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Explain Keynes Money Demand Theory

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It is a subset of his theory of the demand for different sorts of assets which is known as theory of liquidity preference. Keynes believed that it was possible for resource to remain idle and workers to be unemployed as a result of deficiency in aggregate demand. His argument for demand for money was based on a near full employment level. Keynes considered that there are three reasons why people demand for many rather than invest that money in bond.

i) Transaction demand People need to hold a certain amount of money to meet their normal everyday transactions such as entertainment, buying food, travel etc. This is a first choice since it is not affected by the interest and depends on the consumer?s income. Whether interest increases or decreases the transaction motive for demand money will be perfectly inelastic. The demand for money for this purpose is related to income. People with higher income will tend to have larger transaction demand for money than those who have lower incomes. In inflation times the transaction demand may increase because in order to obtain the same level of goods / service more money is needed. It is also known as liquidity preference I (LPI)

ii) Precautionary demand for money This is holding idle money balance due to uncertainties or emergency purposes. Money is keep to fulfill the function of store of value. He argues that if the consequences of all our actions were known with certainties the quantity theory would have been right to argue that money could only be held for transaction purposes. In reality the world is dominated by uncertainties. In consequence despite the opportunity cost of holding money precautionary balance will be held in case there is a need for unplanned expenditure e.g. getting sick at night, retirement, retrenchment etc. The amount kept under this motive depends on the conditions under which one is living. It also depends on the income and personality. It is also fairly affected by interest rates. Many people will be tempted to invest in capital markets by buying securities or bonds in order to receive higher rewards in the future. It also known as liquidity preference II (LP2).

iii) Speculative demand foe money This is the demand for money to invest in business which will generate higher returns. It is called liquidity preference III (LP3), holding money for commercial purposes. It is the heart of Keynes theory on
demand for money. When considering speculative demand for money, the opportunity cost of holding money is considered. Keynes argues that individuals could hold money depending on the return tied to that money. According to Keynes, when money is not required immediately as a means of payment it can be held as an asset for future consumption or it can be converted into another asset. He talks of bond as a major finance asset which can be acquired by an individual. A bond is a government stock or security whose terms (capital repayment at maturity and interest) are always honoured.

Individuals hold bond due to two reasons:-
a) To earn interest
b) For capital gain

Wilfykil answered the question on March 8, 2019 at 11:07

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