demand for money in normal terms would be proportional to the nominal level of income for each individual and hence for the aggregate economy as well.

This approach includes time and savings deposits and other convertible funds in the demand for money. It also stresses the importance of factors that make money more or less useful such as the costs of holding money, the uncertainty about the future and so on.

Criticisms it says little about the nature of the relationships that one expects to prevail among its variables and it does not highlight the most important ones.

It neglects storage of value as a function of money. The classical economists emphasized only the medium of exchange function of money which simply acted as a go between to facilitate transactions .for them money performed a neutral role in the economy. It was barren and would not multiply if stored in form of wealth .this was an erroneous view because money performed the asset function when transformed into other assets like bonds, equities, debentures, real assets, etc. Thus the neglect of the asset function of money was the major weakness of the classical theory that Keynes remedied.

THE KEYNESIAN APPROACH: LIQUIDITY PREFERENCE
Lord Keynes in his general theory of employment, interest and money used a new term of “liquidity preference” for the demand for money. Keynes suggested three motives which led to the demand for money in an economy; 1. transactions demand 2. the precautionary demand 3. the speculative demand

Transactions demand for money
The transactions demand for money arises from the medium of exchange function of money in making regular payments for the goods and services. According to Keynes, it relates to “the need to the need of cash for the current transactions of personal and business use”. It is further sub-divided into two other motives that is to say:

The income motive
This is meant to bridge the gap between the interval of receipt of income and its disbursement.

The business motive
This is meant to bridge the gap between incurring of business costs and the receipt of the sales proceeds. If the time between the incurring of business costs and the receipt of sales proceeds is long, much cash will be demanded but if the gap is smaller, less cash will be demanded.

There will be changes in transactions demand for money depending upon the expectations of income recipients and businessmen. They depend upon the level of income, the rate of interest, the business turnover and the normal period between the receipt and disbursement of income.

The demand for transactions money is income elastic and it is a direct proportional and positive function of income levels that can be expressed as

LT=kY
Where
➢ LT is the transactions demand for money ➢ k is the proportion of income kept for transaction purposes ➢ Y is the income

Therefore there is a general conclusion that changes in income is the chief determinant of the changes in the in the transactions balances held by an individual in the economy .from the equation, changes in transactions balances is as a result of changes in Y rather than changes in k.

Regarding the rate of interest rates as the determinant transactions demand for money, Keynes made the LT function interest inelastic. He pointed out that the “demand for money in the active circulation is also to some extent as a function of interest rate, since a higher rate of interest may lead to a more economical use of active balances.”

However he did not stress the role of the rate of interest in this part of his analysis and many of hi followers ignored it altogether.

In recent years, two post Keynesian economists William j. baumol and James Tobin have shown that the rate of interest is an important determinant of transactions demand for money. They have also pointed out that the relationship between transactions demand for money and income is not linear and proportional. Rather changes in income lead to proportionately smaller changes in transactions demand.

Transactions balances are held because income received once a month is not spent on the same day. Individuals spread their expenditures evenly over the month.

Precautionary demand for money
The precautionary motive relates to the desire to provide for contingencies requiring sudden expenditure and unforeseen opportunities. Both individuals and businessmen keep cash in reserves to meet unexpected needs.

Individuals keep money for accidents and unforeseen contingencies. Similarly, businessmen keep money in reserves in order to crossover unfavorable conditions like fire or losses or to gain from unexpected deals. Therefore money held under the precautionary motive is like water kept in reserve in a water tank.

The precautionary demand for money depends on the level of income, businessmen activities, opportunities, unexpected profitable dealings, availability of cash and the cost of holding liquid assets.

Keynes was of a view that the demand for money for transaction purposes, was like the demand for precautionary purposes because both of these demand for money functions are dependent on the level of income and not interest rate. As observed in transaction demand for money by the post Keynesian economists, it’s not true that demand for money is independent of interest.
The transaction and precautionary demand for money will be unstable, particularly if the economy is not at full employment level and transactions are therefore less than the maximum and are liable to fluctuate up and down .since precautionary demand for money is a function of income and interest rates, the demand for money for precautionary and transactions is expressed in a single equation LT =f(Y,r)

Speculative demand
The speculative (asset) demand for money is for “securing profit from knowing better than the market what the future will bring forth”. Individuals and businessmen having funds after keeping enough for the transactions and precautionary motives, like to make a speculative gain by investing in bonds. Money held for speculative purposes is a liquid store of value which can be invested at an opportune time in interest bearing bonds.
Bond prices and the rate of interest are inversely related to each other. low bond prices are indicative of high interest rates, and high bond prices reflect low interest rates. A bond carries a fixed rate of interest.
It should be noted that when the interest rate is so low, the public will not loose anything to hold money balances because there will be low interest rates to forego. The speculative demand for money therefore is a function of income and interest rate.
Md = f(Y, r) for instance if a bond is of the value 100$ and carries 4% interest and the market rate of interest rises to 8%,the value of this bond falls to 50$ in the market. If the market rate of interest falls to 2%, the value of the bond will rise to 200$.
This can be worked out using the equation
V = R r

where V is the current value of a bond, R is the annual return on the bond and r is the rate of return currently earned or the market rate of interest. so for a bond worth 100$ (V) and carrying a 4%rate of interest (r) ,gets an annual return (R) of 4$ that is V=4/0.04.

Thus individuals gain by buying bonds worth 100$ at an 8% interest rate when they are worth 50$ and selling them when they are dearer at a 2% rate of interest at 200$

According to Keynes, it is expectations about changes in bond prices or in the current market rate of interest that determine the speculative demand for money. In explaining the speculative demand for money, Keynes had a critical rate of interest (rc) in mind. If the current rate of interest (r) is above the critical rate of interest, businessmen, expect it to fall and bond prices to rise. They will therefore, buy bonds to sell them in future when their prices rise in order to gain thereby. At such times, the speculative demand for money would fall. Conversely, if the current rate of interest happens to be below the critical rate, businessmen expect it to rise and bond prices to fall. They will therefore sell bonds in the present if they have any and the speculative demand for money would increase. Thus when r> rc, an investor holds all his liquid assets in bonds and when r< rc , his entire holdings go into money. But when r = rc , he becomes indifferent to hold bonds or money .

The speculative demand for money is a decreasing function of interest. the higher the interest rate, the higher the speculative demand for money as shown in the diagram below.

[pic]
The figure shows that at a very high rate of interest r3, the speculative demand for money is very low(S) and businessmen invest their cash holdings in bonds because they believe that the interest rate can not rise further. As the rate of interest falls to r2, the speculative demand for money increases to (S(). Thus the Keynesian speculative demand for money function is highly volatile, depending upon the behavior of interest rates.

The liquidity trap
Keynes visualized conditions in which the speculative demand for money would be highly or totally elastic so that changes in quantity of money would be absorbed fully into speculative balances. This is the famous Keynesian liquidity trap. In this case, changes in the quantity of money have no effects at all on prices and income. According to Keynes, this is likely to happen when the market interest rate is very low so that the yields on bonds, equities and securities will also be low.

At a very low rate of interest, such as r1 in the diagram above, the LS curve becomes perfectly elastic and the speculative demand for money becomes infinitely elastic. This portion of the LS curve is known as the liquidity trap. At such a low rate, people prefer to keep money in cash rather than invest in bonds because purchasing bonds will mean a definite loss. People will not buy bonds so long as the interest rates remain at the low level and they will be waiting for the rate of interest to return to the normal level and bond prices to fall.

According to Keynes, as the rate of interest approaches zero, the risk of loss in holding bonds becomes greater. “When the price of bonds has been bid up so high that the rate of interest is say 2% or less, a very small decline in the price of the bonds will wipe out the yield entirely and a slight further decline would result in loss in the principal” thus the lower the interest rate, the smaller the earnings from bonds, therefore, the greater the demand for cash holdings. Consequently, the LS curve will become perfectly elastic.

Further according to Keynes, “a long term rate of interest of 2% leaves more to fear than to hope, and offers, at the same time a running yield which is only sufficient to offset a very small measure of fear.” This makes the LS curve “virtually absolute in the sense that everybody prefers cash to holding a debt which yields so low a rate of interest”

Prof. Modigliani believes that an infinitely elastic LS curve is possible in a period of great uncertainty when the price reductions are anticipated and the tendency to invest in bonds decreases, or if there prevails “a real scarcity of investment outlets that are profitable at rates of interest higher than the institutional minimum”

The phenomenon of liquidity trap possesses certain important implications.
First, the monetary authority cannot influence the rate of interest even by following a cheap monetary policy. An increase in the quantity of money cannot lead to a further decline in the rate of interest in a liquidity trap situation.
Secondly, the rate of interest cannot fall to zero

Thirdly, the policy of a general wage cut cannot be efficacious in the face of a perfectly elastic liquidity preference curve such as in the figure above. No doubt a policy of general wage cut would lower wages and prices, and thus release money from transactions to the speculative purpose, the rate of interest would remain unaffected because people would hold money due to the prevalent uncertainty in the money market.

Lastly, if new money is created, it instantly goes into speculative balances and is put into bank vaults or cash boxes instead of being invested. Thus there is no effect on income. Income can change without any change in the quantity of money. Thus monetary changes have a weak effect on economic activity under conditions of absolute liquidity preference.

The total demand for money
According to Keynes, money held for transactions and precautionary purposes is primarily a function of the level of income, LT= f(Y), and the speculative demand for money is a function of the rate of interest, Ls =f(r). Thus the total demand for money is a function of both income and interest rate.
LT +Ls =f(Y) + f(r)
L= f(Y) + f(r)
L=f(Y, r)
Where L represents the total demand for money. Thus the demand for money can be derived by the lateral summation of the demand function for transactions and precautionary purposes and the demand

The post Keynesian approaches
Keynes believed that the transactions demand for money was primarily interest inelastic. Prof. Baumol has analyzed the interest elasticity of the transactions demand for money on the basis of hi inventory theoretical approach. Further in the Keynesian approach, the speculative demand for money is analyzed in relation to uncertainty in the market. Prof Tobin has given an alternative theory which explains liquidity preference as behavior towards risk. The third important post Keynesian development has been Friedman’s formulation that the demand for money is not merely a function of income and the rate of interest but also of the total wealth. This analysis has already been discussed under Friedman’s reformulation of the quantity theory of money.

Baumol inventory theoretic approach.
William baumol has made an important addition to the Keynesian transactions demand for money. Keynes regarded transactions demand for money as a function of the level of income, and the relationship between transactions and income as linear and proportional. Baumol shows that the relationship between transactions demand and income is neither linear nor proportional. Rather changes in income lead to less than proportionate changes in transactions demand for money. Further, Keynes considered transactions demand for money as primarily interest inelastic. But baumol analyses the interest elasticity of the transactions demand for money.

Baumol’s analysis is based on the holding of an optimum inventory of money for transactions purposes by a firm or an individual. He writes; “a firm’s cash balance can usually be interpreted as an inventory of money which its holder stands ready to exchange against purchases of labour, raw materials, etc.” cash balances are held because income and expenditure do not take place simultaneously. “But it’s expensive to tie up large amounts of capital in the form of cash balances. For that money could otherwise be used profitably elsewhere in the firm….it could be invested profitably in securities” thus the alternative to holding cash balances is bonds which earn interest. A firm would always try to keep minimum transactions balances in order to earn maximum interest from its assets. The higher the interest rate on bonds, the lesser the the transactions balances it holds.

Baumol assumes that a firm receives Y dollars once per time period; say a year, which are spent at a constant rate over the period. It is therefore; always profitable for the firm to spend some idle funds on buying bonds which can be sold when it needs cash for transactions purposes .
The theory is summarized by the equation

Md=0.5P(2bY/r where ➢ P is the general price level ➢ b is the brokerage fee (non interest costs) ➢ Y is the income received in a given period ➢ r is the rate of interest ➢ Md is the demand for money
In the inventory theory of demand for money, baumol emphasizes that demand for money is demand for real balances
The equation shows that the demand for real transactions balances is proportional to the square root of the volume of transactions and inversely proportional to the square root of the rate of interest.
It means that the relationship between changes in the price level and the transactions demand for money is direct and proportional. The pattern of a firm’s purchases remaining unchanged, the optimal cash balances (Y) will increase in exactly the same proportion as the price level P. if the prices level doubles, and the monetary value of the firm’s transactions will also double. When all prices double, brokerage fee (b) will also double. Thus baumol’s analysis of the demand for real balances implies that there is money illusion in the demand for money for transactions purposes.

The superiority of Baumol’s model over the classical and the Keynesian approaches
Baumol’s model is an improvement of the classical and the Keynesian approaches in the following ways.
The cash balance quantity theory of money assumed the relationship between the transactions demand and the level of income as linear and proportional. Baumol showed that this relationship is not accurate. No doubt it’s true the transactions demand increases with increases in income but increases less than proportionately because of the economies of scale of cash management.
The theory also has the merit of demonstrating the interest elasticity of the transactions demand for money as against the Keynesian view that it is interest inelastic.
Further baumol analyses the transactions demand for real balances thereby emphasizing the absence of money illusion.
Lastly, the model integrates the transactions demand for money with the capital theory approach by taking assets and their interest and their non interest cost into account.

Tobin’s portfolio selection model: the risk aversion theory of liquidity preference
James Tobin in his famous article "Liquidity Preference as Behaviour towards Risk,"18 formulated the risk aversion theory of liquidity preference based on portfolio selection. This theory removes two major defects of the Keynesian theory of liquidity preference. One, Keynes's liquidity preference function depends on the inelasticity of expectations of future interest rates; and two, individuals hold either money or bonds.
Tobin has removed both the defects. His theory does not depend on the elasticity of expectations of future interest rates but proceeds on the assumption that the expected value of capital gain or loss from holding interest-bearing assets is always zero. Moreover, it explains that an individual's portfolio holds money and bonds rather than only one at a time.
Tobin starts his portfolio selection model of liquidity preference with this presumption that an individual asset holder has a portfolio of money and bonds. Money neither brings any return nor imposes any risk on him. But bonds yield interest and also bring income. However, income from bonds is uncertain because it involves a risk of capital losses or gains. The greater the investment in bonds, the greater is the risk of capital loss from them. An investor can bear this risk if he is compensated by an adequate return from bonds. .
If g is the expected capital gain or loss, it is assumed that the investor bases his actions on his estil\1ate of its probability distribution. It is further assumed that this probability distribution has an expected value of zero and is independent of the level of the current rate of interest, r, on bonds."
His portfolio consists of a proportion M of money and B of bonds where both M and B add up to 1. They do not have any negative values. The return on a portfolio R is
R =B (r+ g) where 0