4MON1_041140597_TMA-2.docx - BBF 301/05 MONEY AND BANKING Question 1 The Keynesian Theory of demand for money is created by economist John M Keynes This

# 4MON1_041140597_TMA-2.docx - BBF 301/05 MONEY AND BANKING...

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BBF 301/05 MONEY AND BANKING Question 1 The Keynesian Theory of demand for money is created by economist John M. Keynes. This theory believe in money was demanded due to 3 main motives, which are transaction motive; precautionary motive and speculative demand. Transaction motive is results from the need for liquidation that occur in day to day transactions in our daily life. This is inextricably that bound with the use of money as the medium of exchange in economy transaction. Precautionary motive is refer to people hold money to prevent any unexpected expenditure or unforeseen opportunities of advantage in purchasing a product. Last but not least, speculative motive may anticipate the changes in the prices such as fall in future prices as will make a loss of foregone interest earnings look relatively smaller thus people will hold extra surplus cash in the face of interest- earning bonds. Thus, when bond prices fall, they can avoid from capital losses and switch into bonds when the anticipated bond prices have been realized. While, Keynesian theory is believe that the demand of money is influences by the money balance that are held by customer and the interest rate. As the interest rate increase, the opportunity cost for holding cash for transactions would be increase too, thus the transactions part of demand in money is also negatively related to the interest rate. When interest rates are high, people will hold lesser in their precautionary balances. Thus, the equation for Keynesian theory is M d P = f ( i ,Y ) . The “I” equal to interest rate, Y is real income. Interest rates is always have a negatively impact on demand for real money balances. While, there is positively related to real income. The equation will be PY M = Y f ( i,Y ) if rearranging the equation to P M d = 1 f ( i ,Y ) and multiplying both side by Y and replacing M d with M. The velocity will have any changes according to future expectation and interest rates. pg. 1

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BBF 301/05 MONEY AND BANKING While in Friedman’s theory, it says that any changes in interest rate may have little effect on demand for money. Money demand, for example the demand for any other assets, may be a function of wealth and the returns of other assets relative to money. The equation of Friedman’s theory is M d P = f ( Y p ,r b r m ,r e r m , π e r m ¿ . Y p = Permanent income r b = expected return on bond r m = expected return on money r e = expected return on stock π e =expected inflation rate Friedman’s theory view permanent income is more important than current income in determining money demand. Because permanent income is a long run average and is more stable, so it will not be a source of a lot of fluctuation in money demand. The other terms in demand of money like expected in bond, stock, and goods relatively to the expected return on money. These items have negatively impact on the demand of money. The higher the return on the bonds, stocks and goods that relative to the return of money, the lower the quantity of the demand of money.
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