The Keynesian Analysis of the Demand for Money
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General Theory – claimed money stock only important to the extent that it influenced the i. rate, which led to repercussions (stimulate inv. & consumption).  Keynesians (not K himself) – note: pointed to a point where increase in MS would have no effect on i. rate & hence no effect on econ in toto.

Keynesian Motives for Money Holding: Motivation for holding money/cash balances divided in 3 component parts: i.) Transactions. ii.) Precautionary. – both income det. iii.) Speculative – i rate det. 

1.      Transactions Motive: given institutionalised time lags between receipt of factor incomes & expenditure outlays, a certain amount of money required for normal day-to-day transactions, and real value of this transactions demand will be closely related to real income of economy.  The assumption: real volume of transactions closely related to real income of economy. 

2.      Precautionary Motive: Cash balances held in case of unforeseen outlays, essentially of a transaction nature (e.g. unforeseen medical bill).  Though vary between indivs, reasonable to expect that in the aggregate, related to real income & in nominal terms to price level. 

Together – form L1.

3.      Speculative Demand: (or Asset Demand) – for speculative financial transactions.  (To simplify analysis, Keynes assumed existence of just 2 financial assets – cash & consols: interest bearing, non-redeemable bonds). Keynes argued inverse relationship between bond prices and interest rates.  V. simplified e.g.: suppose a bond issued for $100 paying an annual coupon of $5.  The effective rate of interest accordingly 5%.  If market rate were later to rise to 10%, holder of this bond would be able to obtain only $50 when sold – since $50 is all that’s needed to yield an interest income of $5.  Equally, had i. rate fallen to 2.5%, bond’s market value would approximate $200. 

-         Indivs will each have their own expectations of a normal rate of i. rate with which they will expect the market rate ultimately to coincide.

-         At a high i. rate, indivs will expect i. rates to fall and bond prices to rise.  To benefit from the rise in bond prices indiv.s will use their speculative balances to buy bonds.  Thus, when i. rates are high, speculative balances are low.

-         At low i. rates, indivs will expect i. rates to rise and bond prices to fall.  To avoid the capital losses associated with a fall in bond prices, indivs will sell their bonds and add to their speculative cash balances.  Thus, when i. rates are low, speculative balances will be high. 

-         Ultimately, i. rate reached where no one thinks it can go higher – universal expectations of a fall (point A in Fig 1b) – idle spec cash balances zero, as everyone will try to move into bonds  in expectation of making a capital gain.

-         Ultimately, minimal i. rate such that univ. expectation of a future rise – here no call for bonds with demand for idle balances infinite up to total wealth.  (liquidity trap)

-         Inverse relationship between rate of interest and the speculative demand for money.

(a) L1 = Transactions & Precautionary MD  (b) Speculative MD         (c) Total MD

(Individual Speculative MD – rests on assumption that indivs have a concept of normal interest rate: if current market i. rate > normal, expectation that i. rates will fall/bond Ps will rise – so All asset cash to buy bonds – so spec cash demand zero.  If converse, spec cash demand infinite: so implies that indivs either hold cash or bonds but not both)

Money Market Equilibrium:

-         Keynesian model implies MD increases as i. rates fall.  Also implies that increased MS (Fig 3) implies fall in i. rates, which in turn stimulates inv & cons’n outlays, impact magnified by multiplier, resulting in expansion of money Nat Inc.  Whether output or P increase largely dependent on unemployed resources/extent of spare capacity.  But 1 exception (Liquidity trap): if i. rates so low that universal belief that they’ll rise.  So no one willing to buy gov. bonds.  If gov. enlarges MS (= Money Stock), would be no effect on i. rates (Fig 4).  Since money stock at any one time must be held by somebody, it would find its way into hands of public.  But no change in income level, so no desire to add to transaction balances.  With no desire to purchase gov. bonds, just added to speculative money holdings – implies a minimum constraint on interest rates. 

-         Liquidity Trap – implies impotence of monet pol at a point, where increased Money STOCK accumulated in idle balances

-         So K’n Theory suggests that impact of a MS increase will vary  (sometimes reduce i. rates, sometimes not), so, unlike trad quantity theory, can’t make 1 generalised statement about impact of MS hike. 

                      i. rates in conventional K’n theory.               of an enlarged MS upon i. rate.

Other Notes in this Category

1. Classical Monetary Theory – The Traditional Quantity Theory
2. Essential Functions of Money
3. Introduction
4. Post-Keynesian Modifications to the Demand for Money
5. The Keynesian Analysis of the Demand for Money
6. The Revival of the Quantity Theory (Friedman & the ‘Chicago School’)

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