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Classical Theory Of Demand For Money

 Demand for Money

Introduction

            The demand for money occurs from two significant roles of money. The prime factor is that money performs as a medium of exchange and the next is that it is a store of value. Therefore, individuals and businesses wish to keep money a portion in cash and in the form of assets.

There are to outlooks on this matter. The first is the scale outlook which is associated to the contact of the earnings or affluence level upon the demand for money. The demand for money is straight associated to the earnings level.

The higher the earnings level, the huger will be the demand for money. The second is the substitution outlook which is associated to relative attractiveness of assets that can be substituted for money.

Illustration 55

The demand for money function is given as follows:

                        Md      =          1.2Y – 150i
Where income Y is million dollars and interest rate ‘i’ is percentage.

  1. Compute the demand for money when income rate i 8000 million dollars and the interest is 10 percent.

  2. Given that level of income remains equal to $8000 millions, if interest rate of interest drops to 4 percent, how much does it affect demand for money?

  3. If interest rate hikes to 16%, what will be the demand for money?

Solution

 (a)
                                    Md      =          1.2Y – 150i                 ………..Equation (1)

Substituting the values of Y and i in the equation, we obtain the following:

                                    Md      =          (1.2*8000) – (150*10)

                                                =          9600 – 1500

                                                =          8100

(b) When the interest rate declines to 4 percent, then we obtain the following:

                                    Md      =          (1.2*8000) – (150*4)

                                                =          9600 – 600

                                                =          9000

Therefore, at a lesser rate of interest the demand for money to hold is more.

(c) When the rate of interest is 16 %, then we obtain the following:

                                    Md      =          (1.2*8000) – (150 *16)

                                                =          9600 – 2400

                                                =          7200

Therefore, at a higher rate of interest, the demand for money made by people will be lesser to hold.

Approaches to Demand

  1. The Classical Approach
  2. The Keynesian Approach or Liquidity Preference

The above are the two approaches for ascertaining the demand for money.

  1. The Classical Approach

    The classical economists did not unambiguously devise demand for money thesis but their outlooks are intrinsic in the volume of thesis of money. They highlighted the transactions demand for money of exchange and smooth the progress of the exchange of goods and services. In Fisher’s Equation of Exchange,

                            MV      =          PT

    Where M is the total volume of money, V is its velocity of circulation, P is the price level and T is the aggregate amount of goods and services exchanged for money.

    The right hand side of this equation PT represents the demand for money which actually based on the value of the transactions. MV represents the supply of money which is specified and in symmetry parities the demand for money. Thus the equation becomes

                            MV      =          PT

    This transaction demand for money, in turn is ascertained by the level of full employment earnings. This is due to the classicists assumed in Say’s Law whereby supply created its own demand, presuming the full employment level of earnings. Thus the demand for money in Fisher’s approach is invariable ration of the level of transactions which in turn abides an invariable association to the level of national earnings. Moreover, the demand for money is connected to the quantity of business going on in a fiscal system at any point of time. Therefore, its underlying hypothesis is that people keep money to buy goods.

    However, people also keep money for other causes such as to earn interest and to provide against unanticipated proceedings. It is therefore, not feasible to say that V will remain invariable where, M is variable. The most significant thing about money in Fisher’s Thesis is that it is shift able.

    However, it does not describe fully why people possess money. It does not elucidate whether to add as money such items as time deposits or savings deposits that are not right away accessible to pay debts without first being rehabilitated into currency.

    Cambridge Demand Equation for money is as follows:

                            Md      =          kPY

    Where Md is the demand for money which should parity the supply of money (Md = Ms) in symmetry in the fiscal system. k is the fraction of the actual money earnings (PY) which people wish to keep in cash and demand deposits or the ratio of money stock to earnings, P is the price level and Y is the aggregate actual earnings.

    This equation tells us that “other things being equal, the demand for money in normal terms would be in ration to the nominal level of earnings for each individual and hence for the total fiscal system as well.”

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