Question

use diagram to explain. thanku . write clearly..

Explain the relationship between the rate of interest and the demand for money within the Keynesian theory of money demand.

Answer 1

According to Keynes, there are three types of demand for money (cash balance):

1) Transaction demand for money - to incur personal or business exchange

2) Precautionary demand for money - To make contingent payment in order to cover events of uncertain nature, and

3) Speculative demand for money

As per Keynes, transaction & precautionary demand for money are determined by level of income, whereas speculative demand for money is determined by rate of interest on bonds.

According to Keynes, the wealth of an individual consists of money (cash balance) and bonds. While money is perfectly liquid, bonds are not. But both money and bonds are assets. The rate of interest on bonds measures the opportunity cost of holding the money. At higher interest rate, this opportunity cost is higher. A higher interest rate in current time is expected to fetch a higher capital gain in present time than in future time and thus, holding bonds is preferred to holding money.

People anticipate interest rate to rise or fall. Higher interest rate means lower bond price and vice-versa. When the bond price is low (interest rate is high), people move from money to bonds and vice-versa.

Thus, there is an inverse relationship between speculative demand for money and rate of interest.

This also establishes the fact that there is asset demand for money also known as "Liquidity Preference".

Thus, combined for transaction and precautionary requirement of holding money along with speculative demand for money, according to Keynesian theory of demand for money, the demand for money is dependent on income and rate of interest.

Due to inverse relationship between interest rate & demand for money (cash balance), the asset demand for money curve is downward sloping from left to right implying larger cash balances are held at lower interest rate as shown in the diagram below.

In the diagram above, MDT + MDP shows the combined transaction and precautionary demand for money, which are considered independent of rate of interest.

The speculative demand for money is MDS that shows the inverse relationship with interest rate.

At a very low interest rate, people prefer to hold only cash balance and such situation is called liquidity trap.

Thus, as observed , over a range of interest rate, there is inverse relationship between interest rate and demand for cash balance and when the interest rate is very low, the demand for money becomes perfectly elastic.