classical theory of money ppt

: i. 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. 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. If the market rate of interest falls to 2 per cent, the value of the bond will rise to Rs 200 in the market. Thus a portion of money meant for transactions purposes can be spent on short-term interest-yielding securities. 48 1.2 The Classical Theory of Employment 50 Consequently, the transactions demand curve shifts to Y2. What may happen if increase in money supply can in fact change aggregate output (GDP)? Report a Violation, Main Motives for which Money is Wanted by the People, Keynes Theory of Demand for Money (Explained With Diagram), Commercial Bank: Meaning, Types and Function (1797 Words). It can be expressed algebraically as Ls = f (r), where Ls is the speculative demand for money and r is the rate of interest. At such a low rate, people prefer to keep money in cash rather than invest in bonds because purchasing bonds will mean a definite loss. äwU/á/ú,Wß֑©Ù\D…&tY²ˆ)ã Thus the equation becomes. 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). With larger incomes, people want to make larger volumes of transactions and that larger cash balances will, therefore, be demanded. Mill, Irving Fisher, Marshall, Pigou and Robertson—all grouped as classical economists. So he has Rs 900 idle money in the first week, Rs 600 in the second week, and Rs 300 in the third week. The classical theory of employment is based on the assumption of flexibility of wages, interest and prices. 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. The proposition that money growth does not have real effects is known as monetary neutrality/neutrality of money. Content Guidelines 2. Changes in the transactions balances are the result of movements along a line like kY rather than changes in the slope of the line. With the increase in income to Rs 1200 crores, the transactions demand would be Rs 300 crores at point В on the curve kY. 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. TWO THEORIES OF EMPLOYMENT 46 1.1 General Theory or Special Case? The classical theory implies that money is neutral. Plagiarism Prevention 4. A Treatise on Money was the culmination and fullest statement of this analysis, but it also marks the point of departure to the second stage. He, therefore, converts his entire holdings into money, as shown by OW in the figure. 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. 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. Second, the rate of interest cannot fall to zero. nƒäÐ. An increase in the quantity of money cannot lead to a further decline in the rate of interest in a liquidity-trap situation. Thus its underlying assumption is that people hold money to buy goods. Panel (B) shows the speculative demand for money at various rates of interest. They emphasized the transactions demand for money in terms of the velocity of circulation of money. 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. They will, therefore, sell bonds in the present if they have any, and the speculative demand for money would increase. In this case, changes in the quantity of money have no effects at all on prices or income. Fisherian Approach: To the classical economists, the demand for money is transactions demand for money. Md=kPY. Similarly, the business motive is meant “to bridge the interval between the time of incurring business costs and that of the receipt of the sale proceeds.” If the time between the incurring of expenditure and receipt of income is small, less cash will be held by the people for current transactions, and vice versa. The Precautionary motive relates to “the desire to provide for contingencies requiring sudden expenditures and for unforeseen opportunities of advantageous purchases.” Both individuals and businessmen keep cash in reserve to meet unexpected needs. Money helps to buy goods and services. We saw above that LT = kY. Demand for Money Quantity Theory of Money Keynes & Liquidity Preference Friedman s Modern Quantity Theory Friedman vs. Keynes Empirical Evidence – A free PowerPoint PPT presentation (displayed as a Flash slide show) on PowerShow.com - id: 4d592a-MzRhM People will not buy bonds so long as the interest rate remain at the low level and they will be waiting for the rate of interest to return to the “normal” level and bond prices to fall. The income motive is meant “to bridge the interval between the receipt of income and its disbursement.”. This is illustrated by the LM portion of the vertical axis. Since precautionary demand, like transactions demand is a function of income and interest rates, the demand for money for these two purposes is expressed in the single equation LT=f(Y, r)9. This section will define what money is (which turns out to be less obvious a question than one might immediately think), describe theories of money demand, and describe the long-run behavior of money and the price level. Keynes visualised conditions in which the speculative demand for money would be highly or even totally elastic so that changes in the quantity of money would be fully absorbed into speculative balances. Similarly, businessmen keep cash in reserve to tide over unfavourable conditions or to gain from unexpected deals. Image Guidelines 5. CLASSICAL APPROACHCLASSICAL APPROACH According to classical economists there isAccording to classical economists there is no direct demand for money. 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? Government borrowing It shows that for income of Rs 1000 and 1200 crores, transactions balances would Rs 200 and 240 crores at points С and D respectively in the figure. 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. It is supported and calculated by using the Fisher Equation on Quantity Theory of Money. The transactions demand for money arises from the medium of exchange function of money in making regular payments for goods and services. The extreme complexity and dynamism of modern economies, ii. Hence there is indirect demand for money. In the equation, changes in transactions balances are the result of changes in Y rather than changes in k.”. The classicists emphasized only the medium of exchange function of money which simply acted as a go-between to facilitate buying and selling. V=Rs 4/0.04=Rs 100. […] The classical economists did not explicitly formulate demand for money theory but their views are inherent in the quantity theory of money. Thus individuals and businesses wish to hold money partly in cash and partly in the form of assets. Classical economists maintain that the economy is always capable of achieving the natural level of real GDP or output, which is the level of real GDP that is obtained when the economy's resources are fully employed. This portion of the Ls curve is known as the liquidity trap. Milton Friedman, at the forefront of the modern quantity theory, outlines a stable demand for money and its determinants. In the first, his theories concerned money as a means of exchange but were still classical in nature. 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. Consequently, the Ls curve will become perfectly elastic. Bond prices and the rate of interest are inversely related to each other. Chapter 22. When the market rate of interest rises to 8 per cent, then V=Rs 4/0.08=Rs50; when it fall to 2 per cent, then V=Rs 4/0.02=Rs 200. We discuss these approaches below. Content Filtrations 6. Suppose an individual receives Rs 1200 as income on the first of every month and spends it evenly over the month. It is an inverse function of the rate of interest. J. M. Keynes has rejected the simple quantity theory of money. The structure of cash and short-term bond holdings is shown in Figure 70.2 (A), (B) and (C). The first is the “scale” view which is related to the impact of the income or wealth level upon the demand for money. Irving Fisher further extended the equation of exchange so as to include demand (bank) deposits (M’) and their velocity, (V’) in … The classical theory projects public administration as a science. 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. This transactions demand for money, in turn, is determined by the level of full employment income. But the post-Keynesian economists believe that like transactions demand, it is inversely related to high interest rates. The transactions demand curves Y1, and Y2 are interest- inelastic so long as the rate of interest does not rise above r8 per cent. The restrictive nature of the assumptions made by the theory, such as absence of trading costs and non-price competition, etc. At r2 interest rate, the total demand for money curve also becomes perfectly elastic, showing the position of liquidity trap. Thus when the rate of interest rises to r12, the transactions demand declines to Rs 250 crores with an income level of Rs 1200 crores. The problem here is that there is a cost involved in buying and selling. Keynes positioned his argument in contrast to this idea, stating that markets are imperfect and will not always self correct. The modern view is that the transactions demand for money is a function of both income and interest rates which can be expressed as

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