LECTURE THREE

MONEY DEMAND
Lecture Outline
3.1 Introduction
3.2 Objectives
3.3 The Classical Theory
3.4 Keynesian Theory
3.5 The General Equilibrium Approach
3.6 The Monetarist Case
3.7 The Neoclassical Theory
3.8 The Neo-Keynesian Theory
3.9 Summary
3.10 References

3.1 Introduction
In this third lecture we will use the models of money demand to explain why individuals and
businesses hold money balances i.e. cash, checkable deposits, and their close substitutes. We
then use the models of money demand to show how the behavior of individuals and businesses
causes the level of money balances in the economy to increase or decrease. Our understanding of
the determinants of money demand comes from the work that economists have performed over
the past century.

3.2 Objectives
1. State and explain the determinants of money demand
2. Discuss the various models of money demand
3. Explain how the demand for money can be controlled in the
economy
4. Examine the policy implications of the various models of money
demand
5. Discuss the controversy between Keynesian and Monetarist
economists
6. Explain the transmission of monetary policy in the economy

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3.3 The Classical Theory
The classical theory is based on Say’s Law that states that supply creates its own demand.
Therefore, if Say’s Law were correct there would be no situations of either unemployment or
under consumption. Total expenditure in the economy would always equal production at full
employment level. The classical argument can be easily illustrated as follows.

Real SL
wage
C
D
W2
E
W0

W1

A B
DL

N
DL SL
Employment
Figure 3.1
Where
E = Equilibrium
CD = Excess supply of labour
Wo = Equilibrium wage
W1 = Disequilibrium wage

When there is excess supply of labour C-D, the wage rate falls until equilibrium is restored. The
converse is also true. The above analysis can be applied to the goods market. If there is an excess
demand for goods, prices will rise. This will lead to a rise in supply and a fall in demand.
Eventually the equilibrium will be restored. The converse is also true. Since all markets clear due
to flexible wages and prices, unemployment will be associated with dynamic disequilibrium
only. Therefore, in this model money plans no significant role in economic activity.
Consequently, the classical economists never studied money demand as such.

Assumptions of the Classical Theory

1. Competitive markets for goods, services and labour

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 2. Fully flexible wages that respond to demand and supply
3. Markets are always at equilibrium

3.3.1 Classical Savings, Investments and Interest Rate

Classical economists argued that savings will always be invested as a result of the interest
mechanism.
Let S stand for saving, I stands for investment, and r denote interest rate. We can derive the
following relationships:
S = S(r) (3.1)
I = I(r) (3.2)
S=I (3.3)
The above relationships are illustrated in Figure 3.2 below:

I
r

S S1
G F
r1

r0 E

r2

S
r3
I
S1
S,I
DL S0=I0
Figure 3.2

Savings increases directly with the interest rate. However, investments decrease with an increase
in interest rates. The latter is inverse relationship, since the cost of borrowing raises with r. In
Figure 3.2 the equilibrium interest rate is ro. If ro rises to r1, there will be excess savings GF and
r1 will fall until equilibrium is attained at E, where S=I. The propensity to invest will depend on
MR and r. If people decide to save more, the savings curve will shift form SS, to S1S1 and
equilibrium will be restored at r2 <r0.

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Output in the above analysis is determined by labour, capital, savings and exiting technology.
The classical economists argued that the function of money is to determine the general level of
prices at which exchange of goods and services will occur. Money is just a ‘veil’.

3.3.2 The Classical Quantity Theory of Money (CQTM)

The CQTM can be best illustrated by Irving Fisher’s (1911) equation of exchange given by
equation (3.4) below:
MV = PQ (3.4)
Where
M = average stock of money
V = the velocity of money
P = the price level
Q = income or output in the period.

In the original formulation T was used instead of Q. We use Q because there are some
transactions which are not included in GDP. Let us assume V and Q are constant then we can
express the direct relationship between M and P as shown in equation (3.5) or equation (3.6):
PQ
M  (3.5)
V
or
MV
P (3.6)
Q
These two equations express the direct relationship between M and P. Thus when M is doubled P
will also be doubled, and nothing else in the real world changes. Money is just a veil.

The CQTM assumes that individuals are rational and maximize utility. But money fails to
maximize utility since it is only a medium of exchange. Therefore according to the classical
economists it makes no sense to discuss the demand for money according to the classical
economists.

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3.3.3 The ‘Cambridge’ Demand for Money: The Cash Balance Approach
Economists in the Cambridge school argued that in order to understand money demand it is
necessary to pay attention to the fraction of income that could be held in cash. Therefore
equation (3.4) can be expressed as:
M = kPQ, (3.7)
where k is the fraction of income that is held in cash. Note that

kI (3.8)
V
Thus the difference between equations (3.4) and (3.7) is not important. However, equation (3.8)
shows the demand for money for transaction purposes. Equation (3.4) is an identity which can be
modified to express a causal relationship. If V and Q are assumed constant, a rise in M will cause
an increase in P.

According to the Cambridge school the demand for money will always equal supply in
equilibrium. If M rises there would be more money than people would wish to hold. This will
raise the level of expenditure and prices, since output cannot change in the short run. The focus
here is on the real money demand rather than nominal money demand.

In summary, the classical analysis is viewed as a long-run analysis, since Q and V are assumed
constant.

3.3.4 Limitations of the Classical Theory of Interest

The classical theory of money demand suffers from the following limitations:
1. The theory ignores factors other than saving and investment that affect interest rates.
For instance money creation and destruction affects interest rates and must be
included in any explanation of interest rates.
2. The theory assumes that interest rates are the primary determinants of the quantity of
savings available. Now economists know that income is the main determinants of
savings.
3. The classical theory argues that the demand for borrowed funds comes mainly from
the business sector. Today, however, consumers and governments are also important
borrowers.

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3.4 The Keynesian Theory (Liquidity Preference Theory)
The Keynesian theory of money demand is also known as the liquidity preference theory.
Keynes argued that the classical mechanism might fail to guarantee full employment equilibrium
because of several reasons;
1. Wages and prices may not be flexible.
2. Income rather than interest rates may determine savings and
3. If the speculative demand for money is infinitely elastic with respect to changes in the
interest rate, then no extra investment would be forthcoming from a further rise in saving
and the economy would end up in unemployment equilibrium.

3.4.1 Keynesian ‘Building Blocks’

To build his theory Keynes used the concept of the income multiplier. He showed that at
equilibrium planned saving must be equal to planned investment. If saving is greater than
investment the sequence of events which would ensue in the classical world are unlikely to
occur. This is because wages could be inflexible downwards so that whenever savings exceed
investments, production plans are cut back and unemployment follows. It is very difficult to
restore full employment by reducing the level of wages because of trade union resistance. Also
the interest rate may not determine the equilibrium level of savings and investment.

The process of interest rate determination was regarded by Keynes as a monetary phenomenon.
The rate of interest is determined in the market where the demand for money is equal to the
supply of money and the equilibrium saving(s) and investment (i) determines the level of income
(y). Hence output will continue to fall so long as planned savings exceeds planned investment.
Eventually equilibrium is returned as S=I.

In the Keynesian analysis the theory of the consumption function plays an important role.
Keynes argued that at the macro level, expenditure (E) determines income (Y). Total expenditure
is the sum of consumption expenditure (C) and investment expenditure (I):
Y=C+I (3.9)
Consumption depends on income. This relationship is expressed as follows:
C = a + by (3.10)
Where

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 b  C / Y  MPC , 0  b  1
a = constant and is known as autonomous consumption
The process of income generation can then be described as follows:
Y  C 1
(3.11)

Y  C  I (3.12)
Dividing by Y
Y C I
  (3.13)
Y Y Y
C I
Or I   (3.14)
Y Y
Y I
  m (3.15)
I I  C / Y
Y I I I
or  or or
I I  MPC I b MPS
Where MPS = marginal propensity to save.
I
Thus Y I
I b
The variable m is called the multiplier, and is the inverse of the marginal propensity to save.
Evidently, m will be positively related to the value of b or MPC and inversely to MPS. This
explains why savings constitute a leakage in the income generation process. This is illustrated in
figure 3.3(a) and Figure 3.3(b) below. If savings increase, MPS increases and Y falls. In figure
3.3(a) the equilibrium between S and I now determines the level of Y rather than interest rate.
Savings in the Keynesian theory is assumed to vary differently with income that is why we have
S(Y). However, investment (I) is assumed to be autonomous.

S(Y)
S,I

I0 I

I1 I1

0 y1 Y0
Y
Figure 3.3 (a)

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 S (Y)

S,I I0 C+I=E

C + I1
I0

I1 I

0
Y Y0 Y
Figure 3.3 (b)
1

In figure 3.3(b) we show that total expenditure E determines income Yo. We do not assume that
equilibrium Y will also be at full employment level income. The investment function could be
unstable as it depends on the investors expectations regarding future demand for planned
savings. If investment prospects are bad, then investments (I) may fall and this will reduce
equilibrium income, Y, to a less than full employment level. This is illustrated for a change from
I0 to I1 in Figure 3.3 (a) and Figure 3.3(b) which causes income to fall from Yo to Y1. To restore
full employment equilibrium it may be necessary to stimulate expenditure (G) or cut taxes to
stimulate demand, or both. These are usually regarded as the Keynesian remedies to cure
recession or depression.

Therefore, according to Keynes, an increase in money supply would increase cash balances held
by economic agents. Economic agents will then be confronted with the following three choices:

(1) Keep money idle (2) Buy plant and machinery, and (3) Buy bonds. Keynes argued
that people are likely to buy bonds with excess balances. This will raise the bonds prices
and drive down the interest rate. A fall in the interest rate will stimulate the level of
investment and an increase in investment will raise the level of income via the workings
of the multiplier. Thus an increase in money supply beyond the level of full employment
will raise the price level in the classical fashion. This is illustrated in Figure 3.4 below.
Beyond full employment, a rise in money supply from OM3 to OM4 simply bids up the
prices to P1 and P2.

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 Output P2 Price level (p)
and P1
prices
Qf
Output (y)
Q2

Q1

M1 M2 Mf M3 M4

Figure 3.4
Money and the Interest Rate
In the Keynesian model the rate of interest (r) is determined by the demand for (Md) and supply
of money (Ms). Money supply is treated as invariant in the short-run. Therefore Ms does not
change as r varies. This is illustrated in Figure 3.5 below.

S1
r S2 S3

r1

r2 Msp1

r1 Msp

S1 S2
Figure 3.5 Md, Ms

Keynes showed that the demand for money consists of three parts: (a) transaction demand for
money, Mt (b) precautionary demand for money, Mp (c) speculative demand for money, Msp.
Therefore,
Md = Mt + Mp + Msp. (3.17)

The transaction demand for money depends on the level of income, Y. The precautionary demand
for money also depends on Y and it arises from the need to hold cash for the rainy days.

Keynes invented the speculative demand for money. If money could be regarded as a financial
asset in the portfolio, then such an asset could be held in the portfolio along with other assets.

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Keynes referred to those other assets as bonds. People may wish to hold bonds rather than liquid
money because interest is paid on bond holdings. The bond prices fluctuates thereby exposing
bond holders to risk. Different bonds earn different interest rates because their risk profiles
differ. Keynes contended that the demand for money is an inverse function of r.
Msp = f(r) (3.18)

The reason is simple. When r is low, people expect that it will rise soon in the future. Since the
bond price and the interest rate, r, are inversely related people would like to avoid the capital
loss which accompanies a rise in r. Hence they would wish to hold more money. The reverse is
also true. Thus r is the price paid for parting with liquidity.

As shown in Figure 3.5 as Ms rises to S1S2, r declines to r1. However, further increase in Ms does
not lead to a fall in r1 while Md is constant. The economy is caught in the liquidity trap. Since r
has stopped declining there would be no change in investment and income. The liquidity trap
demonstrates the limits of monetary policy in curing recessions. The liquidity trap could operate
at low levels of r when the demand for money is infinitely elastic since everybody expects a rise
in r and a consequent fall in bond prices thus, nobody wants to hold bonds. It also follows that
monetary policy will be less effective when the demand for money is more elastic. Moreover, it
also implies that if the demand function is interest-elastic then there will be a large impact on
output or income. Obviously, the effectiveness of monetary policy will decline significantly if
the investment function is interest inelastic. If the Msp rises, the money demand function will
shift to Msp on the right of the marginal curve, and r rises to r2.

Limitations of the Liquidity Preference Theory

The Keynesian theory of money demand has the following limitations:
1. It is a short term approach to interest rate determination unless modified because it
assumes that income remains stable. In the long-run, interest rates are affected by
changes in the level of income, saving and investment in the economy.

2. It considers only the demand and supply for the stock of money, whereas business,
consumers and government demands for credit clearly have an impact on the cost of

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 credit. Therefore, a more comprehensive view of interest rates is needed that takes into
account the roles played by all actors in the financial systems: businesses, households,
and governments.

3.5 The General Equilibrium Approach to Money Demand

The General Equilibrium Approach is also called the Loanable Funds Theory. This theory was
developed by the economist R.J. Hicks of Cambridge University. Hicks argued that a truly
general theory of interest rate determination should be stated in a framework of a general
equilibrium analysis. In a more general version of the determinants of the demand for money we
should include the income Y and the rate of interest. Thus, we have,
Md = f(r,Y) (3.19)
This could be alternatively expressed as:
Md = kY + f(r) (3.20)
The interest rate r can be determined by the demand for and supply of loanable funds. The
demand for loanable funds is given by savings plus dishoardings:
Md = f(r,Y) (3.21)
S = S (r,Y) (3.22)
I = I (r,Y) (3.23)
Hicks contended that it is important to examine the basic relationships between r and Y through
changes in savings and the demand for money. If income (Y) increases then savings (S) will
increase, and the interest rate (r) will decrease. This is illustrated in Figure 3.6 below:
r
S0 Y0

S1 Y1
r0

S2 Y2
r1

r2

S,I
0
Figure 3.6

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If we join all the equilibrium points between S and I, we obtain the IS curve which depicts as
inverse relationship between r and Y. Every point on the IS curve is an equilibrium between S
and I. In the money market, the rise in income causes an increase in money demand. As money
demand increases the interest rate also rises. This is illustrated in Figure 3.7 below:

r0

r1
Md2 Y2

r2
Md1 Y1

Md0 Y0

0 Ms Md1 Ms

Figure 3.8

If we join all the equilibrium points between Md and Ms with a rise in Y, we trace out the LM
curve. The LM curve shows the relationship between r and Y when the money market is in
equilibrium. If we now combine the IS curve and the LM curve as shown in Figure 3.8 we obtain
the equilibrium interest rate, r*
r I
M

r*
S

0 Y
Figure 3.9

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In summary, a general equilibrium theory of interest rate determination includes the following
factors:
1. Savings
2. Investment demand
3. The liquidity preference
4. The quantity of money

The IS and LM curves are powerful tools to describe the workings of Monetary and fiscal
policies.

The Working of Monetary policy

If monetary policy is expansionary, the LM curve shifts to right to L1M1 as shown in Figure 3.9
and this causes the interest rates to decrease from  * to r*. Income increases from y0 to y1 . If
investment is interest inelastic the effect on income generation would be much less i.e. y0y2 <
y0y1. Also given and interest inelastic demand for money, a steep LM curve, an expansionary
monetary, policy will have a greater impact on Y. with an interest-elastic IS curve.

I M

I2
M1

r*

r1 * S2

L L1 S
y0 y2 y1
Figure 3.9

3.5.2 The Working of Fiscal policy

If an expansionary fiscal policy such as an increase in government expenditure, shifts the IS
curve to the right to I1S1, as shown in Figure 3.10, then income rises from YO to Y1, while r rises
from r0 to r1. If the LM curve is more interest-inelastic i.e. L1M1 rather than LM1 the increase in
output will be smaller Y0Y2 < Y0Y1. This is due to the fact that an interest inelastic LM curve
would require a larger rise in r to make the demand for money equal to the money supply. Such

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an increase in r will reduce significantly the level of private investment causing a small increase
in output Y. This impact is known as the crowding out effect. When the LM curves is completely
inelastic, fiscal policy has no effect on output, Y. The shift of the IS curve to I1S1 on the LM
curve simply raises the interest rate.

I1 M1
I
M
r2
r1
r0
S1
L S
L1
Yo Y2 Y1 Y

Figure 3.10

3.6 The Monetarist Case

The monetarist case has its root in the classical theory. The famous exponent of the monetarist
case is Professor Milton Friedman of Chicago University. Friedman has stated the Modern
Quantity Theory of Money which is based on the classical quantity theory of money. The
modern quantity theory states that changes in money supply will change the price level as long as
the demand for money is stable. Such a change affects the real value of national income and
economic activity but in the short run only. As long as money demand is stable it is possible to
predict the effects of changes in money supply on total expenditure and income.

The monetarists argue that if the economy operates at less than full employment level, then an
increase in money supply will lead to a rise in output and employment because of rise in
expenditure, but only in the short run. After a time, the economy will return to a less than full
employment situation which must be caused by other ‘real’ factors. The monetarists do not belief
that changes in money supply can affect real variables in the long run. At full employment point
or beyond it, an increase in money supply will only raise prices.

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Before full employment, income, Y, rises with a rise in money supply and expenditure. The rise
in Y will, then crucially depend on the ratio of income to money supply i.e. Y/M or velocity.
With an increase in spending during a recession, Y will continue to rise until it has reached a
limit where it stands in its previous ratio to M because at that point output can no longer be
increased. People will now raise their demand for money rather than spend it and the supply of
and demand for money would once again be equal to one another. These arguments are
illustrated in Figure 3.11 below.

Note that in contrast to the Keynesian analysis there is no change in the interest as M s changes.
It is also assumed that demand for money remains stable. Granted the stability in the velocity, the
Central Bank can control the volume of spending by controlling the money supply. The
stabilization policy should then concentrate only on monetary policy – controlling the volume of
money supply.

Ms Ms1
Md = ky

Y2

Yo

Y1

Md, Ms

Md, = Ms
Figure 3.11
3.6.2 The controversy between Keynesians and Monetarists
The debate between Keynesians and Monetarists revolves around the issue of changing
aggregate demand by monetary or fiscal policies. On the one hand Keynesians argue that only
fiscal policies can change the level of income by changing aggregate demand. On the other hand
the monetarist argued that aggregate demand can be changed only by monetary policies. Overall
it seems that the monetarist case rests on the working of the vertical or near vertical LM curve.
This means that the demand for money is very inelastic to changes in the interest rate.
Similarly, the Keynesian case rests on the working of a vertical IS schedule with a normal LM

15
 curve. This implies a low elasticity of the investment function with respect to changes in the
interest rate.

3.6.3 Limitations of the Monetarist View

The monetarist theory of money demand has the following limitations:
1. Monetarists assume that the velocity of money is stable when evidence shows otherwise.
2. Price control is more important than monetary supply control only if the economy has
spare capacity (supply side economics).
3. Social costs of bringing down inflation are too high compared to benefits.
4. The link between Ms and aggregate expenditure are too variable to justify emphasis on
money supply control.

3.7 The Neoclassical Theory of Money Demand

The Neoclassical theory has its origin in the classical theory. Unlike its predecessor, the
neoclassical theory argues that money can affect real economic activity in the short run. The link
between money supply and output is due to imperfect information. Neoclassical economists
believe firms do not completely adjust their wages in the short run because business managers
and workers have imperfect information about changes in the price level. Thus, inflexible prices
prevent money from being neutral in the short-run.

a) Expected increase in the money supply b) Unexpected increase in money supply

SRAs1
SRAS0
E1
Prices
Y is P1 SRAs0 P1 1. Money
constan supply
1. Money rises
t supply
rises
P0 P0 2. YP AD1
AD1
P AD0
AD0 rises

Y0 Current Y Y0 Y1 Y

Figure 3.12

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In the neoclassical view, output increases when the price level is higher than expected.
Households and businesses incorporate expectations of changes in money supply into their
forecasts of the aggregate price level. Expected increases in money supply raise households and
firms’ expected value of the price level, and expected decreases in money supply reduce the
expected value of the price level. According to the new classical economists the impact of the
changes in the nominal money supply on output in the short run depends on whether those
changes are expected or not. This is illustrated in Figure 3.12.

As shown above in Figure 3.13(a), from an initial equilibrium at Eo an expected increase in the
nominal money supply shifts the AD curve from AD0 to AD1. The expected price level increases,
shifting SRAS curve from SRAS0, to SRAS1. At the new equilibrium, E1 the price level rises to
P1, and output remains unchanged to Y0.

b) Unexpected Changes in the Money Supply

From an initial equilibrium at E0, in Figure 3.12(b) an unexpected increase in the nominal money
supply shifts AD curve from AD0 to AD1. At the new equilibrium E1, the price level rises to P1,
and output rises to Y1. Therefore, in the new classical model, only unexpected changes in the
money supply affect output in the short-run.

3.8 New Keynesian Theory of Money demand

The Link between changes in money supply and output is due to sticky prices i.e. prices are not
completely flexible. The new Keynesians propose two reasons for price stickiness in the short
run: (1) Long term contracts (2) Imperfect competition among sellers in the goods markets.
According to new Keynesians, neither expected nor unexpected changes in the nominal money
supply are neutral in the short run. These arguments are illustrated in Figure 3.13 below.

a) Unexpected Decrease in Money Supply

As shown in the Figure 3.13 (a) from an initial equilibrium Eo, a monetary contraction shifts the
AD curve from AD0 to AD1. Because the decline in money supply is unexpected, the SRAS
curve remains at SRAS0. At the new equilibrium E1, output has fallen from Y0 to Y1.

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b) Expected Decrease in Money Supply
As shown in Figure 3.13 (b), below, from an initial equilibrium E0, a monetary contraction shifts
the AD curve from AD0 to AD1. Because the decline in money supply is expected, the expected
price level falls, and some but not all prices fall. The SRAs shifts from SRAS 0 to SRAS1. At the
new equilibrium, E1 output has fallen from Y0 to Y1, which is greater than Y1 in Figure 3.14 (a).

E0 SRAS0
Price level

E1 AD0

AD1

Y1 Y0 Y

Figure 3.13 (a)

Price level , P

AD0

AD1
Y1 Y0 Y
Output, Y
Figure 3.13 (b)
Activity 3.1
Discuss the policy implications of the Keynesian view of money demand.
Distinguish between the classical Theory, the Monetarist Theory and the
Neoclassical Theory of money demand.
Critically analyze the key assumptions of the classical theory of money demand.
Compare and contrast the Neoclassical theory and the Keynesian theory of

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money demand.
Discuss the policy implication of the Loanable Funds Theory of money demand.

3.9 Summary
In this third lecture you have learnt the following important points:
 The study of money demand is important to understand, control and
predict the demand for money in the economy.
 There are at least six models of money demand: the classical theory, the
Keynesian theory, the General Equilibrium Theory, the Modern
Quantity Theory, the Neoclassical Theory, and the Neo-Keynesian
Theory.
 The focus of the Classical theory is the long run. Therefore, money does
not affect real economic variables at this time horizon. In the long run
the economy is able to automatically adjust itself after a random shock.
The remaining five theories focus on the short run thus it is possible for
money to affect the real economy as it adjusts itself to its equilibrium
level.
 The Keynesian economists argue that money affects real economic
activity in the short run due to the presence of structural rigidities in the
economy. According to the Keynesian economists only fiscal policy is
effective for stabilizing the economy.
 The Monetarist economists contend that money affects real economic
activity in the short run due the existence of spare capacity in the
economy. Once the economy reaches its full employment level of output
further increase in money supply only serves to increase the price level.
According to monetarist economists only monetary policy is effective in
stabilizing the economy.
 The General Equilibrium theory argues that the demand for money can
only be understood by examining the factors determining equilibrium in
all factor markets. These are savings, investment demand, liquidity and

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 the quantity of money in the economy.

 The Neoclassical economists argue that money affects real economic

variables in the short run due to misperceptions of information. This
implies that only unannounced policy changes can affect real economic
activities. Pre-announced policy is totally ineffective because rational
economic agents are able to adjust the economic activities on the basis
of anticipated policy changes. Thus when a policy change comes to pass
its effects had already been incorporated in previous decisions by
rational economic agents.
 The Neo-Keynesian economists content that money can affect real
economic variables in the short run due to the existence of structural
rigidities in the economy. Thus, whether policy is unannounced or pre-
announced it will still have a real effect on the economy. The only
difference is that unannounced policy will have a larger impact
compared to pre-announced policy.

3.10 References
1. Colin D. Campbell, Rosemary G. Campbell and Edwin C. Dolan,
Money, Banking and Monetary Policy, Dryden Press, 1988.

2. Strutter, O.N. and Speith, H., Money Institutions: Theory and

Practice, Longrnan, 1986.

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