classical theory of money ppt

04 dez classical theory of money ppt

Similarly, when the national income is Rs 1600 crores the transactions demand would decline to Rs 350 crores at r12 interest rate. We discuss these approaches below. Recall that the classical dichotomy is the separation of variables into real variables (those that measure quantities or relative prices) and nominal variables (those measured in terms of money). 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. • 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. The transactions demand for money arises from the medium of exchange function of money in making regular payments for goods and services. In explaining the speculative demand for money, Keynes had a normal or critical rate of interest (rc) in mind. It also stresses the importance of factors that make money more or less useful, such as the costs of holding it, uncertainty about the future and so on. Thus the transactions demand for money varies directly with the level of income and inversely with the rate of interest. 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. When there is a change in the supply of money, there is a proportional change in the price level and vice-versa. 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. Neoclassical economics theories underlie modern-day economics, along with the tenets of Keynesian economics. 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. Panel (A) of the Figure shows ОТ, the transactions and precautionary demand for money at Y level of income and different rates of interest. 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. The transactions demand curves Y1, and Y2 are interest- inelastic so long as the rate of interest does not rise above r8 per cent. People use money only as an easy and reliable source of exchange. The Quantity Theory of Money Yi Wen research.stlouisfed.org Views expressed do not necessarily reflect official positions of the Federal Reserve System. L1 = f (Y, r). “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. 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. 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. 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? 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. Irving Fisher further extended the equation of exchange so as to include demand (bank) deposits (M’) and their velocity, (V’) in … 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. We saw above that LT = kY. Conversely, if the current rate of interest happens to be below the critical rate, businessmen expect it to rise and bond prices to fall. At r2 interest rate, the total demand for money curve also becomes perfectly elastic, showing the position of liquidity trap. It is possible to “put funds to work for a matter of days, weeks, or months in interest-bearing securities such as U.S. Treasury bills or commercial paper and other short-term money market instruments. If the transactions demand falls due to a change in the institutional and structural conditions of the economy, the value of к is reduced to say, 1/5, and the new transactions demand curve is kY. 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. He, therefore, converts his entire holdings into money, as shown by OW in the figure. : i. Consequently, the transactions demand curve shifts to Y2. Keynesian economics suggests governments need to use fiscal policy, especially in a recession. Government borrowing nƒäÐ. The classical quantity theory of money is based on two fundamen­tal assumptions: First is the operation of Say’s Law of Market. On the first day of the second week he sells bonds worth Rs. The proposition that money growth does not have real effects is known as monetary neutrality/neutrality of money. This relationship between income and interest rate and the transactions demand for money for the economy as a whole is illustrated in Figure 3. Thus the shape of the Ls curve shows that as the interest rate rises, the speculative demand for money declines; and with the fall in the interest rate, it increases. It is therefore, not possible to say that V will remain constant when M is changed. 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). This was an erroneous view because money performed the “asset” function when it is transformed into other forms of assets like bills, equities, debentures, real assets (houses, cars, TVs, and so on), etc. Individuals hold some cash to provide for illness, accidents, unemployment and other unforeseen contingencies. 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). Individuals and businessmen having funds, after keeping enough for transactions and precautionary purposes, like to make a speculative gain by investing in bonds. 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. But the pointed out that the “demand for money in the active circulation is also the some extent a function of the rate of interest, since a higher rate of interest may lead to a more economical use of active balances.” “However, he did not stress the role of the rate of interest in this part of his analysis, and many of his popularizes ignored it altogether.” In recent years, two post-Keynesian economists William J. Baumol and James Tobin have shown that the rate of interest is an important determinant of transactions demand for money. As the rate of interest falls to say, r8 the speculative demand for money is OS. The policies pursued by national government and economically powerful business corporations, and ADVERTISEMENTS: iii. Why? In Fisher’s “Equation of Exchange”. This is shown as Y1 curve in Figure 70.3. 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. 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. Thus the precautionary demand for money can also be explained diagrammatically in terms of Figures 2 and 3. The classical theory implies that money is neutral. CLASSICAL APPROACHCLASSICAL APPROACH According to classical economists there isAccording to classical economists there is no direct demand for money. Hence there is indirect demand for money. 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. The scale and substitution view combined together have been used to explain the nature of the demand for money which has been split into the transactions demand, the precautionary demand and the speculative demand. Content Guidelines 2. First, the monetary authority cannot influence the rate of interest even by following a cheap money policy. 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 The phenomenon of liquidity trap possesses certain important implications. It is an inverse function of the rate of interest. Rather, changes in income lead to proportionately smaller changes in transactions demand. Both theories pay significant attention to money supply and demand for money as essential factors that influence the rate of interest within the economy. Low bond prices are indicative of high interest rates, and high bond prices reflect low interest rates. 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. What may happen if increase in money supply can in fact change aggregate output (GDP)? Image Guidelines 5. Chapter 22. This is the famous Keynesian liquidity trap. The month has four weeks. The most important thing about money in Fisher’s theory is that it is transferable. The restrictive nature of the assumptions made by the theory, such as absence of trading costs and non-price competition, etc. Two particularly controversial propositions of new classical theory relate to the impacts of monetary and of fiscal policy. Problems in the … Thus individuals and businesses wish to hold money partly in cash and partly in the form of assets. 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. 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. 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. Accordingly, his transactions demand for money in each week is Rs 300. Suppose an individual receives Rs 1200 as income on the first of every month and spends it evenly over the month. Financial institutions are able to create money, for example by lending to businesses and home buyers, and accept- ing deposits backed by those loans. Md=kPY. Regarding the rate of interest as the determinant of the transactions demand for money Keynes made the LT function interest inelastic. They have also pointed out the relationship, between transactions demand for money and income is not linear and proportional. According to classical macroeconomic theory, changes in the money supply affect nominal variables but … […] In fact, an individual spreads his expenditure evenly over the month. Classical Quantity Theory of Money „Due to Irving Fisher (1911) „Idea: to examine the link between total money supply Msand the total amount of spending on final goods and services produced in a given period (PY). Similarly, businessmen keep cash in reserve to tide over unfavourable conditions or to gain from unexpected deals. 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. Thus the equation becomes. Income can change without any change in the quantity of money. Panel (C) shows the total demand curve for money L which is a lateral summation of LT and Ls curves: L=LT+LS. analyses you went through. For instance, if a bond of the value of Rs 100 carries 4 per cent interest and the market rate of interest rises to 8 per cent, the value of this bond falls to Rs 50 in the market. Concept of money supply, QTM theory, and keynesian theory of money - Duration: 1:04:45. The quantity theory of money seeks to explain the value of money in terms of changes in its quantity. 1. The classical economists did not explicitly formulate demand for money theory but their views are inherent in the quantity theory of money. If the income level rises to Rs 1600 crores, the transactions demand also increases to Rs 400 crores, given k = 1/4. Geometrically, it is shows in Figure 70.5. Money helpsno direct demand for money. This transactions demand for money, in turn, is determined by the level of full employment income. For example, at rb rate of interest, the total demand for money is OD which is the sum of transactions and precautionary demand ОТ plus the speculative demand TD, OD=OT+TD. Essentially, Keynes’ theory of demand for money is an extension of the Cambridge cash-balances approach and stresses the asset role (i.e., the store of value function) of money. So he has Rs 900 idle money in the first week, Rs 600 in the second week, and Rs 300 in the third week. Second, the rate of interest cannot fall to zero. Transactions balances are held because income received once a month is not spent on the same day. Thus its underlying assumption is that people hold money to buy goods. 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. The problem here is that there is a cost involved in buying and selling. They will, therefore, buy bonds to sell them in future when their prices rise in order to gain thereby. There will, however, be changes in the transactions demand for money depending upon the expectations of income recipients and businessmen. 48 1.2 The Classical Theory of Employment 50 Bond prices and the rate of interest are inversely related to each other. According to this view, when alternative assets like bonds become unattractive due to fall in interest rates, people prefer to keep their assets in cash, and the demand for money increases, and vice versa. There are two views on this issue. This equation tells us that “other things being equal, the demand for money in normal terms would be proportional to the nominal level of income for each individual, and hence for the aggregate economy as well.”. ڐ¾"5wâK"¤ãçʸFpTéô‹Ô”Û…¯ƒì³ÄàlµÃw]þ§«¾±zð?8_íðU@уÿá Ët´¨\ÿ?8Ù*õ?õ×xÜZÐmM¹Ë’þHÎ@òúç.›Y”ªËš½lN^»Õà Prohibited Content 3. According to Keynes, this is likely to happen when the market interest rate is very low so that yields on bond, equities and other securities will also be low. His saving is zero. 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. The transactions and precautionary demand for money will be unstable, particularly if the economy is not at full employment level and transactions are, therefore, less than the maximum, and are liable to fluctuate up or down. 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. This can be worked out with the help of the equation. 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 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. Thus the total demand for money is a function of both income and the interest rate: Where L represents the total demand for money. It indicates that “given the cost of switching into and out of securities, an interest rate above 8 per cent is sufficiently high to attract some amount of transaction balances into securities.” The backward slope of the K, curve shows that at still higher rates, the transaction demand for money declines. At such times, the speculative demand for money would fall. It is supported and calculated by using the Fisher Equation on Quantity Theory of Money. 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.”. Although the neoclassical approach is the most widely taught theory … Say’s law states that, “Supply creates its own demand.”. 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”. 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Then LT = Rs 300 crores Keynes in his General theory or Special Case … Md=kPY self. Structure of cash and short-term bond holdings are reduced to Rs 1600 crores the transactions demand curve for money from...

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