4. Plagiarism Prevention 4. 50 each when the rate of interest is high (8 per cent), and sell them again when they are dearer (Rs. Prof. Tobin has given an alternative theory which explains liquidity preference as behaviour towards risk. The Post-Keynesian Approaches. Empirical evidence suggests that the income elasticity of demand for money is greater than unity which means that income velocity is falling over the long run. Third, like Keynes, Tobin regards the demand for money as closely dependent on interest rates and inversely related to interest rates and his theory provides a basis for liquidity preference. It is therefore, not possible to say that V will remain constant when M is changed. Lower yield on bonds induces people to put their money elsewhere, such as investment in new productive capital that will increase output and income. Human capital is the productive capacity of human beings. Nominal income is measured in the prevailing units of currency. This is because the total wealth in the portfolio consists of bonds plus money. According to Keynes, as the rate of interest approaches zero, the risk of loss in holding bonds becomes greater. “When the price of bonds has been bid up so high that the rate of interest is, say, only 2 per cent or less, a very small decline in the price of bonds will wipe out the yield entirely and a slightly further decline would result in loss of the part of the principal.” Thus the lower the interest rate, the smaller the earnings from bonds. Similarly, businessmen keep cash in reserve to tide over unfavourable conditions or to gain from unexpected deals. This is because the classicists believed in Say’s Law whereby supply created its own demand, assuming the full employment level of income. Given these assumptions, Baumol’s analysis is based on the holding of an optimum inventory of money for transactions purposes by a firm or an individual. TOS 7. This transactions demand for money, in turn, is determined by the level of full employment income. Second, the rate of interest cannot fall to zero. Money neither brings any return nor imposes any risk on him. 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. The first is that money acts as a medium of exchange and the second is that it is a store of value. “However, he did not stress the role of the rate of interest in this part of his analysis, and many of his popularizes ignored it altogether.” Two post-Keynesian economists William J. Baumol and James Tobin have shown that the rate of interest is an important determinant of transactions demand for money. Since the average cash withdrawal are K/2, the interest cost of holding cash balances is rK/2. The amount of cash held for transactions purposes by the individual during each week is shown in saw-tooth pattern in Panel (B), and the bond holdings in each week are shown in blocks in Panel (C) of Figure 2. According to Keynes, money held for transactions and precautionary purposes is primarily a function of the level of income, LT=f (F), and the speculative demand for money is a function of the rate of interest, Ls = f (r). Plagiarism Prevention 5. The classical economists did not explicitly formulate demand for money theory but their views are inherent in the quantity theory of money. This is depicted in Figure 10 as the Ls curve. Prohibited Content 3. 200 each when the rate of interest falls (to 2 per cent). 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. Income can change without any change in the quantity of money. Assuming k= 1/4 and income Rs 1000 crores, the demand for transactions balances would be Rs 250 crores, at point A. 2. In Fisher’s “Equation of Exchange”. The Keynesian Approach Liquidity Preference 3. At such times, the speculative demand for money would fall. for converting cash into bonds, and vice versa. Thus the Keynesian speculative demand for money function is highly volatile, depending upon the behaviour of interest rates. where V is the current market value of a bond, R is the annual return on the bond, and r is the rate of return currently earned or the market rate of interest. As the rate of interest falls to say, r8 the speculative demand for money is OS. They will, therefore, diversify their portfolios, and hold both money and bonds. His theory does not depend on the inelasticity of expectations of future interest rates but proceeds on the assumption that the expected value of capital gains or losses from holding interest- bearing assets is always zero. The phenomenon of liquidity trap possesses certain important implications. Using the line drawing tool , draw a money demand curve on the graph indicating the relationship between the interest rate and the opportunity cost of holding money. Read this article to learn about the demand for money: the classical and the Keynesian approach towards money: The demand for money arises from two important functions of money. Baumol’s theory removes the dichotomy between transactions and speculative demand for money of the Keynesian approach. A firm would always try to keep minimum transactions balances in order to earn maximum interest from its assets. 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. This can be worked out with the help of the equation. Given these factors, the transactions demand for money is a direct proportional and positive function of the level of income, and is expressed as L=kY. If the-price level doubles, the money value of the firm’s transactions will also double. V=Rs 4/0.04=Rs 100. The scale and substitution view combined together have been used to explain the nature of the demand for money which has been split into the transactions demand, the precautionary demand and the speculative demand. 600. Therefore, “money held under the precautionary motive is rather like water kept in reserve in a water tank.” The precautionary demand for money depends upon the level of income, and business activity, opportunities for unexpected profitable deals, availability of cash, the cost of holding liquid assets in bank reserves, etc. It shows the combinations of risk and expected return on the basis of which he arranges his portfolio of wealth consisting of money and bonds and l2 are indifference curves.
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