Speculative Demand for money 3

If people are plungers and they believe that the normal interest
rate re, they will hold either all bonds or all money. Therefore the
speculative demand for money is discontinuous. A discontinuous
money demand function can only happen if people are plungers,
i.e. they will put all or none of their money into bonds.

As different individuals have different expectations regarding
interest rate and aggregation of the demand for money will yield a
demand for money curve that slopes continuously downwards.

Taking both his concepts of transaction demand and
speculative demand for money together, the Keynesian money
demand function can be represented as:
Md / P = f( r , Y)

Speculative Demand for money 2

Taken together, when interest rate is high, the high interest
payment foregone as well as a likely capital gain on bonds means
that demand for money (as a store of value) will be low. As
interest rate falls, the demand for money as an asset would increase.
Therefore according to Keynes, the demand for money as a store
of value is inversely related to interest rate. This is Keynes
speculative demand for money.

If current interest rate is higher than re, people would
rather hold all their extra money in bonds in the hope of making
capital gains when interest rate returns to the normal level. If
current interest rate is lower than re, people would prefer to hold
money in idle cash, so as to avoid capital losses when interest
rate returns to the normal level.

Speculative Demand for Money

Speculative Demand for Money

The most important contribution of Keynes is that
he added the idea that since money is a store of value it is therefore
an asset that people can hold as wealth. He therefore viewed money
as one asset in an individual’s portfolio and considered how an
individual divides his wealth between money and alternative interest
earning assets.

The important variable according to Keynes that determine the split
of an individual’s portfolio between money and bonds was the
interest rate on bonds. At high interest rate, the opportunity cost of
holding money is high (the forgone interest payments). Added
to this according to Keynes is the fact that when interest rate is
high relative to some fixed view of the normal level, the public
would expect interest rate to fall. A decline in interest rate will
mean a capital gain on bonds.

Keynes Liquidity Preference Theory

Keynes Liquidity Preference Theory

Keynesian theory considered money as a store of value in
addition to a medium of exchange.

Transaction and Precautionary Demand for Money
Keynes, like the classical economists, held the view that real
income was the most important determinant of the transaction
demand and precautionary demand for money.
Therefore, according to Keynesian theory, both the transaction and
precautionary demand for money are proportional to income.

Mechanism of Money Demand

To understand how money affects the economy, it is useful to
express the quantity of money in terms of the quantity of goods
and services it can buy which is the concept of real money
balances (M/P). Real money balances measure the purchasing
power of the stock of money.


Since V is rather stable, we can represent it as k = 1/V, and
therefore M can be written as:

M = k PY
The quantity theory of money is also a theory of the demand for
money. When the money market is in equilibrium, quantity of
money supplied (M) equals the quantity of money demanded
(Md)

Therefore:
Md = kPY


This means that the real demand for money (Md/P) is proportional
to real income or the level of output. Therefore according to the
Classical school, the demand for money is purely a function of
income.

Classical Quantity Theory of Money

Classical Quantity Theory of Money

Classical economists saw money’s role only as a medium of
exchange.
The relationship between transactions and money is expressed in
the following identity, called the quantity theory of money.
MV= PY

It relates the nominal money supply (M) and income velocity of
money (V) to the price level (P) and real GDP (Y ).


Fisher viewed velocity as constant in the short run. This is because
velocity is affected by institutions and technology that change
slowly over time.