classical theory of money ppt

The policies pursued by national government and economically powerful business corporations, and ADVERTISEMENTS: iii. Thus there is no effect on income. analyses you went through. Thus the demand for money in Fisher’s approach is a constant proportion of the level of transactions, which in turn, bears a constant relationship to the level of national income. Where L1 is the transactions demand for money, k is the proportion of income which is kept for transactions purposes, and Y is the income. Government borrowing Two fundamental assumptions of Classical macro theory are (1) that equilibrium values of most real variables can be determined without knowing the price level or the inflation rate; and (2) that the equilibrium value of the price level and the inflation rate are determined primarily by the central bank’s supply of money. Changes in the transactions balances are the result of movements along a line like kY rather than changes in the slope of the line. It was barren and would not multiply, if stored in the form of wealth. With the increase in income to Rs 1200 crores, the transactions demand would be Rs 300 crores at point В on the curve kY. But it says little about the nature of the relationship that one expects to prevail between its variables, and it does not say too much about which ones might be important. Transactions balances are held because income received once a month is not spent on the same day. This is because the classicists believed in Say’s Law whereby supply created its own demand, assuming the full employment level of income. With larger incomes, people want to make larger volumes of transactions and that larger cash balances will, therefore, be demanded. Consequently, the Ls curve will become perfectly elastic. 1. “Thus we conclude that the chief determinant of changes in the actual amount of the transactions balances held is changes in income. Thus the precautionary demand for money can also be explained diagrammatically in terms of Figures 2 and 3. Thus when r > r0, an investor holds all his liquid assets in bonds, and when r < r0 his entire holdings go into money. The demand for money is directly related to the income level. Both are implications of the rational expectations hypothesis, which assumes that individuals form expectations about the future based on the information available to them, and that they act on those expectations. 1.0 0.8 0.6 0.4 0.2 0.0 ±0.2 ±0.4 0.00 0.05 0.10 0.15 0.20 0.25 0.30 0.35 0.40 0.45 0.50 Frequency (Inverted Horizon) Money-Inflation Correlation. The classical theory projects public administration as a science. The Classical Approach: The classical economists did not explicitly formulate demand for money … John Maynard Keynes published a book in 1936 called The General Theory of Employment, Interest, and Money, laying the groundwork for his legacy of the Keynesian Theory of Economics. People will not buy bonds so long as the interest rate remain at the low level and they will be waiting for the rate of interest to return to the “normal” level and bond prices to fall. In his General Theory of Employment, Interest and Money (1936), J.M. The income motive is meant “to bridge the interval between the receipt of income and its disbursement.”. Both these authors argued that like the stream of engineering became science through methods of empirical observation, systematic finding and recordings over a period of time similarly, public administrators can create the science of administration. When there is a change in the supply of money, there is a proportional change in the price level and vice-versa. This section will define what money is (which turns out to be less obvious a question than one might immediately think), describe theories of money demand, and describe the long-run behavior of money and the price level. Image Courtesy : yourmoney.com/IMG/495/248495/stacked-money.png. The first is the “scale” view which is related to the impact of the income or wealth level upon the demand for money. It can be expressed algebraically as Ls = f (r), where Ls is the speculative demand for money and r is the rate of interest. According to classical macroeconomic theory, changes in the money supply affect nominal variables but … Further, according to Keynes, “a long-term rate of interest of 2 per cent leaves more to fear than to hope, and offers, at the same time, a running yield which is only sufficient to offset a very small measure of fear.” This makes the Ls curve “virtually absolute in the sense that almost everybody prefers cash to holding a debt which yields so low a rate of interest.”, Prof. Modigliani believes that an infinitely elastic Ls curve is possible in a period of great uncertainty when price reductions are anticipated and the tendency to invest in bonds decreases, or if there prevails “a real scarcity of investment outlets that are profitable at rates of interest higher than the institutional minimum.”. 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. STUDY 24 Udaipur 8,961 views. Last, if new money is created, it instantly goes into speculative balances and is put into bank vaults or cash boxes instead of being invested. Although the neoclassical approach is the most widely taught theory … Keynes held that the precautionary demand for money, like transactions demand, was a function of the level of income. ... #Classical_theory_of_Employment - Duration: 39:36. According to Keynes, it is expectations about changes in bond prices or in the current market rate of interest that determine the speculative demand for money. If the current rate of interest (r) is above the “critical” rate of interest, businessmen expect it to fall and bond price to rise. Keynes positioned his argument in contrast to this idea, stating that markets are imperfect and will not always self correct. When the market rate of interest rises to 8 per cent, then V=Rs 4/0.08=Rs50; when it fall to 2 per cent, then V=Rs 4/0.02=Rs 200. Milton Friedman, at the forefront of the modern quantity theory, outlines a stable demand for money and its determinants. Rather, changes in income lead to proportionately smaller changes in transactions demand. 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. Income can change without any change in the quantity of money. The higher the income level, the greater will be the demand for money. Privacy Policy 8. TOS 7. mhœ¶øÊÓ¢¨tü\j¬¬ÃÎ¿Ì¥ÆÊp”éüË\j¬”D•Î¿Ì¥ÆJèxŠLÆÏ¥Æ2Xô=øÏ¥ÆÒyLO2—K+Pô(‹ñ_+TéŋÌ%RR‘ŸKý$wèzПKý„zî¹ÔO8‰é›Oå¿Ø„éÑüQ¹ÄO(*¡m:~.ñ£í±ü¹ÄOÄn`Ûÿx«êÇ/×±&ÜÈe1 ì.¶°`UB¿#˜nõà(÷«.#æ_b£,žáý ô½icÀåâþ®^|‹ßÀÑ*Ö폍U¯‹úG¡•ùOMnSç7SžÔúÙJ{ÏÒ.Ðyµ/ŽG®F 48 1.2 The Classical Theory of Employment 50 Thus monetary changes have a weak effect on economic activity under conditions of absolute liquidity preference. As the rate of interest starts rising above r8, the transactions demand for money becomes interest elastic. Hence there is indirect demand for money. Prof. John Munro. The right hand side of this equation PT represents the demand for money which, in fact, “depends upon the value of the transactions to be undertaken in the economy, and is equal to a constant fraction of those transactions.” MV represents the supply of money which is given and in equilibrium equals the demand for money. Classical theory is the basis for Monetarism, which only concentrates on managing the money supply, through monetary policy. A theory of money needs a proper place for nancial intermediaries. Second, the rate of interest cannot fall to zero. Thus the neglect of the asset function of money was the major weakness of classical approach to the demand for money which Keynes remedied. This equation is illustrated in Figure 70.1 where the line kY represents a linear and proportional relation between transactions demand and the level of income. The figure shows that when r is greater than r0, the asset holder puts all his cash balances in bonds and his demand for money is zero. Content Guidelines 2. Panel (A) of the Figure shows ОТ, the transactions and precautionary demand for money at Y level of income and different rates of interest. Neoclassical economics theories underlie modern-day economics, along with the tenets of Keynesian economics. In the equation, changes in transactions balances are the result of changes in Y rather than changes in k.”. 3 Main Approaches to Demand for Money are described below: (A) Classical Approach to Demand for Money: The main exponents of this approach are J.S. 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). Say’s law remains valid even in the money economy because classical economists view money only as a medium of exchange with no active role in influencing the real sector of the economy. Mill, Irving Fisher, Marshall, Pigou and Robertson—all grouped as classical economists. It does not clarify whether to include as money such items as time deposits or savings deposits that are not immediately available to pay debts without first being converted into currency. This transactions demand for money, in turn, is determined by the level of full employment income. The classical economists include: Smith, Ricardo, Malthus, and Say Assumptions of Classical Model Pure Competition Exists Wages and Prices are Flexible Self Interest People don’t have money illusion- they understand nominal vs. real value. As the rate of interest falls to say, r8 the speculative demand for money is OS. He keeps and spends Rs 300 during the first week (shown in Panel B), and invests Rs 900 in interest-bearing bonds (shown in Panel C). It is an inverse function of the rate of interest. The restrictive nature of the assumptions made by the theory, such as absence of trading costs and non-price competition, etc. This approach includes time and saving deposits and other convertible funds in the demand for money. 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? Money helps to buy goods and services. The most important thing about money in Fisher’s theory is that it is transferable. Thus the equation becomes. Fisherian Approach: To the classical economists, the demand for money is transactions demand for money. An increase in the quantity of money cannot lead to a further decline in the rate of interest in a liquidity-trap situation. We saw above that LT = kY. This can be worked out with the help of the equation. Content Filtrations 6. Where V is the current market value of a bond, R is the annual return on the bond, and r is the rate of return currently earned or the market rate of interest. Given the perceived centrality of the rate of profit in a capitalist economy, for classical political economy it becomes a crucial problem in the theory of economic growth to account for movements in the rate of profit associated with the process of capital accumulation and development of the economy. Thus a portion of money meant for transactions purposes can be spent on short-term interest-yielding securities. This means that wage rate, interest rate and price level change in their respective markets according to the forces of demand and supply. 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. Third, the policy of a general wage cut cannot be efficacious in the face of a perfectly elastic liquidity preference curve, such as Ls in Figure 70.5. Thus its underlying assumption is that people hold money to buy goods. On the first day of the second week he sells bonds worth Rs. In explaining the speculative demand for money, Keynes had a normal or critical rate of interest (rc) in mind. The figure shows that at a very high rate of interest rJ2, the speculative demand for money is zero and businessmen invest their cash holdings in bonds because they believe that the interest rate cannot rise further. In their viewindirect demand for money. Thus when the rate of interest rises to r12, the transactions demand declines to Rs 250 crores with an income level of Rs 1200 crores. In fact, an individual spreads his expenditure evenly over the month. † Nominal Rigidities and … A Treatise on Money was the culmination and fullest statement of this analysis, but it also marks the point of departure to the second stage. Thus the Keynesian speculative demand for money function is highly volatile, depending upon the behaviour of interest rates. Keynes expounded his theory of demand for money. Md=kPY. According to Keynes, it relates to “the need of cash for the current transactions of personal and business exchange” It is further divided into income and business motives. Among other things, the cost per purchase and sale, the rate of interest, and the frequency of purchases and sales determine the profitability of switching from ideal transactions balances to earning assets. If the income level rises to Rs 1600 crores, the transactions demand also increases to Rs 400 crores, given k = 1/4. Thus the speculative demand for money is a decreasing function of the rate of interest. Problems in the … The transactions demand curves Y1, and Y2 are interest- inelastic so long as the rate of interest does not rise above r8 per cent. J. M. Keynes has rejected the simple quantity theory of money. Suppose an individual receives Rs 1200 as income on the first of every month and spends it evenly over the month. Therefore, “money held under the precautionary motive is rather like water kept in reserve in a water tank.” The precautionary demand for money depends upon the level of income, and business activity, opportunities for unexpected profitable deals, availability of cash, the cost of holding liquid assets in bank reserves, etc. Classical economists maintain that the economy is always capable of achieving the natural level of real GDP or output, which is the level of real GDP that is obtained when the economy's resources are fully employed. Similarly, the business motive is meant “to bridge the interval between the time of incurring business costs and that of the receipt of the sale proceeds.” If the time between the incurring of expenditure and receipt of income is small, less cash will be held by the people for current transactions, and vice versa. Further, the demand for money is linked to the volume of trade going on in an economy at any time. Regarding the rate of interest as the determinant of the transactions demand for money Keynes made the LT function interest inelastic. The Cambridge demand equation for money is, where Md is the demand for money which must equal the supply to money (Md=Ms) in equilibrium in the economy, k is the fraction of the real money income (PY) which people wish to hold in cash and demand deposits or the ratio of money stock to income, P is the price level, and Y is the aggregate real income. The second is the “substitution” view which is related to relative attractiveness of assets that can be substituted for money. What may happen if increase in money supply can in fact change aggregate output (GDP)? They will, therefore, buy bonds to sell them in future when their prices rise in order to gain thereby. With a further fall in the interest rate to r6, it rises to OS’. At r2 interest rate, the total demand for money curve also becomes perfectly elastic, showing the position of liquidity trap. 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. 300 to cover cash transactions of the second week and his bond holdings are reduced to Rs 600. 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. The modern view is that the transactions demand for money is a function of both income and interest rates which can be expressed as “When the price of bonds has been bid up so high that the rate of interest is, say, only 2 per cent or less, a very small decline in the price of bonds will wipe out the yield entirely and a slightly further decline would result in loss of the part of the principal.” Thus the lower the interest rate, the smaller the earnings from bonds. : i. The higher the interest rate, the larger will be the fraction of any given amount of transactions balances that can be profitably diverted into securities.”. Assuming k= 1/4 and income Rs 1000 crores, the demand for transactions balances would be Rs 250 crores, at point A. Thus the total demand for money is a function of both income and the interest rate: Where L represents the total demand for money. Panel (B) shows the speculative demand for money at various rates of interest. Individuals hold some cash to provide for illness, accidents, unemployment and other unforeseen contingencies. Given these factors, the transactions demand for money is a direct proportional and positive function of the level of income, and is expressed as. In a money economy, the purchase and sale of goods and services is made possible by money. What explains changes in the demand for money? Thus, the classical quantity theory of money states that V and T being unchanged, changes in money cause direct and proportional changes in the price level. At a very low rate of interest, such as r2, the Ls curve becomes perfectly elastic and the speculative demand for money is infinitely elastic. There will, however, be changes in the transactions demand for money depending upon the expectations of income recipients and businessmen. The month has four weeks. In the first, his theories concerned money as a means of exchange but were still classical in nature. The classical theory of employment is based on the assumption of flexibility of wages, interest and prices. The problem here is that there is a cost involved in buying and selling. The classical economists did not explicitly formulate demand for money theory but their views are inherent in the quantity theory of money. The Classical Theory The fundamental principle of the classical theory is that the economy is self‐regulating. Thus the transactions demand for money varies directly with the level of income and inversely with the rate of interest. They depend upon the level of income, the interest rate, the business turnover, the normal period between the receipt and disbursement of income, etc. This is because money acts as a medium of exchange and facilitates the exchange of goods and services. According to Keynes, money held for transactions and precautionary purposes is primarily a function of the level of income, LT=f (F), and the speculative demand for money is a function of the rate of interest, Ls = f (r). CLASSICAL APPROACHCLASSICAL APPROACH According to classical economists there isAccording to classical economists there is no direct demand for money. There are three approaches to the demand for money: the classical, the Keynesian, and the post-Keynesian. 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”. But the post-Keynesian economists believe that like transactions demand, it is inversely related to high interest rates. Geometrically, it is shows in Figure 70.5. Keynes in his General Theory used a new term “liquidity preference” for the demand for money. This is illustrated by the LM portion of the vertical axis. The classical theory of demand for money is presented in the classical quantity theory of money and has two approaches: the Fisherman approach and the Cambridge approach. Money helpsno direct demand for money. Department of Economics University of Toronto MODERN QUANTITY THEORIES OF MONEY: FROM FISHER TO FRIEDMAN. But people also hold money for other reasons, such as to earn interest and to provide against unforeseen events. The proposition that money growth does not have real effects is known as monetary neutrality/neutrality of money. Report a Violation, Main Motives for which Money is Wanted by the People, Keynes Theory of Demand for Money (Explained With Diagram), Commercial Bank: Meaning, Types and Function (1797 Words). Plagiarism Prevention 4. Both theories pay significant attention to money supply and demand for money as essential factors that influence the rate of interest within the economy. The structure of cash and short-term bond holdings is shown in Figure 70.2 (A), (B) and (C). For them, money performed a neutral role in the economy. • This theory states the changes in the quantity of money tend to affect the purchasing power of money inversely, • That is, with every increase in the quantity of money, each monetary unit (such as dinar or dollar) tends to buy a smaller quantity of goods and services while a decrease in the quantity of money has the opposite effect. ڐ¾"5wâK"¤ãçʸFpTéô‹Ô”Û…¯ƒì³ÄàlµÃw]þ§«¾±zð?8_íðU@уÿá Ët´¨\ÿ?8Ù*õ?õ×xÜZÐmM¹Ë’þHÎ@òúç.›Y”ªËš½lN^»Õà Before publishing your articles on this site, please read the following pages: 1. Chapter 22. His saving is zero. Two particularly controversial propositions of new classical theory relate to the impacts of monetary and of fiscal policy. The amount of cash held for transactions purposes by the individual during each week is shown in saw-tooth pattern in Panel (B), and the bond holdings in each week are shown in blocks in Panel (C) of Figure 70.2. In this case, changes in the quantity of money have no effects at all on prices or income. Read this article to learn about the demand for money: the classical and the Keynesian approach towards money: The demand for money arises from two important functions of money. When r falls below r0, the individual expects more capital losses on bonds as against the interest yield. So a bond worth Rs 100 (V) and carrying a 4 per cent rate of interest (r), gets an annual return (R) of Rs 4, that is.

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