1. Outline the various theories of money demand and discuss their strengths and weaknesses. Word count :
Money demand is defined as the desired holding of money balances in the form of cash or bank deposits.
The Quantity Theory of Money Demand is most prominently found in the work of Irving Fisher who examined the relationship between total quantity of money M and the total spending in the economy P x Y, where P is the price level and Y is aggregate output. V is the velocity of money and can be defined as: V=P ×YM
By rearranging this equation to MV=PY we obtain the “equation of exchange”.
Fishers view that velocity remains fairly constant in the short run converts the “equation of exchange” into the “quantity theory of money”, which states that only changes in quantity of money would determine nominal income.
If we rearrange the above equation to:
When the money market is in equilibrium the quantity of money held M equals the money demand Md. If we substitute M as Md and 1V as k we obtain: Md=k ×P.Y
Since k is a constant, the total spending in the economy, P.Y, controls the quantity of money Md that is demanded. Thus the theory establishes that demand for money is exclusively dependant on income and that it is not affected by interest rates.
Keynes pointed out that this model neglected the important effect that interest rates had on money demand. He and Ludwig von Mises both also criticised the fact that the model tries to explain money supply without adequately explaining the demand for money. Mises said the theory“fails to explain the mechanism of variations in the value of money”.
The Cambridge Approach to Money demand was developed by Alfred Marshall and A.C. Pigou. In their model people are considered to be more flexible in their decisions to hold money.
Marshall and Pigou suggested that nominally, wealth is proportional to income and that the wealth component of money is proportional to nominal income. They also defined...
References: Friedman (1987), “quantity theory of money”, p. 19.
Milton Friedman (2005), “The Quantity Theory of Money: A Restatement” in Studies in the Quantity Theory of Money”.
Gauti B. Eggertsson (2008), "liquidity trap," The New Palgrave Dictionary of Economics, 2nd Edition.
Bibow, J. (1998), “On Keynesian Theories of Liquidity Preference”. The Manchester School 66, p.238-73.
Frederic S. Mishkin (2009), “the economics of money, banking, financial markets”, ninth edition.
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