DSST Money & Banking Part 1

Money demand varies proportionately with nominal

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 Money demand varies proportionately with nominal income,  Interest rates DO  NOT affect the quantity of money demanded,  the price level is directly proportional to the stock of  money, and Velocity is a constant in the short run. 2. Cambridge Approach / Cambridge Quantity Theory:  Included A.C. Pigou and Alfred Marshall.  Similar  to Fisher’s except that interest rates were assumed to be involved.  Reasoned that people would hold  money: to make transactions (varying by the level of nominal income) and as a store of value for a  fraction of their wealth.   The Cambridge Equation:   M d =k(PY),  where  k is the fraction of wealth that is treated as a constant; k is  thus equal to the reciprocal of Fisher’s V. Cambridge Key points:  Money demand varies proportionately with nominal income,  Interest rates, in  principle, can affect the quantity of money demanded , The price level is directly proportional to the  stock of money if k is constant, and Velocity is a constant in the short run if k is constant.
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Keynes’s Theory of Money Demand:  Keynes in 1936 rejected the treatment of k or V as a constant when he wrote  The  General Theory of Employment, Interest, and Prices.   Instead, Keynes argued that money differed from other assets by  virtue of its liquidity and named his money demand theory the  Liquidity Preference Theory – which focused on three  motives: Transaction Motive (TM), Precautionary Motive (MV), and Speculative Motive (MV) Transactions Motive:  desire to maintain money balances in order to facilitate  anticipated   transactions  (such as  monthly rent) and depends on the level of income.  Precautionary Motive:  is the desire to hold money for  unanticipated  expenditures. Speculative Motive:  Major departure from classical theory in that Keynes noted that some assets (Bonds) were  risky in that the market value and rate of return varied, while money was perfectly liquid, and hence – riskless.  Keynes was saying in effect that a person’s desire for specific investments was tied to liquidity, or aversion to the  risk associated with less liquid assets.  Keynes said that the decision was to hold money or bonds, and would  depend on whether a person expected interest rates to rise or fall.  If the investor expected rates to rise and  bonds to fall, he would hold his wealth as money; the reverse would be the case if the investor believed that rates  would fall – he would put all of his wealth (less transactions or precautionary motive income,) in bonds.
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