If income increases fourfold, optimal transactions balances only double. Since precautionary demand, like transactions demand is a function of income and interest rates, the demand for money for these two purposes is expressed in the single equation LT=f(Y, r)9. When a firm or an individual purchases large number of bonds, it is left with small transactions balances and vice versa. The present discounted value of these expected income flows from these five forms of wealth constitutes the current value of wealth which can be expressed as: where W is the current value of total wealth, y is the total flow of expected income from the five forms of wealth, and r is the interest rate. Image Guidelines 5. Baumol’s theory removes the dichotomy between transactions and speculative demand for money of the Keynesian approach. If the market rate of interest falls to 2 per cent, the value of the bond will rise to Rs. Question 2 a)With diagrams , discuss three (3) motives of money demand from Keynesian perspective 1) Transactions motive interest rate L1 money demand The transactions and precautionary demand for money The primary reason people hold money is because they want to use it to buy goods and services. 3. where LT is the transactions demand for money, k is the proportion of income which is kept for transactions purposes, and Y is the income. This is because the total wealth in the portfolio consists of bonds plus money. This is shown by the budget line r1 rotating upward to r2 and r3 Consequently, returns increase in relation to risk with increase in the interest rate, and the budget line touches higher indifferences curves. But people also hold money for other reasons, such as to earn interest and to provide against unforeseen events. Nonetheless, with the cost per purchase and sale given, there is clearly some rate of interest at which it becomes profitable to switch what otherwise would be transactions balances into interest-bearing securities, even if the period for which these funds may be spared from transactions needs is measured only in weeks. Then the total cost of making transactions, C, may be written in equation form as: The optimal value of K is that which minimizes the total inventory cost C. By differentiating C with respect to K, setting the derivative dC/dK equal to zero, and solving for C, we obtain. Rather, changes in income lead to proportionately smaller changes in transactions demand. Keynes’s theory was the … Discover how the debate in macroeconomics between Keynesian economics and monetarist economics, the control of money vs government spending, always comes down to proving which theory is better. It was the Cambridge cash balance approach which raised a further question: Why do people actually want to hold their assets in the form of money? Baumol’s analysis points toward another important fact about the behaviour of demand for transactions balances. Baumol shows that the relation between transactions demand and income is neither linear nor proportional. Assuming k= 1/4 and income Rs 1000 crores, the demand for transactions balances would be Rs 250 crores, at point A. Baumol Model of Money Demand (Inventory Approach): The inventory theoretic approach to the demand for money is associated with the names of W. Baumol (1952) and J. Tobin (1958), each of whom used it to study the demand for money. But he argued that this explained only the transactions and the precautionary demand … It can be expressed algebraically as Ls = f (r), where Ls is the speculative demand for money and r is the rate of interest. Hence, the larger the total amounts involved, the less significant will be the brokerage costs, and the more frequent will be optimal withdrawals.” This is because of the operation of economies of scale in cash management or use of money. However, income from bonds is uncertain because it involves a risk of capital losses or gains. For that money could otherwise be used profitably elsewhere in the firm or it could be invested profitably in securities.”. So he has Rs 900 idle money in the first week, Rs 600 in the second week, and Rs 300 in the third week. For them, money performed a neutral role in the economy. The monetary authorities increase the money supply by purchasing bonds which raises their prices and reduces the yield on them. Thus its underlying assumption is that people hold money to buy goods. Further, the demand for money is linked to the volume of trade going on in an economy at any time. When the money involved in transactions is larger, the smaller will be the brokerage costs. Liquidity preference is his theory about the reasons people hold cash; economists call this a demand-for-money … The higher the interest rate on bonds, the lesser the transactions balances which a firm holds. to the holder which is measured in terms of the general price level (P). If g is the expected capital gain or loss, it is assumed that the investor bases his actions on his estimate of its probability distribution. Tobin describes three types of investors. With larger incomes, people want to make larger volumes of transactions and that larger cash balances will, therefore, be demanded. For the economy as a whole the individual demand curve can be aggregated on this presumption that individual asset-holders differ in their critical rates r0. A bond carries a fixed rate of interest. 11 3. Panel (C) shows the total demand curve for money L which is a lateral summation of LT and Ls curves: L=LT+LS. A bond carries a fixed rate of interest. His portfolio consists of a proportion M of Money and B of bonds where both M and Badduptol. Consequently, the transactions demand curve shifts to Y2. They accept risk of loss in exchange for the income they accept from bonds. One must weigh the financial cost and inconvenience of frequent entry to and exit from the market for securities against the apparent advantage of holding interest-bearing securities in place of idle transactions balances. It is point T on the budget line Or and I1 curve. With larger incomes, people want to make larger volumes of transactions and that larger cash balances will, therefore, be demanded. Another variable is trading in existing capital goods by ultimate wealth holders. This is because risk averters prefer to hold more bonds than money. In this respect, Tobin regards his theory as a logically more satisfactory foundation for liquidity preference than the Keynesian theory. Being a Cambridge economist, Keynes retained the influence of the Cambridge approach to the demand for money under which M d is hypothesised to be a function of Y. The discussion draws heavily on and develops the approach of Tily (2010 ), which details what are regarded as fundamental and grave misunderstandings of both his analytical approach and his policy approach. Thus when the rate of interest rises to r8, the transactions demand declines to Rs. The nominal rate of return may be zero as it generally is on currency, or negative as it sometimes is on demand deposits, subject to net service charges, or positive as it is on demand deposits on which interest is paid, and generally on time deposits. In his General Theory of Employment, Interest and Money (1936), J.M. Further suppose that K is the sum received from the sale of bonds and the firm’s average cash holdings equal half the sum (1 /2K) received from the sale of bonds. If the-price level doubles, the money value of the firm’s transactions will also double. Friedman calls the ratio of non-human to human wealth or the ratio of wealth to income as w. 3. It depends on both prices and quantities of goods traded. The bond market is perfect where there is easy conversion of bonds into cash and vice versa. The approaches are: 1. 4/0.02=Rs.200. We discuss these approaches below. Thus relationship between an individual’s demand for money and the rate of interest is shown in Figure 70.4 where the horizontal axis shows the individual’s demand for money for speculative purposes and the current and critical interest rates on the vertical axis. The higher the income level, the greater will be the demand for money. In the equation, changes in transactions balances are the result of changes in Y rather than changes in k.”, Regarding the rate of interest as the determinant of the transactions demand for money, Keynes made the LT function interest inelastic. Besides liquidity, variables are the tastes and preferences of wealth holders. There is a fixed cost in exchanging bonds for cash and vice versa. This is because of the economies of scale that encourage larger investment in bonds when the amount of money involved in transactions is larger due to increase in income. Individuals hold some cash to provide for illness, accidents, unemployment and other unforeseen contingencies. It is held for the stream of income or consumable services which it renders. This transactions demand for money, in turn, is determined by the level of full employment income. Where M is the total quantity of money, V is its velocity of circulation, P is the price level, and T is the total amount of goods and services exchanged for money. The speculative (or asset or liquidity preference) demand for money is for securing profit from knowing better than the market what the future will bring forth”. Given these factors, the transactions demand for money is a direct proportional and positive function of the level of income, and is expressed as. Thus individuals and businessmen can gain by buying bonds worth Rs 100 each at the market price of Rs 50 each when the rate of interest is high (8 per cent), and sell them again when they are dearer (Rs 200 each when the rate of interest falls (to 2 per cent). As the rate of interest starts rising above r8, the transactions demand for money becomes interest elastic. Nominal income is measured in the prevailing units of currency. The demand function for money leads to the conclusion that a rise in expected yields on different assets (Rb, Re and) reduces the amount of money demanded by a wealth holder, and that an increase in wealth raises the demand for money. John Maynard Keynes (1883-1946) was a British economist whose ideas still influence academics and government policy makers. The problem here is that there is a cost involved in buying and selling. This is illustrated by the LM portion of the vertical axis. In this approach, the demand for money is usually expressed in nominal terms. As the rate of interest falls to say, r8 the speculative demand for money is OS. But the post-Keynesian economists believe that like transactions demand, it is inversely related to high interest rates. They are prepared to bear some additional risk only if they expect to receive some additional return on bonds, provided every increase in risk borne brings with it greater increase in returns. The transactions 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 or down. This is known as the liquidity trap when people prefer to keep money in cash rather than invest in bonds and the speculative demand for money is infinitely elastic. He will, therefore, convert this idle money into interest bearing bonds, as illustrated in Panel (B) and (C) of Figure 70.2. Thus the precautionary demand for money can also be explained diagrammatically in terms of Figures 2 and 3. Low bond prices are indicative of high interest rates, and high bond prices reflect low interest rates. Assuming k= 1/4 and income Rs1000crores, the demand for transactions balances would be Rs. 300 in the beginning of the third week and keep the remaining bonds amounting to Rs. Prof. Tobin has given an alternative theory which explains liquidity preference as behaviour towards risk. This is illustrated in Figure 9. Prof. Baumol has analysed the interest elasticity of the transactions demand for money on the basis of his inventory theoretical approach. 4. It is OP of bonds shown as B, and PW of money shown as M in the figure. No doubt it is true the transactions demand increases with increase in income but it increases less than proportionately because of the economies of scale in cash management. Prohibited Content 3. Thus Y/K is the number of withdrawals that occur over the year. The transactions demand for money arises from the medium of exchange function of money in making regular payments for goods and services. The contribution of post-Keynesian economics has extended beyond the theory of aggregate employment to theories of income distribution, growth, trade and development in which money demand plays a key role, whereas in neoclassical economics these are determined by the forces of technology, preferences and endowment. This relationship between an individual asset holder’s demand for money and the current rate of interest gives the discontinuous step demand for money curve LMSW. Keynes suggested three motives which led to the demand for money in an economy: The transactions demand for money arises from the medium of exchange function of money in making regular payments for goods and services. Keynes in his General Theory used a new term “liquidity preference” for the demand for money. Assume that at the beginning of the year, Y is the income of the firm which is equal to the real value of the transactions performed by it, and K is the size of each cash withdrawal at intervals over the year when the bonds are sold. Changes in the transactions balances are the result of movements along a line like kY rather than changes in the slope of the line. Keynesian economists generally say that spending is the key to the economy, while monetarists say the amount of money in circulation is the greatest determining factor. Suppose an individual receives Rs.1200 as income on the first of every month and spends it evenly over the month. Account Disable 12. The greater the investment in bonds, the greater is the risk of capital loss from them. Since Baumol takes the income elasticity of demand for money to be one-half (1/2), the demand for money will not increase in the same proportion as the increase in income. But the other factors are important. 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