THEORIES OF MONEY DEMAND (POST-KEYNESIAN THEORIES)

Introduction

In the previous lesson we looked at the Classical and Keynesian theories of money demand. In this
lesson, we will continue with our study on money demand by looking at the post-keynesian money
demand theories.

Objectives

By the end of this lesson you should be able to:

 Explain the Tobin’s Portfolio Approach to Money

Demand
 Explain the Baumol Inventory Approach to Transaction
Demand for Money
 Explain the Friedman Theory of Money Demand

Classical and Keynesian theories of money assume that the stock of money, and by extension,
money demand, is exogenously defined by the monetary authorities. The post Keynesian theories
however, view money as being endogenously defined. A major theme for post Keynesians is that
monetary authorities do not have complete control over the supply of credit and hence cannot
effectively control aggregate spending: business borrowers and banks together, at least in the short
period, determine the amount of credit supplied, and in this sense, the demand for credit creates its
own supply. The prevailing post Keynesian view is that when firms decide to take on additional
investment, given their understanding of market conditions for the sale of additional output,
finance for the projects is rarely an operating constraint. Such institutional factors as credit supply
agreements which obligate banks to supply credit on demand will push up demand for money in
the economy as banks augment assets with business debt. The same argument can be used for
individual borrowers who mainly demand for money for transaction purposes.
In this lesson, we will look at three post-Keynesian theories of money demand:
 Tobin’s Portfolio Approach
 Baumol Inventory Approach
 Friedman Theory of Money Demand

TOBIN’S PORTFOLIO APPROACH TO MONEY DEMAND

An American economist, James Tobin, explained that rational behaviour on the part of individuals
dictates that they should keep a portfolio of asset which consists of both bonds and money.
According to him people prefer more wealth to less.

An investor is faced with a problem of what proportion of portfolio/financial assets he should keep
in the form of money which earns no interest and bonds which earn interest and income.

Faced with various risky assets, individuals diversify their portfolio by holding a balanced
combination of safe and risky assets. According to Tobin individuals’ behavior shows risk aversion
i.e. they prefer less risk to more risk at a given rate of return. Individuals are uncertain about future
receipts. If a wealth holder chooses to hold a greater proportion of risky assets such as bonds in
his portfolio he will be earning high average returns but will have to bear a high degree of risk.
Tobin argues that a risk averse person does not invest in such a portfolio with all risky bonds or
hold a bigger proportion of them.

A person who in his portfolio of wealth holds only safe and riskless assets such as money will not
earn any returns but his asset will be riskless and will not grow his wealth. An individual will be
unwilling to hold all risky assets such as bonds unless he obtains a higher average return in them.

In view of the desire of individuals to have both safety and reasonable returns they strive to have
a balance between safety and riskiness and hold a mix and balance the portfolio consisting of
money and risky assets. This balance varies between individuals depending on attitudes towards
risk.
Tobin delivered his liquidity preference function depicting the relationship between interest rate
and money demand. He argues that with an increase in interest rates wealth holders will generally
be attracted to hold a greater fraction of wealth in bonds and hence reduce their money holdings.
At lower levels of interest they will hold more money and less bonds in their portfolio. These
yields a downward sloping liquidity preference function as shown below:

Interest Rate (r)

Liquidity preference curve

Md

Tobin’s approach has done away with the limitations of Keynes additive model i.e. individuals
holds wealth in either whole money or whole bonds. According to him individuals simultaneously
hold both money and bonds at different proportions.

BAUMOL INVENTORY APPROACH TO TRANSACTIONS DEMAND

FOR MONEY

Instead of Keynes speculative demand for money baumol concentrated on transactions demand for
money. This theory is explained in the view put of inventory management. Individuals hold
inventories of money because this facilitates transactions of goods and services.

In view of the cost incurred on holding inventories of goods there is need to keep optimal goods
to reduce costs. Similarly individuals have to keep an optimum inventory of money for transaction
purposes. They incur cost of these inventories as they have to forego interest which they could
have earned had they kept their wealth in saving deposits.
The income foregone is the cost of holding money for transactions purpose. In this way he
emphasized that money demand for transactions purpose is not independent of the rate of interest.
Money is quite safe and riskless but carries no interest. Bonds yield interest but they are risky and
may involve capital losses. Savings deposits in banks according to Baumol are quite risk free and
yield some interest.

It is for convenience of money being easily used for transactions purpose that people hold it with
them in preference of saving deposits. Individuals compare the cost and benefit of funds in the
form of money with interest bearing savings deposits. People incur the opportunity cost of funds
by having money as inactive balances.

Baumol’s Analysis for Transaction Demand for Money

Baumol analyzed the transaction demand for money of an individual who receives income at
specified intervals e.g. every month and spends it gradually at a steady rate as illustrated below:

Money
Holdings(c )

12,000

6,000 Time money holdings

 Jan 1st Feb 1st Mar 1st April 1st Time

It is assumed that the individual is paid a salary of Ksh. 12,000 at the 1 st day of every month.
Supposing he gets it cashed the same day and gradually spends all of it throughout the month at a
rate of Ksh. 400 per day so that he is left with no money at the end of the month. Assume the
following:

C: Money/Cash holdings

Y: Monthly Income

y
B: Brokerage fee per transaction (transactions T= )
c

C: Ksh. 12,000

C  12, 000  0 
Average money holdings =  6, 000  
2  2 

Suppose instead of withdrawing his entire salary at the 1st day of the month he withdraws half of
the total amount and deposits the remaining amount (shs 6,000) in a savings account which gives
him interest at a rate of 5% his daily expenditure remaining sh 400 per day.

Y c
Tc  b r
C 2

Where: Tc = Total Cost

r = Interest rate

Likewise the individual may decide to withdraw Ksh. 4000 on the 1st day of each month and
deposit Ksh. 8000 in a savings deposit account. His Ksh. 4000 will be reduced to zero at the end
of the 10th day and on the 11th of each month he again will withdraw Ksh. 4000 to spend in goods
and services till the 20th day. On the 21st day of every month he again withdraws Ksh 4,000 to
spend until end month. In this scheme he will on average be holding Ksh. 4000 and invest the rest
in a savings deposit account and earn interest on them.

By investing in a savings deposit account and then withdrawing cash to meet his transaction
demand, it involves cost also. Cost on account of brokerage is incurred when one invests in interest
bearing bonds and sells them. One has to spend on the cost of making extra trips to the bank which
increases the brokerage fee (b). If he withdraws more cash he will avoid some cost on brokerage
hence the individual faces a trade off problem i.e. the greater the amount of pay cheque he
withdraws in cash the less is the cost on brokerage fee but the greater is the opportunity cost on
foregone investments. Baumol has shown that the optimal C is determined by minimizing the
opportunity cost & brokerage fee.

Let:

Y = Size of the pay cheque

C = Average amount of money withdrawn

T = No of times to the bank

b = Brokerage fee.

Thus Total Cost (TC) will be:

c y c
TC = bT + r  T .C  b  r
2 c 2

dtc  yb r
At minimum cost 0 2  0
dc c 2

Baumol has shown that the average amount of cash withdrawn which minimizes the costs is given
by

2bY
C
r
This means that the average amount of C which minimizes cost is the square root of brokerage fee
and income divided by the rate of interest. This is refereed to as the square root rule meaning that
the lower the r, the higher is the C because it will induce individuals to make more withdrawals.
A higher rate of interest will induce people to reduce C; they will be attracted to keep more funds
in the savings deposit accounts.

Similarities and Differences between Tobin and Baumol’s Approaches

Similarities

i) The proposition on liquidity preference for the two theories was formulated from
Keynesian school of though, that is, from the use of liquid assets.
ii) The two prepositions were based on the relationship between interest rates and money

Differences

i) Tobin’s theory was primarily based on transaction’s role of money while Baumol’s was
based on portfolio investment
ii) Baumol identified money as a source of all transactions while Tobin emphasized on
the interest rate as the basis of all transactions.
iii) Baumol opined that, liquidity preference theory is an inventory of purchasing power
that base on finance while Tobin focused on the interest rate that was used to explain
the demand for money.

FRIEDMAN THEORY OF MONEY DEMAND

A noted monetary economist, Milton Friedman put forward a money demand function which
played an important role in determination of prices. He believed that the money demand function
is a stable macroeconomic function. He treated money as one type of an asset in which wealth
holders can keep a part of their wealth.
Business entities view money as a capital good; a factor of production which they combine with
the services of other productive assets to produce goods and services. The service rendered by
money is that it serves as a general purchasing power so that it can be conveniently used for buying
goods and services. Like other capital assets money yields returns.

The value of goods and services that money buys are the benefits in kind which money yields.
Return on bonds is the rate of interest and the anticipated capital gain due to the expected changes
in the market price. Equity also provides some yield in the form of dividend and expected capital
gain due to changes in the price level.

People can also hold their wealth in the form of stock of producer durables and consumer
commodities. The yield from these commodities is in the form of expected interest rate and the
change in the price per unit of the product.

Money demand can be formulated as:

P
Md  f ( w,h,rm , rb , re , p, , u)
P

Where w is wealth of individuals, h is the proportion of human wealth to the total wealth held by
individuals, rm is the rate of return or interest on money, rb is the rate of interest on bonds, re is the
∆𝑃
rate of return on equities, p is the price level, rate of change in price level, and u is institutional
𝑃
factors

We explain each one of them:

Wealth

Wealth is the major factor that determines money demand. It is composed of non-human wealth
i.e. bonds, shares; and also human wealth i.e. value of an individual’s present and future wage
earnings. Whereas non-human wealth can be converted into money, such conversion is not
possible with human wealth. Human wealth represents an illiquid component of an indivudual’s
wealth. Money demand directly depends on the total wealth. The greater the wealth of an
individual the more money he will demand for transactions and other purposes.

Since human wealth is much less liquid as compared to non-human wealth, Friedman argued that
the higher the proportion of human wealth in the total wealth, the greater will be the demand for
money to make up for the illiquid nature of human wealth.

Rate of Interest (rm, rb, re)

Money kept in form of currency and demand deposits does not earn any interest. This is the income
foregone by not investing in other forms of assets such as savings deposits, bonds and equities.
Money demand is thus negatively related to rm rb and re and returns on such other non money
assets.

The Price Level

High price levels will mean that people will require a large nominal money balance in order to do
the same amount of transactions as when the prices were down. As the price level goes up money
demand will increase and vice versa.

Institutional Factors (U)

This includes the mode of wage payment, recession if war is anticipated, instability of the capital
markets which erode the confidence of people in making investments. All these factors will
increase money demand.

Limitations of Friedman’s Theory

 Friedman’s analysis implies that different forms of assets are close substitutes; he does not
address how suitability affects money demand.
 The model takes no notice of time lags involved and their implications to money demand.
It is an improved concept since it may determine the value of variables from one period to
another.
  The derivation of money demand considers money as an asset but the transactions motive
for money demand has not been analyzed adequately

If we assume no price change is anticipated and income remained fixed and also that the three rates
of interest are lumped up to one:

Md  f ( y, r , p, u )

This function is modified to:

Md  f ( y, r )

Friedman’s theory thus collapses to Keynes liquidity preference theory.

You can also make reference to the following video:

VIDEO LINK

http://www.learnerstv.com/video/Free-video-Lecture-12779-Economics.htm

REVIEW QUESTIONS

1. Explain the similaries and differences between the Friedman and

Keynesian theories of Money demand.
2. Derive the square root rule as fronted by Baumol

ACTIVITY

If individuals in an economy are earning an average of Ksh. 36,000 per

month, explain how the Tobin’s portfolio approach can help in arriving at
money demand in this economy.
SUMMARY

In this lesson we have looked at three post-keynesian theories of

money demand. These are the Tobin’s Portfolio Approach, the
Baumol Inventory Approach to Transaction Demand for Money
and the Friedman Theory of Money Demand

FURTHER READINGS

1. Mishkin, F. (2010), The Economics of Money, Banking and

Financial Markets, 9th Edition, Pearson Addison-Wesley
2. Branson W. H. (1989), Macroeconomic Theory and Policy, 3rd
Edition, New York: Harper & Row.