Theory of Money Demand

By: EconomyWatch   Date: 13 October 2010

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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 clasical theory the Keynesian theory decomposes money demand into Consumption, investment, Government spending and trade balance.

Mathematically,

AD = C+I+G+(X-M) whereC = 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.

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