Lesson 15: Keynes theory of money

Objectives:
After studying this lesson, you will be able to understand,

• The defination of demand for money given by Keynes

• The different motives for demand for money
• The Transactions, Precautionary and Speculative motives for money
• The difference between Transactions demand for money, Precautionary demand
for money and speculative demand for money
• The total demand for money

15.1 Introduction

15.2.1 Transactions demand for money

15.2.2. Precautionary demand for money

15.2.3 Speculative Demand for money

15.2.4 Total demand for money

15.2.5 Derivation of LM Curve

15.3 Summary

15.4 Check your progress

15.5 Key concepts

15.6 Self Assessment questions

15.7 Answers to check your progress

15.8 Suggested Readings

15.1 Introduction

We studied the Cambridge equation in an earlier chapter, the present chapter is devoted
to discuss about the Keynes theory of money. Keynes propounded a theory of demand for
money in his famous book “General theory” which occupies an important place in his
monetary theory. In other words his demand for money is called as liquidity preference.
How much of his income will a person hold in the form of ready money and how much
will he part with or lend depends upon what calls his ‘liquidity preference’. Liquidity
preference means the demand for money to hold or the desire of the public to hold cash.

Keynes suggested three motives which led to the demand for money in an economy.
They are: the transactions motive, Precautionary motive and Speculative motive.

15.2.1 The Transactions demand for money:

Let us now start the discussion on the transaction demand for money. This type of
demand for money arises from the medium of exchange function of money in making
regular payments for goods and services. According to Keynes, it relates to ‘the need of
cash for the current transactions of personal and business exchange’. Further, he stated
that the changes in transactions demand for money depending upon the changes in
income. Therefore, the transactions demand for money is a direct proportional and
positive function of the level of income, and is expressed as :
Lt = f(ky) 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 equation is illustrated in the following diagram;
Regarding the rate of interest and transactions demand for money, Keynes made the Lt
function interest inelastic. But he did not stress the role of the rate of interest in this part
of his analysis, and many of his popularizers ignored it altogether. In recent years, two
post Keynesian economists WJ Baumol and James Tobin have shown that the rate of
interest is an important determinant of transactions demand for money. they have also
pointed out that the relationship between transactions demand for money and income is
not linear and proportional . Rather changes in income lead to proportionately smaller
changes in transactions demand. The modern view is that the transactions demand for
money is a function of both income and interest rates which can be expressed as:
Lt = f(Y,r) because, as the rate of interest starts rising over and above certain level the
transactions demand for money becomes interest elastic. It is because the higher rates of
interest will attract some amount of transactions balances into securities. So the backward
slope of Y curve shows that at still higher rates, the transaction demand for money
declines. When there is a rise in income level, the level of decline in trasactions balances
at the same rate of interest is comparatively low. Thus, the transactions demand for
money varies directly with the level of income and indirectly varies with the rate of
interest.
15.2.2 The Precautionary demand for money:

The precautionary motive relates to “ the desire to provide for contingencies requiring
sudden expenditures and for unforeseen opportunities of advantageous purchases”.
Both individuals and businessmen keep cash in reserve to meet unexpected needs.
Individuals hold some cash to provide for illness, accidents and other unforeseen
contingencies. Similarly, businessmen keep cash in reserve to tide over unfavourable
conditions or to gain from unexpected deals. 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.
Keynes held that the precautionary demand for money, like transactions demand, was
function of the level of income. But the post-Keynesian economists believe that like
transactions demand, it is inversely related to high interest rates.

15.2.3. The speculative demand for money:

The speculative demand for money is for ‘securing profit from knowing better than the
market what the future will bring froth’ Individuals and businessmen having funds, after
keeping enough for transactions and precautionary purposes, like to make a speculative
gain by investing in bonds. Money held for speculative purposes is a liquid store of value,
which can be invested at an opportune moment in interest – bearing bonds or securities.
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. In explaining
the speculative demand for money, Keynes had a normal or critical rate of interest in
mind. If the current rate of interest is above the critical rate of interest, businessmen
expect it to fall and bond price to rise. They will, therefore, by bonds to sell them in
future when their prices rise in order to gain thereby. A t such times, the speculative
demand foe money would fall, conversely, if the current rate of interest happens to be
below the critical rate businessmen expect it to rise and bond prices to fall.

Thus, the speculative demand for money is a decreasing function of the rate of interest.
The higher the rate of interest, the lower the speculative demand for money, and the
lower the rate if interest, the higher the speculative demand for money. It can be
expressed algebraically as Ls = f ®, where Ls is the speculative demand for money and r
is the rate of interest. Thus, the Keynesian speculative demand for money function is
highl6y volatile, depending upon the behaviour of interest rates.

15.2.4 The Total Demand for Money:

According to Keynes, money held for transactions and precautionary purposes its
primarily a function of the level of income, Lt = f(Y), and the speculative demand for
money is a function of rate of interest, Ls = f®.

Thus the total demand for money is a function of both income and interest rate.

L = f (Y,r)

Where L represents the total demand for money. Thus the total demand for money can be
derived by the lateral summation of the demand function for transactions and
precautionary purposes and the demand function for speculative purposes, as illustrated
in figures
Panel A of the figure shows OT, the transactions and precautionary demand for money at
Y level of income and different rates of interest. Panel B shows the speculative demand
for money at various rate of interest. It is an inverse function of the rate of interest. For
instance, at r6 rate of interest it is OS and as the rate of interest falls to r2, the Ls curve
becomes perfectly elastic. Panel C shows the total demand curve for money L which is a
lateral summation of LT and Ls curves: L = LT + Ls. Total demand for money also
becomes perfectly elastic showing the position of liquidity trap.

15.3 Summary

Keynes in his theory stated that the demand for money arises for three motive;
transactions motive, precautionary and speculative motive. According to Keynes the total
demand for money means total cash balances which may be of two types: active and Idle
balances. The former comprises transactions and precautionary demand and the later
comprise speculative demand. Both the transaction and precautionary demand are
positively associated with the changes in the money income but change in rate of interest
no role to play in determining transaction and precautionary demand. Speculative demand
for money is negatively associated with the changes in the rate of interest. Finally Keynes
held that the total demand for money is determined by both interest and income.

15.4 Check your progress

State whether the following statements are true or false

a) According to Keynes demand for money arises because of liquidity

b) Transactions motive is the function of rate of interest
c) Speculative motive is the function of income
d) Total demand for money is the function of income and interest

15.5 Key concepts

Liquidity
Transactions demand
Precautionary demand
Liquidity trap
Active balances
Idle balances

15.6 Self Assessment questions

Short answer type questions

1. Define the term liquidity preference?
2. Explain the Keynes theory of Speculative demand for money?
3. what is meant by total demand for money?
4. what is liquidity trap?

Essay type Questions

1) Critically evaluate the Keynes liquidity preference theory?

2) Discuss liquidity preference theory of money, explain how is it
superior than classical theory of demand for money?
15.7 Answers to check your progress

a) True b) False c) False d) True

15.8 Suggested Readings

Ackley Gardner : Macro economic theory
Ward R A: Monetary theory and policy
Rana & Verma : Macro economic analysis
Hajela TN: Monetary economics
Ghatak : Monetary economics in developing economies
Gupta SB : Monetary policy in india