Question

Give and explain the three theories of money demand

Answer 1

The following are the three theories of demand for money:-

1. Keynes theory of money demand - The central theme for this theory has been the liquidity preference. It is the immediate money in the form of cash which a person holds according to his/her needs. There are the basically three motives for which a person keeps the cash with himself/herself and they are;

(a) Precautionary motive - The people keeps money to fight any unexpected problems. They hold because it may be possible that some situation in future will arise which will need lot of cash.

(b) Speculative motive - We keep liquid money to get the advantage of market fluctuations in the rate of interest of fixed securities like rate of interest on bond securities.

(c) Transaction motive - We also keep money to maintain daily activities. There are some situations in which we require a lot of cash money in our day to day expenses.

So, basically in this theory, liquidity has been given the preference and one would hold cash based on the three motives.

2. Portfolio approach - This theory is given and explained by James Tobin. According to this theory, an individual in his portfolio also keeps money. The portfolio consists of money and bonds. A person who invests into this faces problem of how much proportion he or she should keep in the form of money be because, the money form will earn no interest.

An investor face the problem of risk exposure. The higher the risk then the return will be higher. If one chooses to invest in the risky assets then he is taking more risk and ultimately his return will be higher. On the other hand, if he chooses to invest in the non-riskier assets, then the return will be lower.

So, basically in this theory an investor faces the problem of how much cash should be added in the portfolio and how much risk should be taken according to risk preference of an individual.

3. Transaction approach - This theory is known as Fisher's transaction approach.

In his theory, medium of exchange of money has been given the importance. We know one of the features of money is the medium of exchange. With money we can exchange every commodity.

So, money paid for the commodity should be equal to the value received. Thus, for all the money paid must be equal to the all the transaction made.

In this theory basically the demand for money depends on three factors;

(a) The number of transaction - We need more money if we make more number of transaction. It is directly dependent upon the on the habit of expenditure of an individual.

(b) The average price of transaction - If the prices are high then we need more of it. The more the prices per transaction the more funds needed to make that transaction.

(c) The velocity of money - The need for money also arises how fast the money is circulating in the economy. If the velocity is higher, the need will be lower. If someone holds money in their locker then that money is not the part of economy. And in this situation we need more of it.

So, these are the three needs for money in the transaction theory.