Tutorial 5

Money Demand

Midterm: Compare between models, get hints in tutotial and lecture

Question 1

(a) Describe the quantity theory of money. (6 marks)

(b) Distinguish between Cambridge theory of money demand and the Classical quantity theory of
money demand. (8 marks)

Question 2

(a) Explain why velocity of money is constant in short-run in Classical quantity theory of money
demand. (6 marks)

(b) Calculate the velocity of money using Classical approach if quantity of money is RM 30
billion and nominal GDP is RM 120 billion. (4 marks)

(c) From (b), calculate the total money demand by using Cambridge approach given that k is 3.
(2 marks)

Question 3

(a) Explain THREE (3) motive of money demand proposed by Keynesian Liquidity Preference
theory. (9 marks)

(b) Briefly explain why relationship between money demand and interest rate are negative under
Keynesian Liquidity Preference theory. (4 marks)

Question 4

(a) Describe the modern quantity theory of money introduced by Milton Friedman. (8 marks)

(b) Briefly explain why velocity of money in Keynesian Liquidity Preference theory is fluctuated as
compare to Classical theory which is constant in short-run. (6 marks)

Question 5

(a) Distinguish between Baumol-Tobin theory and Keynesian Liquidity Preference theory in
explaining motive of money demand. (10 marks)

(b) In modern quantity theory of money, why velocity of money is stable while Keynesian proposed
that velocity of money is fluctuated with interest rate? (6 marks)
Suggested Answers

Question 1

(a) Quantity theory of money states that money supply has a direct, proportional relationship with
the price level. For example, if the currency in circulation increased, there would be a
proportional increase in the price of goods. It assumes that money demand only for
transaction purposes; hence, money supply will be equivalent to nominal GDP in the
economy. These relationship is shown in the equation of exchange:

MV = PY
Where M is quantity of money, V is velocity of money, P is price level and Y is total
transaction in the economy. The equation proposes that velocity of money and total
transaction in economy is constant. Hence, inflation in economy is purely the result of money
growth in the economy.

(b) In quantity theory of money, it states that money supply has a direct, proportional relationship
with the price level. It assumes that money demand only for transaction purposes; hence,
money supply will be equivalent to nominal GDP in the economy. These relationship is
shown in the equation of exchange:

MV = PY
Where M is quantity of money, V is velocity of money, P is price level and Y is total
transaction in the economy. The equation proposes that velocity of money and total
transaction in economy is constant. Hence, inflation in economy is purely the result of money
growth in the economy.

Whereas, Cambridge theory of money demand argue that that people hold money not only to
serves the purpose of medium of transaction but also store of value. Hence, portion of the
money in economy will not be used for transactions but instead, it will be held for the
convenience and security of having cash on hand. Hence, the movement of money (velocity)
is depends on the desirability of holding cash.

Md = k x PY
Given that k is the ratio of desirability of holding cash over income (liquid cash in hand)
where k = 1/V. Md is quantity of money demand and PY is nominal income. K is fixed in
short-run, hence, money demand is a function of income.

*Difference in holding money purpose, Cambridge add on for liquidity purpose

Question 2

(a) Velocity of money is determined by the institutions in an economy that affects the ways
individual conduct transactions. When people use credit card to conduct transactions, lesser
physical quantity of money is needed and hence M decrease. With P x Y constant, velocity of
money (V) will increase.

However, institutional feature of the economy only affects velocity slowly over time. Thus,
velocity of money will normally remain constant in short-run.

(b) MV = PY (nominal GDP)

(c) Md = k x PY
k = 3 hence md = RM360billion

Question 3

(a) Transaction motive

(b) In Keynesian theory of money demand, interest rates influence the decisions regarding how
much of money to hold as store of value and how much wealth to hold as bonds. Hence, as
interest rate rise, expected return on bonds increase, people hold bonds now rather than
money and money demand fall. Thus, the demand for money is negatively related to the level
of interest rate.

前提：people believe the interest rate level is constant and will balance in the future

Question 4

(a) Modern theory of money state that demand for money is influenced by the same factors that
affecting demand for any assets, instead of influence by specific motives like Keynes. It
applied the theory of assets demand to money. Specifically, money demand is influences by
the resources available to individuals, such as wealth, liquidity and the expected returns on
other assets relative to the expected return of money

Md/P = f (Yp, rb – rm, re – rm, pe – rm)

Where,
◦ Md/P = demand for real money balance
◦ Yp = Permanent income (Average long-run income)
◦ rm = expected return on money
◦ rb = expected return on bonds
◦ re = expected return on equity
◦ pe = expected inflation

(b) Velocity of money in Keynesian is fluctuated because interest rates influence the decisions
regarding how much of money to hold as store of value and how much money to hold as
bonds. Hence, as interest rate rise, expected return on bonds increase, people hold bonds now
rather than money and money demand fall. Thus, the demand for money is negatively related
to the level of interest rate.

In contrast, classical theory of money proposes that money demand is just for transaction
motive. Velocity of money is determined by the institutions in an economy that affects the
ways individual conduct transactions. Hence, velocity of money is determined by the way of
payment made which is constant in short-run.

Question 5
(a) Baumol-Tobin provides a better understanding on the role of interest rates in the demand for
money. They argue that not only speculative motive is influence by interest rate but also
others motive of money demand.

In transaction demand for money, the money held for transactions are sensitive to the level of
interest rate. Money earns zero interest, is held only because it can be used to carry out
transactions. Hence, if the interest rate is high, the benefits of holding bonds will be high
relative to the transaction cost of holding bonds. The amount of cash held for transactions
purpose will decline. As result, people will hold more bonds and less money and velocity will
increase as interest rates increase.

In precautionary demand for money, people hold money by comparing the opportunity cost
and benefit of holding money. If they are uncertainty about the level of future transactions
grows and cost, they will forgone interest rates for holding money. Hence, as interest rates
rise, the opportunity cost of holding precautionary balances raises (opportunity cost of the
interest forgone by holding money), the holding of these money balance fall, velocity will
rises.

In speculative demand for money, people will diversify and still will hold money (zero
expected return) and bonds (high expected return), because money is less risk and its return is
certain while bonds can have substantial fluctuation in price and return can be quite risky. If
the expected returns on bonds are more than expected return on money, people might still
want to hold money as store of value because it has less risk associated with its return than
bonds. Besides, people also can reduce the total amount of risk in a portfolio by diversifying
which holding both bonds and money, as store of wealth.

*Extension of Keynesian

(b) In Keynesian, the demand for money sensitive to interest rate. This is because expected return
on money is equal to zero. Hence, velocity of money is depend on interest rate fluctuation.

In Modern theory of money, the demand for money is insensitive to interest rate. Rise in the
expected return on other assets as a result of interest rates increase would be matched by rise
in the expected return on money (bank pay interest). Hence, money demand is more stable
and velocity can be predictable because income is predictable. Thus, the money supply will
be the primary determinant of nominal income as in the quantity theory of money.

Meuton Frachman model