Model Answer
0 min readIntroduction
The demand for money, a fundamental concept in macroeconomics, refers to the desired holding of financial assets in the form of money. Understanding the motives behind this demand is crucial for effective monetary policy. Two prominent theories attempt to explain this demand: the Transaction Approach, pioneered by John Maynard Keynes in his *General Theory*, and the Cash Balance Approach, a refinement of earlier ideas. While both acknowledge the transactional motive, they differ significantly in their treatment of other motives and the overall determinants of money demand. This answer will delineate the major differences between these two approaches.
Transaction Approach
The Transaction Approach, as initially proposed by Keynes, posits that people hold money primarily to facilitate everyday transactions. It focuses on the time lag between income receipt and expenditure. The demand for money is directly proportional to the level of national income (Y) and inversely proportional to the velocity of money (V). The equation representing this is: L = kY, where L is the demand for money and k is a constant representing the proportion of income people choose to hold as money. This approach assumes that individuals hold just enough money to cover the gap between receiving income and making purchases.
Cash Balance Approach
The Cash Balance Approach, also developed by Keynes, builds upon the Transaction Approach by incorporating the precautionary and speculative motives for holding money. It recognizes that individuals hold money not only for transactions but also as a buffer against unforeseen expenses (precautionary motive) and to profit from anticipated changes in interest rates (speculative motive). This approach emphasizes the importance of the interest rate (r) in determining money demand. Higher interest rates increase the opportunity cost of holding money, leading to a decrease in demand. The equation representing this is: L = kY - lr, where 'l' represents the responsiveness of money demand to changes in the interest rate.
Key Differences: A Comparative Analysis
| Feature | Transaction Approach | Cash Balance Approach |
|---|---|---|
| Motive for Holding Money | Primarily transactional; focuses on bridging the time gap between income and expenditure. | Transactional, precautionary, and speculative; considers multiple motives. |
| Determinants of Money Demand | National Income (Y) | National Income (Y) and Interest Rate (r) |
| Equation | L = kY | L = kY - lr |
| Role of Interest Rate | Interest rate is irrelevant; money demand is independent of it. | Interest rate has a negative relationship with money demand; higher rates reduce demand. |
| Elasticity of Money Demand | Inelastic with respect to interest rate. | Elastic with respect to interest rate. |
| Focus | Short-run demand for money. | Both short-run and long-run demand for money. |
Implications for Monetary Policy
The Transaction Approach suggests that monetary policy can influence the economy primarily through its impact on the money supply, affecting the level of transactions. However, the Cash Balance Approach highlights the importance of interest rate manipulation. Lowering interest rates, for example, can stimulate investment and consumption by reducing the opportunity cost of holding money, thereby increasing aggregate demand. Modern monetary policy relies heavily on the principles of the Cash Balance Approach, utilizing tools like the repo rate and reverse repo rate to influence interest rates and manage liquidity.
Evolution of Thought
Post-Keynesian developments, such as the work of Milton Friedman, further refined the understanding of money demand. Friedman’s Quantity Theory of Money, while differing from both approaches, emphasized the long-run stability of the demand for real money balances, influenced by income and the expected rate of inflation.
Conclusion
In conclusion, while the Transaction Approach provided a foundational understanding of money demand based on transactional needs, the Cash Balance Approach offered a more comprehensive framework by incorporating precautionary and speculative motives and acknowledging the crucial role of interest rates. The Cash Balance Approach remains more relevant for modern monetary policy, allowing central banks to effectively manage liquidity and influence economic activity through interest rate adjustments. Understanding both approaches is vital for a nuanced grasp of the complexities of money demand and its implications for macroeconomic stability.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.