In economics, the Theory of Money Demand stresses on the positive relationship existing between the general prices or the nominal expense rate and the total amount of money.
Historical Evolution of the Theory of Money Demand:
The Theory of Money Demand is considered the brain-child of the famous Polish astronomer and mathematician, Copernicus. In the hands of the Jean Bodin, the noted economist, the theory progressed immensely in establishing the relation between gold and silver imports and rise in the market prices. In the Quantity Theory of Money, the “Equation of Exchange” which substantiates the relation between the supply of money and the value of cash transaction was first affirmed by David Hume, the well-known philosopher and later expanded by the renowned British political economist, John Stuart Mill. Between 19th and 20th century, other prominent economists like Irving Fisher, Simon Newcomb and Alfred de Foville further developed the theory, offering it the present form.
There are basically three theories to the demand for money. They are the Classical, Keynesian and the Quantity Theory of Money. Each of them may be discussed under the following heads:
Classical theory of money demand:
The main concern of this theory is to analyse how money may affect the Aggregate Demand (AD) of goods and services in the economy. According to the Classical Theory the AD is more or less stable . Shifts in the demand and the supply of money cause changes in the AD and the general price level. This theory does not explain the different components of AD.
Keynesian Theory of Money Demand:
As opposed to the classical theory the Keynesian theory decomposes money demand into Consumption, investment, Government spending and trade balance.
Mathematically,
AD = C+I+G+(X-M) where C = Consumption of currently produced goods and services
I = Investment
G = Government Spending in the currently produced goods and services
X = Export
I = Import
According to the Keynesian Theory of the demand for money, the Aggregate demand is highly unstable due to changes in business and consumer expectations. Money does not play a vital role in the determination of the general price level and the Aggregate Demand of the economy.
Quantity Theory Of Money
The Quantity Theory of Money can be explained by the equation :
MsV = PY
or Ms = (Y/V) *P
Where Ms: Supply of Money
Y : Income Level
V: Velocity of Money
P: Price Level
This equation implies that keeping the velocity of money and the income level constant, changes in the supply of money would cause changes in the general price level.
Money Supply Theory in macroeconomics refers to the study of the quantity of money available at the hands of people within the economy to buy goods, services and securities. The interest rate is the value of money over time, that is the price paid for acceding payment of monetary debts. These two are inversely proportional as the supply of money increases the interest rate decreases. The equilibrium at the money market is reached when the quantity of money demanded and supplied becomes equal to the rate of interest.
Money involves both coins and banknotes, therefore the supply of money in an economy will consist of both the supply of banknotes and coins. Precisely the concept of money supply involves the sum total of all electronic, credit-based bank deposits balance accounts along with the printed-paper notes and minted coins. According to the principle, money is a medium of transaction that is utilized in settling a debt. Money supply can take place in varying measures. The narrowest measure counts only liquid money while the broader measure takes into account the form that deals money as a store of value. The situation of inflation occurs when the supply of money increases to an extreme level.
Role of Central Bank in Supply of Money
When the Central Bank is ‘easing’ the money supply increases and when it is ‘tightening’ the money supply decreases. In the condition of easing more liquid money is available for the private banks. During the condition of tightening the liquid money is pulled out of the private banking sector. The Central Bank also creates new reserves that let the banks lend out more money. Then through the process of ‘money multiplier’ the loans and bank reserves increase. According to Mises the state of the art monetary policy of money supply expansion runs the risk of undermining the value of currency. Mises endorsed the view of formulating a monetary policy that is different from the state of the art monetary policy. He aspired to minimize the risk of devaluation and create a free society.
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