Theories of Money Demand – Quantity Theory of Money Demand

What is Money Demand?

Money Demand refers to the desire or need of individuals, businesses, and the government to hold money (cash or bank balances) instead of investing it in other assets like bonds, shares, or real goods.

In simple words, money demand is the amount of money people want to keep with them at a given time.

What do Classical Theories say about Money Demand?

The classical economists (like Irving Fisher, Alfred Marshall, and A.C. Pigou) believed that money is demanded only for transaction purposes. According to them, money is primarily a medium of exchange, rather than an asset for earning interest.

Quantity Theory of Money Demand

There is a positive and proportional relationship between the quantity of money demanded and its price level. It illustrates the relationship between money demand and the price level, assuming a positive and proportional relationship.

Neo-Classical Theory of Money Demand
Monetarist/Friedman’s Theory of Money Demand

Neo-Classical Theory of Money Demand (Quantity Theory)

Marshall, Pigou, Robertson, and Wicksell
Cambridge cash balance approach to money demand

The neoclassical slightly reorganizes the classical quantity theory of money to develop the neoclassical money demand theory.

For the neo-classist, people do not spend the whole of their income; they hold some part of their income in the form of a cash balance, which is the money demand.

According to the neo-classist, money gives utility in the form of security and comforts. So, they hold some proportion of their income in the form of cash. To explain such money or cash holding they use the classical quantity theory of money, which is given by the Fisherian equation of exchange as

$M V = PT$
Where:
1. = Money supply
2. = Velocity of circulation (constant)
3. = Price level
4. = Volume of transactions
👉 Money demand = money needed for transactions
👉 Since $V$ is constant, money demand is directly proportional to

For the classists, V and Y are assumed to be given, and so, there is a positive proportional relationship between M and P. It makes money as a medium of exchange only.

Here, Money demand is a positive function of price level and income.
If the price level increases from Po to P1, then the nominal income also increases from Mo to M1.
Therefore, in the neo-classical theory of money demand (Md), people demand money, which is a constant proportion of their income, and such money demand is a positive function of price level and income.

MV = PY

or, M = 1/V PY

or, M = KPY, where K = 1/V, which is the proportionality constant, and it represents the proportion of income held as a cash balance by the economy. So the equation represents the neo-classical money demand function. (Md = KPY where 0<K<1).

Eg, If K = 0.25, then 25% of the income of the economy is held as a cash balance by the economy. This shows that the money demand is positively dependent on price level and income, which means money demand increases if price level increases because more money is needed for transactions. Similarly, an increase in income increases the expenditure of the individual, and so they demand more money.

Neoclassical money demand

Friedman’s Theory of Money Demand (A re-statement of the Quantity theory)

It is the monetarist theory of money demand.

This theory is more concerned with explaining the determinants of money demand rather than explaining why people demand money.

According to Friedman, there are various determinants of money demand both theoretically and empirically. Friedman argues that there is no separate motive for money demand. As money is a part of the assets, people demand money or cash as they demand other assets such as bonds, equity, physical, and human assets.

The focus of this theory is to identify the determinants of money demand, and the following are the major determinants identified by Friedman.

1. Wealth or Assets (W)

Friedman shows that money demand depends positively on wealth, which means that if people are wealthier, they need more money for their higher expenses.

i.e., if W↑ then Md↑ or W↓ then Md↓

2. Income (Y)

There is a positive relationship between income and money demand.

i.e., if Y↑ then Md↑ or Y↓ then Md↓

3. Price Level (P)

If the price level increases, then people need more money for their transaction expenses. So, there is a positive relationship between Md and P.

i.e., if P↑ then Md↑ or P↓ then Md↓

4. Inflation (P•)

Inflation reduces the value of money or purchasing power, and so a rational individual reduces money demand and invests in other assets if inflation is increasing. There is a higher opportunity cost of holding cash during inflation, and so there is an inverse relationship between inflation and money demand.

i.e., if P•↑ then Md↓ or P•↓ then Md↑

5. Interest Rate (i)

Interest rate is the opportunity cost of holding money, and so there is an inverse relationship between Md and i.

i.e., if i↑ then Md↓ or Pi↓ then Md↑

6. Expected return from bond (r^e_b), equity (r^e_e), and other assets (r^e₀)

If the expected return from bond equity and other assets increases, people invest in them, and they hold less cash or reduce their money demand. This means there is an inverse relationship between the expected return from these assets and money demand.

If r^e_b↑, then Md↓
If r^e_e↑, then Md↓
If r^e_o↑, then Md↓

7. Ratio of human and non-human assets (HA/NHA)

There is an inverse relationship between money demand and the ratio of human and non-human assets.

i.e., if HA/NHA↑ then, Md↓ or HA/NHA↓, Md↑

8. Taste and preference for money (z)

During a crisis and uncertainty, the preference for money increases, which increases the Md.

i.e., if Z↑, then Md↑ or if Z↓, then Md↓

Based on these factors, the theoretical Md function as suggested by Friedman is Md = f(W,Y,P,P•,I,r^e_b,r^e_e,r^e_o,HA/NHA,z)

Where,

Fw >0, Fy > 0, Fp > 0, Fp• <0, Fi < 0, Fr^e_b<0, Fr^e_e< Fr^e_o, f HA/NHA<0, Fz<0

This equation is the theory of Md function developed by Friedman. For the empirical purpose, it is not necessary to consider all of these factors. For the empirical simplification, Friedman suggests dropping some of these factors without reducing the validity and usefulness of the money demand function.

Friedman argues that W and Y are positive and proportional, and so it is not necessary to consider both of them in the empirical model. As the computation of W is statistically difficult, we can drop W and consider Y only.

Similarly, if the price level is stable and the economy is not in hyperinflation or deflation, then we can drop P• in the empirical model.

If the financial market is efficient and competitive, then the return from all the assets is more or less equal. So, we can consider the interest rate as the proxy for the expected return from all the assets. It means we can drop down r^e_b, r^e_e, r^e_o.

Due to the statistical difficulty in computing the ratio of human and non-human assets, we can drop human HA and NHA.

Finally, the taste and preference for money remain stable in the short run, and so we can also drop z in the empirical model. So, the empirical money demand function suggested by Friedman is:

Md = f(Y,P,i) ———– (i)

Where,

fY>0
fP >0
fi <0

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