The problem here is that there is a cost involved in buying and selling. Similarly, businessmen keep cash in reserve to tide over unfavourable conditions or to gain from unexpected deals. It also stresses the importance of factors that make money more or less useful, such as the costs of holding it, uncertainty about the future and so on. This relationship between income and interest rate and the transactions demand for money for the economy as a whole is illustrated in Figure 3. John Maynard Keynes (1883-1946) was a British economist whose ideas still influence academics and government policy makers. Keynes in his General Theory used a new term “liquidity preference” for the demand for money. There are three approaches to the demand for money: the classical, the Keynesian, and the post-Keynesian. Before uploading and sharing your knowledge on this site, please read the following pages: 1. Changes in the transactions balances are the result of movements along a line like kY rather than changes in the slope of the line. Consequently, the Ls curve will become perfectly elastic. 5. 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). Thus Baumol’s analysis of the demand for real balances implies that there is no money illusion in the demand for money for transactions purposes. They emphasized the transactions demand for money in terms of the velocity of circulation of money. It depends on both prices and quantities of goods traded. This is shown as Y curve in Figure 3. Copyright 10. This also means that the demand for money falls by smaller amounts, as the rate of interest increases. Income can change without any change in the quantity of money. But when r = rc he becomes indifferent to hold bonds or money. 3. This can be worked out with the help of the equation. For the economy as a whole the individual demand curve can be aggregated on this presumption that individual asset-holders differ in their critical rates r0. The present discounted value of these expected income flows from these five forms of wealth constitutes the current value of wealth which can be expressed as: where W is the current value of total wealth, y is the total flow of expected income from the five forms of wealth, and r is the interest rate. This is illustrated in Figure 8 where the horizontal axis measures risk (sR) and the vertical axis the expected returns (smR). The phenomenon of liquidity trap possesses certain important implications: First, the monetary authority cannot influence the rate of interest even by following a cheap money policy. 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. “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. It is the total that must be divided among various forms of assets. Individuals and businessmen having funds, after keeping enough for transactions and precautionary purposes, like to make a speculative gain by investing in bonds. Thus the total demand for money can be derived by the lateral summation of the demand function for transactions and precautionary purposes and the demand function for speculative purposes, as illustrated in Figure 6 (A), (B) and (C). for converting cash into bonds, and vice versa. 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. 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. For instance, at r. rate of interest it is OS and as the rate of interest falls to r2, the Ls curve becomes perfectly elastic. One of its major criticisms arises from the neglect of store of value function of money. But Baumol analyses the interest elasticity of the transactions demand for money. Prof. Baumol has analysed the interest elasticity of the transactions demand for money on the basis of his inventory theoretical approach. But people also hold money for other reasons, such as to earn interest and to provide against unforeseen events. Thus whenever a firm holds money for transactions purposes, it incurs interest costs and brokerage fees (non-interest costs). This demand for money curve relates to the speculative demand for money and not to the aggregate demand for money. 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. The Liquidity Preference Theory says that the demand for money is not to borrow money but the desire to remain liquid. The income motive is meant “to bridge the interval between the receipt of income and its disbursement.”. Thus relationship between an individual’s demand for money and the rate of interest is shown in Figure 70.4 where the horizontal axis shows the individual’s demand for money for speculative purposes and the current and critical interest rates on the vertical axis. They will either put all their wealth into bonds or will keep it in cash. 2. 100 each at the market price of Rs. The figure also shows that as the rate of interest increases by equal increments from r1, to r2 to r3 risk averters hold bonds by decreasing increments, B2B3

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