Where the
quantity theory treats money exclusively as a medium of exchange, they
Keynesian theory stresses that money serves other functions as well. There are
three types of demand for money balances:
·
The transactions demand,
which arises from the fact that people need money to finance current
transactions. Households and firms hold money balances to bridge the gap
between the reciept of income and its expenditure. The amount of money held for
such purposes will be closely related to the level of national income. However,
it is also likely to be influenced by the rate of interest. If the rate of
interest is high, there will be a strong motive to avoid holding money and
instead hold interest bearing assets.
·
The precautionary demand, which consists of money to be held
to meet the sudden arrival of unforseen circumstances. Again, the main factor
likely to influence this amount is the level of income, though again high
interest rates will tend to push money out of this category.
·
The speculative demand, which emphasizes the use of money
as a store of wealth rather than a medium of exchange. Holding money has an
opportunity cost: The income or utility foregone on the investments or goods
the money could have bought. Therefore it would seem that households and firms
ought immediately to invest or spend all money above that required for transactional
and precautionary needs. However, in the presence of uncertainty, individuals
or firms will sometimes believe that the returns available in the future might
be sufficiently better than the returns available today that it is worth
waiting.
The speculative
demand bears further analysis. While there will be speculation on all goods and
services whose price can change with time, the speculative demand is
particularly interesting in the market for government bonds. If households and
firms believe the price of bonds will fall in the near future, they will be
likely to sell their current holdings of bonds and to defer purchasing new
bonds until the price drop has taken place. These actions increase the supply
and reduce the demand for bonds on the open market, which will have the effect
of lowering their price. Under this situation, the speculative demand for money
will be high as households and firms will wish to hold money in anticipation of
the price drop. Conversely, if households and firms expect bond prices to rise,
then they will defer selling bonds now and, if they have money available, will
tend to want to buy bonds. This will decrease the supply and increase the
demand for bonds, driving prices up; and the speculative demand for money will
be low, because speculative monies will tend to be invested in bonds.
The price of
government bonds and the interest rate are inversely and tightly related.
Suppose that an individual is considering the purchase of a government bond
which pays $10 per annum. The bond will not be worth buying unless it returns
at least the current rate of interest. If the current rate of interest is 10%,
then the bond is worth buying only if it costs $100 or less. If the current
rate of interest is 15%, then the bond is only worth buying at $66.67 because
this is the amount over which $10/year represents a 15% return. In a
competitive market, sellers will not be willing to sell at less than the ‘going
rate’ so bond prices will be very closely pegged to the price at which they provide
a return equal to the currently prevailing rate of interest. (Or: The interest
rate is the return on government
bonds; the more you have to pay for them, the less return you’re getting.)
We have
established that the speculative demand for money varies based on the expected
changes in bond prices. If bond prices are expected to fall, the demand will be
high, and vice versa. Since bond prices vary inversely with the interest rate,
if the interest rate is expected to rise, the speculative demand for money will
be high, and vice versa. It is reasonable to suppose that when the interest
rate is quite low, most people will expect it to rise; and when it is quite
high, most people will expect it to fall. Therefore, the speculative demand for
money varies inversely with the currently prevailing interest rate. If the
interest rate is low, then the expectation will be that it will rise, which
means that bond prices will fall, which means people would rather hold onto
their money so they can buy the cheap bonds later, so the speculative demand
for money will be high; and vice versa through the whole process.
Considering
all three types of demand for money, it follows that the overall demand for
money balances will vary directly with the level of income and inversely with
the rate of interest. Higher (lower) Y means more (less) money held in
transactional and precautionary balances. Higher (lower) interest rates mean
more (less) incentive to reduce money balances so as to take advantage of
investment returns, and also more (less) incentive to purchase government bonds
with money otherwise held in speculative balances. For a given Y, the
relationship between the demand for money and the rate of interest is called
the ‘liquidity preference schedule’ which looks like this:
The point on
the demand curve that intersects with the (vertical) money supply curve will
determine the equilibrium rate of interest. MT+P represents the
amount of money held for transactional and precautionary purposes, which for
our purposes is assumed to vary only with Y. Since Y is held constant here, MT+P
is a vertical line: At all rates of interest, the same amount of money is held.
The speculative demand for money is a function of the rate of interest,
reflected in the sloped portion of the demand curve. However, once a
sufficiently low interest rate is reached, the curve becomes horizontal. This
reflects the observation that at very low interest rates, households and firms
are simply not interested in buying any more bonds. For one thing, the interest
rate is so low that everyone is convinced it should rise soon, so nobody will
want to invest in current, low-yield bonds. Once this point has been reached,
further increases in the money supply will simply find their way to idle
balances and further reductions in the interest rate will not occur.
The
Keynesian theory of money, unlike the quntity theory, suggests that changes in
the money supply do not lead directly to changes in aggregate demand. Instead,
monetary policy affects interest rates, thus indirectly influencing those
components of aggregate demand which are sensitive to interest rates. Note that
we can conclude from this that the graph above is inadequate to explain the
final equilibrium interest rate. The graph above is for a fixed value of Y. But
a change in interest rates (at least along the sloped portion of the curve)
will result in a change in Y. So the initial equilibrium shown by the graph
above cannot be the final value. This will be analyzed in detail later.
It is also
highly noteworthy that Keynesian theory suggests that monetary policy will be
ineffective in dealing with a deep recession. When the rate of interest is so
low that the liquidity schedule is operating on the horizontal portion of the
curve, the government can expand the money supply until it turns purple and no
further reductions in interest rate—and therefore no further effect on
aggregate demand—will be forthcoming. Keynes suggested that in a deep
recession, with substantial spare capacity and pessimistic business
expectations, extremely low interest rates would be necessary to stimulate
investment, but these rates might be below the minimum to which monetary policy
can force the rate. This is the famous ‘Keynesian liquidity trap.’
