1. Discuss and analyse the various theories of money demand and how they apply to the Nigerian Economy.
2. The formulation and implementation of Monetary Policy in the country by the Central Bank is expected to align with the theoretical postulations of the Monetarist. However, on many occasions this is not always the case. Do you agree? If yes, why? If no why? Discuss extensively.
NAME: NWALI, LAZARUS SUNDAY
DEPARTMENT: ECONOMICS
REGISRERATION NUMBER: PG/MSC/20/94550
COURSE: MONETARY ECONOMICS (ECO. 521)
TITLE: THEORIES OF MONEY DEMAND AND PRACTICE
INTRODUCTION
Theory 1: The Quantity Theory Of Money Demand:
The quantity theory of money states that the quantity of money in circulation is the main determinant of the price level or the value of money. Any change in the quantity of money produces an exactly proportionate change in the price level.
In the words of Irving Fisher, “Other things remaining unchanged, as the quantity of money in circulation increases, the price level also increases in direct proportion and the value of money decreases and vice versa.” If the quantity of money is doubled, the price level will also double and the value of money will be one half. On the other hand, if the quantity of money is reduced by one half, the price level will also be reduced by one half and the value of money will be twice.
Fisher explained his theory in terms of his equation of exchange
Where P = price level, or 1 IP = the value of money;
M’ – the total quantity of credit money;
V’ = the velocity of circulation of M;
T = the total amount of goods and services exchanged for money or transactions performed by money.
This equation equates the demand for money (PT) to supply of money (MV=M’V). The total volume of transactions multiplied by the price level (PT) represents the demand for money.
Assumptions of the Theory:
Fisher’s theory is based on the following assumptions:
1. P is a passive factor in the equation of exchange which is affected by the other factors.
2. The proportion of M’ to M remains constant.
3. V and V are assumed to be constant and are independent of changes in M and M’.
4. T also remains constant and is independent of other factors such as M, M, V and V.
5. It is assumed that the demand for money is proportional to the value of transaction.
6. The supply of money is assumed as an exogenously determined constant.
7. The theory is applicable in the long run.
8. It is based on the assumption of the existence of full employment in the economy.
Criticisms of the Theory:
The Fisherian quantity theory has been subjected to severe criticisms by economists.
1. The Truism:
According to Keynes, “The quantity theory of money is a truism.” Fisher’s equation of exchange is a simple truism because it states that the total quantity of money (MV+M’V’) paid for goods and services must equal their value (PT). But it cannot be accepted today that a certain percentage change in the quantity of money leads to the same percentage change in the price level.
2. Other things not equal:
The direct and proportionate relation between quantity of money and price level in Fisher’s equation is based on the assumption that “other things remain unchanged”. But in real life, V and T are not constant. Moreover, they are not independent of M and P. Rather, all elements in Fisher’s equation are interrelated and interdependent. For instance, a change in M may cause a change in V.
Consequently, the price level may change more in proportion to a change in the quantity of money. Similarly, a change in P may cause a change in M. Rise in the price level may necessitate the issue of more money. Moreover, the volume of transactions T is also affected by changes in P. When prices rise or fall, the volume of business transactions also rises or falls. Further, the assumptions that the proportion M’ to M is constant, has not been borne out by facts. Not only this, M and M’ are not independent of T. An increase in the volume of business transactions requires an increase in the supply of money (M and M’).
3. Constants Relate to Different Time:
Prof. Halm criticises Fisher for multiplying M and V because M relates to a point of time and V to a period of time. The former is a static concept and the latter a dynamic. It is therefore, technically inconsistent to multiply two non-comparable factors.
4. Fails to Measure Value of Money:
Fisher’s equation does not measure the purchasing power of money but only cash transactions, that is, the volume of business transactions of all kinds or what Fisher calls the volume of trade in the community during a year. But the purchasing power of money (or value of money) relates to transactions for the purchase of goods and services for consumption. Thus the quantity theory fails to measure the value of money.
5. Weak Theory:
According to Crowther, the quantity theory is weak in many respects. First, it cannot explain ’why’ there are fluctuations in the price level in the short run. Second, it gives undue importance to the price level as if changes in prices were the most critical and important phenomenon of the economic system. Third, it places a misleading emphasis on the quantity of money as the principal cause of changes in the price level during the trade cycle.
Prices may not rise despite increase in the quantity of money during depression; and they may not decline with reduction in the quantity of money during boom. Further, low prices during depression are not caused by shortage of quantity of money, and high prices during prosperity are not caused by abundance of quantity of money. Thus, “the quantity theory is at best an imperfect guide to the causes of the trade cycle in the short period” according to Crowther.
6. Neglects Interest Rate:
One of the main weaknesses of Fisher’s quantity theory of money is that it neglects the role of the rate of interest as one of the causative factors between money and prices. Fisher’s equation of exchange is related to an equilibrium situation in which rate of interest is independent of the quantity of money.
7. Unrealistic Assumptions: Keynes in his General Theory severely criticised the Fisherian quantity theory of money for its unrealistic assumptions.
* First, the quantity theory of money is unrealistic because it analyses the relation between M and P in the long run. Thus it neglects the short run factors which influence this relationship.
*Second, Fisher’s equation holds good under the assumption of full employment. But Keynes regards full employment as a special situation. The general situation is one of the under-employment equilibrium. Third, Keynes does not believe that the relationship between the quantity of money and the price level is direct and proportional.
Rather, it is an indirect one via the rate of interest and the level of output. According to Keynes, “So long as there is unemployment, output and employment will change in the same proportion as the quantity of money, and when there is full employment, prices will change in the same proportion as the quantity of money.” Thus Keynes integrated the theory of output with value theory and monetary theory and criticised Fisher for dividing economics “into two compartments with no doors and windows between the theory of value and theory of money and prices.”
Theory 2: The Cambridge Cash Balance Theory of Demand for Money:
Cambridge Cash Balance theory of demand for money was put forward by Cambridge economists, Marshall and Pigou. This Cash Balance theory of demand for money sees money demand from a different perspective from Fisher’s Quantity theory approach, in that it places emphasis on the function of money as a store of value or wealth instead of Fisher’s emphasis on the use of money as a medium of exchange
Key Notes on The Cambridge Cash Balance Theory Of Demand For Money:
• It is worth noting that the exchange function of money eliminates the need to barter and solves the problem of double coincidence of wants faced in the barter system.
• In furtherance, the function of money as a store of value lays stress on holding money as a general purchasing power by individuals over a period of time between the sale of a good or service and subsequent purchase of a good or service at a later date.
Marshall and Pigou focused their analysis on the factors that determine individual demand for holding cash balances. Although they recognized that current interest rate, wealth owned by the individuals, expectations of future prices and future rate of interest determine the demand for money, they however believed that changes in these factors remain constant or they are proportional to changes in individuals’ income.
Thus, according to their approach, aggregate demand for money can be expressed as:
Md = kPY
Where,
Y = real national income
P = average price level of currently produced goods and services
PY = nominal income
k = proportion of nominal income (PY) that people want to hold as cash balances
The demand for money (Md) in this Cambridge Cash Balance Approach is a linear function of nominal income. The slope of the function is equal to k, that is, k = Md/Py .Thus important feature of Cash balance approach is that it makes the demand for money as function of money income alone.
Although, Cambridge economists recognized the role of other factors such as rate of interest, wealth as the factors which play a part in the determination of demand for money but these factors were not systematically and formally incorporated into their analysis of demand for money.
Another important feature of Cambridge demand for money function is that the demand for money is proportional function of nominal income (Md= kPY). Thus, it is proportional function of both price level (P) and real income (Y). This implies two things. First, income elasticity of demand for money is unity and, secondly, price elasticity of demand for money is also equal to unity so that any change in the price level causes equal proportionate change in the demand for money.
Criticism:
• It has been pointed out by critics that other influences such as rate of interest, wealth, expectations regarding future prices have not been formally introduced into the Cambridge theory of the demand for cash balances. These other influences remain in the background of the theory. “It was left to Keynes, another Cambridge economist, to highlight the influence of the rate of interest on the demand for money and change the course of monetary theory.”
• Another criticism leveled against this theory is that income elasticity of demand for money may well be different from unity. Cambridge economists did not provide any theoretical reason for its being equal to unity. Nor is there any empirical evidence supporting unitary income elasticity of demand for money.
Besides, price elasticity of demand is also not necessarily equal to unity. In fact, changes in the price level may cause non-proportional changes in the demand for money.
However, these criticisms are against the mathematical formulation of cash balance approach, namely, Md = kPY.
They do not deny the important relation between demand for money and the level of income. Empirical studies conducted so far point to a strong evidence that there is a significant and firm relation between demand for money and level of income.
Theory 3: Keynes’ Theory of Demand for Money:
Keynes propounded a theory of demand for money which occupies an important place in his monetary theory. It is also worth noting that for demand for money to hold Keynes used the term what he called liquidity preference. How much of his income or resources will a person hold in the form of ready money (cash or non-interest-paying bank deposits) and how much will he part with or lend depends upon what Keynes calls his “liquidity preference.” Liquidity preference means the demand for money to hold or the desire of the public to hold cash.
Demand for Money or Motives for Liquidity Preference:
Liquidity preference of a particular individual depends upon several considerations. The question is: Why should the people hold their resources liquid or in the form of ready money when they can get interest by lending money or buying bonds?
The desire for liquidity arises because of three motives:
(i) The transactions motive,
(ii) The precautionary motive, and
(iii) The speculative motive.
1. The Transactions Demand for Money:
The transactions motive relates to the demand for money or the need for money balances for the current transactions of individuals and business firms. Individuals hold cash in order “to bridge the interval between the receipt of income and its expenditure”. In other words, people hold money or cash balances for transaction purposes, because receipt of money and payments do not coincide.
The demand for money is a demand for real cash balances because people hold money for the purpose of buying goods and services. The higher the price level, the more money balances a person has to hold in order to purchase a given quantity of goods. If the price level doubles, then the individual has to keep twice the amount of money balances in order to be able to buy the same quantity of goods. Thus the demand for money balances is demand for real rather than nominal balances.
According to Keynes, the transactions demand for money depends only on the real income and is not influenced by the rate of interest. However, in recent years, it has been observed empirically and also according to the theories of Tobin and Baumol transactions demand for money also depends on the rate of interest.
This can be explained in terms of opportunity cost of money holdings. Holding one’s asset in the form of money balances has an opportunity cost. The cost of holding money balances is the interest that is foregone by holding money balances rather than other assets. The higher the interest rate, the greater the opportunity cost of holding money rather than non-money assets.
Individuals and business firms economies on their holding of money balances by carefully managing their money balances through transfer of money into bonds or short-term income yielding non-money assets. Thus, at higher interest rates, individuals and business firms will keep less money holdings at each level of income.
2. Precautionary Demand for Money:
Precautionary motive for holding money refers to the desire of the people to hold cash balances for unforeseen contingencies. People hold a certain amount of money to provide for the danger of unemployment, sickness, accidents, and the other uncertain perils. The amount of money demanded for this motive will depend on the psychology of the individual and the conditions in which he lives.
3. Speculative Demand for Money:
The speculative motive of the people relates to the desire to hold one’s resources in liquid form in order to take advantage of market movements regarding the future changes in the rate of interest (or bond prices). The notion of holding money for speculative motive was a new and revolutionary Keynesian idea. Money held under the speculative motive serves as a store of value as money held under the precautionary motive does. But it is a store of money meant for a different purpose.
The cash held under this motive is used to make speculative gains by dealing in bonds whose prices fluctuate. If bond prices are expected to rise which, in other words, means that the rate of interest is expected to fall, businessmen will buy bonds to sell when their prices actually rise. If, however, bond prices are expected to fall, i.e., the rate of interest is expected to rise, businessmen will sell bonds to avoid capital losses.
Nothing is certain in the dynamic world, where guesses about the future course of events are made on precarious basis, businessmen keep cash to speculate on the probable future changes in bond prices (or the rate of interest) with a view to making profits.
Given the expectations about the changes in the rate of interest in future, less money will be held under the speculative motive at a higher current rate of interest and more money will be held under this motive at a lower current rate of interest.
The reason for this inverse correlation between money held for speculative motive and the prevailing rate of interest is that at a lower rate of interest less is lost by not lending money or investing it, that is, by holding on to money, while at a higher current rate of interest holders of cash balance would lose more by not lending or investing.
Critique of Keynes’ Theory:
By introducing speculative demand for money, Keynes made a significant departure from the classical theory of money demand which emphasized only the transactions demand for money. However, as seen above, Keynes’ theory of speculative demand for money has been challenged.
The main drawback of Keynes’ speculative demand for money is that it visualizes that people hold their assets in either all money or all bonds. This seems quite unrealistic as individuals hold their financial wealth in some combination of both money and bonds. This gave rise to portfolio approach to demand for money put forward by Tobin, Baumol and Friedman.
The portfolio of wealth consists of money, interest-bearing bonds, shares, physical assets etc. Further, while according to Keynes’ theory, demand for money for transaction purposes is insensitive to interest rate, the modern theories of money demand put forward by Baumol and Tobin show that money held for transaction purposes is interest elastic.
Further, Keynes’ additive form of demand for money function, namely, Md= LX(Y) + L2 (r) has now been rejected by the modem economists. It has been pointed out that money represents a single asset, and not the several ones. There may be more than one motive to hold money but the same units of money can serve several motives. Therefore, the demand for money cannot be divided into two or more different departments independent of each other.
Further, as has been argued by Tobin and Baumol, the transactions demand for money also depends upon the rate of interest. Others have explained that speculative demand for money is an increasing function of the total assets or wealth. If income is taken as a proxy for total wealth then even speculative demand for money will depend upon the size of income, apart from the rate of interest.
In view of all these arguments, the Keynesian total demand for money function is written in the following modified form:
Md = L(Y,r)
where it is conceived that demand for money function (Md) is increasing function of the level of income, it is a decreasing function of the rate of interest. The presentation of the demand for money function in the above revised and modified form, Md = L (Y, r) has been a highly significant development in monetary theory.
Theory 4: Baumol’s Inventory Approach to Transactions Demand for Money:
Instead of Keynes’ speculative demand for money, Baumol concentrated on transactions demand for money and put forward a new approach to explain it. Baumol explains the transactions demand for money from the viewpoint of the inventory control or inventory management similar to the inventory management of goods and materials by business firms.
As businessmen keep inventories of goods and materials to facilitate transactions or exchange in the context of changes in demand for them, Baumol asserts that individuals also hold inventory of money because this facilitates transactions (i.e. purchases) of goods and services.
In view of the cost incurred on holding inventories of goods there is need for keeping optimal inventory of goods to reduce cost. Similarly, individuals have to keep optimum inventory of money for transactions purposes. Individuals also incur cost when they hold inventories of money for transaction purposes.
They incur cost on these inventories as they have to forgo interest which they could have earned if they had kept their wealth in saving deposits or fixed deposits or invested in bonds. This interest income forgone is the cost of holding money for transaction purposes. In this way Baumol and Tobin emphasised that transaction demand for money is not independent of the rate of interest.
According to Baumol, saving deposits in banks are quite free from risk and also yield some interest.
However, he asks the question why an individual holds money (i.e. currency and demand deposits) instead of keeping his wealth in saving deposits which are quite safe and earn some interest as well.
According to him, it is for convenience and capability of it being easily used for transactions of goods that people hold money with them in preference to the saving deposits.
Unlike Keynes, both Baumol argues that transactions demand for money depends on the rate of interest. People hold money for transaction purposes “to bridge the gap between the receipt of income and its spending.” As interest rate on saving deposits goes up people will tend to shift a part of their money holdings to the interest-bearing saving deposits.
Theory 5: Friedman’s Theory of Demand for Money:
A noted monetarist economist Friedman put forward demand for money function which plays an important role in his restatement of the quantity theory of money and prices. Friedman believes that money demand function is most important stable function of macroeconomics.
He treats money as one type of asset in which wealth holders can keep a part of their wealth. Business firms view money as a capital good or a factor of production which they combine with the services of other productive assets or labour to produce goods and services. Thus, according to Friedman, individuals hold money for the services it provides to them.
It may be noted that the service rendered by money is that it serves as a general purchasing power so that it can be conveniently used for buying goods and services. His approach to demand for money does not consider any motives for holding money, nor does it distinguish between speculative and transactions demand for money. Friedman considers the demand for money merely as an application of a general theory of demand for capital assets.
Like other capital assets, money also yields return and provides services. He analyses the various factors that determine the demand for money and from this analysis derives demand for money function. Note that the value of goods and services which money can buy represents the real yield on money.
Obviously, this real yield of money in terms of goods and services which it can purchase will depend on the price level of goods and services. Besides money, bonds are another type of asset in which people can hold their wealth. Bonds are securities which yield a stream of interest income, fixed in nominal terms. Yield on bond is the coupon rate of interest and also anticipated capital gain or loss due to expected changes in the market rate of interest.
Equities or Shares are another form of asset in which wealth can be held. The yield from equity is determined by the dividend rate, expected capital gain or loss and expected changes in the price level. The fourth form in which people can hold their wealth is the stock of producer and durable consumer commodities.
These commodities also yield a stream of income but in kind rather than in money. Thus, the basic yield from commodities is implicit one. However, Friedman also considers an explicit yield from commodities in the form of expected rate of change in their price per unit of time.
Friedman’s nominal demand function (Md) for money can be written as:
Md = f(W, h, rm, rb, re, P, ∆P/P, U)
As demand for real money balances is nominal demand for money divided by the price level, demand for real money balances can be written as:
Md/P = f(W, h, rm, rb, re, P, ∆P/P, U)
where Md stands for nominal demand for money and Md/P for demand for real money balances, W stands for wealth of the individuals, h for the proportion of human wealth to the total wealth held by the individuals, rm for rate of return or interest on money, rb for rate of interest on bonds, re for rate of return on equities, P for the price level, ∆P/P for the change in price level (i.e. rate of inflation), and U for the institutional factors.
1. Wealth (W):
The major factor determining the demand for money is the wealth of the individual (W). In wealth Friedman includes not only non-human wealth such as bonds, shares, money which yield various rates of return but also human wealth or human capital. By human wealth Friedman means the value of an individual’s present and future earnings. Whereas non-human wealth can be easily converted into money, that is, can be made liquid.
2. Rates of Interest or Return (rm, rb, re):
Friedman considers three rates of interest, namely, rm, rb and re which determine the demand for money. rm is the own rate of interest on money. Note that money kept in the form of currency and demand deposits does not earn any interest.
But money held as saving deposits and fixed deposits earns certain rates of interest and it is this rate of interest which is designated by rm in the money demand function. Given the other rates of interest or return, the higher the own rate of interest, the greater the demand for money.
In deciding how large a part of his wealth to hold in the form of money the individual will compare the rate of interest on money with rates of interest (or return) on bonds and other assets. The opportunity cost of holding money is the interest or return given up by not holding these other forms of assets.
As rates of return on bond (rb) and equities (re) rise, the opportunity cost of holding money will increase which will reduce the demand for money holdings. Thus, the demand for money is negatively related to the rate of interest (or return) on bonds, equities and other such non-money assets.
3. Price Level (P):
Price level also determines the demand for money balances. A higher price level means people will require a larger nominal money balance in order to do the same amount of transactions, that is, to purchase the same amount of goods and services.
If income (Y) is used as proxy for wealth (W) which, as stated above, is the most important determinant of demand for money, then nominal income is given by Y.P which becomes a crucial determinant of demand for money. Here Y stands for real income (i. e. in terms of goods and services) and P for price level.
As the price level goes up, the demand for money will rise and, on the other hand, if price level falls, the demand for money will decline. As a matter of fact, people adjust the nominal money balances (M) to achieve their desired level of real money balance (M/P).
4. The Expected Rate of Inflation (∆P/P):
If people expect a higher rate of inflation, they will reduce their demand for money holdings. This is because inflation reduces the value of their money balances in terms of its power to purchase goods and services.
If the rate of inflation exceeds the nominal rate of interest, there will be negative rate of return on money. Therefore, when people expect a higher rate of inflation they will tend to convert their money holdings into goods or other assets which are not affected by inflation.
On the other hand, if people expect a fall in the price level, their demand for money holdings will increase.
5. Institutional Factors (U):
Institutional factors such as mode of wage payments and bill payments also affect the demand for money. Several other factors which influence the overall economic environment affect the demand for money. For example, if recession or war is anticipated, the demand for money balances will increase.
Besides, instability in capital markets, which erodes the confidence of the people in making profits from investment in bonds and equity shares, will also raise the demand for money. Even political instability in the country influences the demand for money. To account for these institutional factors Friedman includes the variable U in his demand for money function.
Simplifying Friedman’s Demand for Money Function:
A major problem faced in using Friedman’s demand for money function has been that due to the non-existence of reliable data about the value of wealth (W), it is difficult to estimate the demand for money. To overcome this difficulty Friedman suggested that since the present value of wealth or W= Yp/r (where Yp is the permanent income and r is the rate of interest on money.), permanent income Yp can be used as a proxy variable for wealth.
The theories of money demand and their application to the Nigerian economy
1. THE QUANTITY THEORY OF MONEY
The quantity Theory of Money is the theory which explains that the nominal income is determined by movements in the quantity of money. It states that money supply and price level in every economy will always move in direct proportion, such that when one increases, the other will increase as well, and when there is a reduction in one, there will be a corresponding decrease in the other. It describes how the nominal value of aggregate income is determined and says that interest rates do not have any effect on the demand for money. This theory was developed by the classical economists such as Irving Fisher, Alfred Marshall and A. C Pigou, in the nineteenth and early twentieth century. Irving Fisher in his book – The purchasing Power of Money published in 1911 examined the link between money supply (M), price level (P) and aggregate income or output (Y). This link is the velocity of money and it is the average number of times money (a dollar) is spent in purchasing total amount of goods and services produced in an economy in a year. Thus, velocity of money is:
V = P * Y/ M
By going further, ‘M’ will be multiplied to both sides of the equation to get the Equation of Exchange which explains that the quantity of money (money supply) multiplied by the number of times that this money is spent in a given year must be equal to the total nominal amount spent on goods and services in that year (the nominal income).
Thus, equation of Exchange = M*V= P*Y. This however does not tell us what happens to nominal income (P*Y) when money supply (M) changes.
Irving Fisher said that velocity is determined by the institutions that affect the way transactions are conducted by individuals in an economy. For instance, if credit cards are used more often than money for transactions and purchases, less money will be needed to for transactions generated by the nominal income. Thus, money supply will fall while the velocity will increase, that is; M relative to P*Y and velocity (P*Y)/M will increase.
In the same vein, if convenience makes it possible for transactions and purchases to be made with more money (cash and check) than with credit cards, then more money will be used to conduct the transactions generated by the same level of nominal income. Thus, money supply will rise and velocity will fall. He opined that the institutional and technological features of an economy would affect velocity but only slowly over time, so velocity would be reasonably constant in the short run. The quantity theory of money is thus transformed from the equation
of exchange. When the quantity of
money supply (M) doubles, M * V doubles and so must P *Y, the value of nominal income.
The Quantity Theory of Money explains that the demand for money by individuals is purely a function of income, and that interest rates do not affect the demand for money. This conclusion was based on Fisher’s belief that money is held by people only for transactions.
Features of this Theory
1. Velocity is fairly constant in the shortrun.
2. Flexibility in wages and prices.
3. The level of aggregate output Y produced in the economy during normal times will always remain at full-employment level.
4. Movements in the price level result from changes in the quantity of money.
Application of Quantity Theory Of Money To The Nigerian Economy
The Classical economists believe that money supply and price level always move in the same proportion, but in reality, in the Nigerian economy, we will find that it is not always so. There could be more cash in circulation and inflation occurring at the same time, in this case we say that more money are chasing fewer goods. There could also be cases when there is an increase in money supply and the resulting inflation is low. Inflation is the persistent rise in the general price level of goods and services. In this case, the higher the supply of money, the lower the interest rate, and the inflation rate. When there is more money in circulation, the prices of goods and services could be low. Also, a decrease in money could lead to depression but an increase in money does not always cause inflation, thus it does not explain efficiently, the trade cycle.
Also, this theory assumes that money is held by people only to perform transactions, but this is not always true. In Nigeria, money is held by people for different reasons or purposes: to perform transactions, for investments, for emergencies, and the amount people keep for these are also affected by the rate of interest especially money held for investment purposes.
Furthermore, the theorists believed that the level of aggregate output produced in the economy during normal times will always remain at full-employment level, but in reality, this is not always so. Velocity and output is assumed to be constant but this is not always true, they could be affected by other factors.
Therefore, the assumption of this theory may not always hold in the Nigerian economy.
2. LIQUIDITY PREFERENCE THEORY
The Liquidity Preference Theory is a theory of the demand for money, for liquidity. This theory was developed by John Maynard Keynes, and he opined that money is demanded for various reasons. He rejected the view of the classical economists that velocity was constant and developed a theory of money demand, while emphasizing the importance of interest rate. In his famous book “The General Theory of Employment, Interest, and Money” published in 1936, John Maynard Keynes asked the question- Why do individuals hold money? In answering this question, he proposed three motives behind the demand for money. These motives are:
• The transactions motive
• The precautionary motive
• The speculative motive.
The Transactions Motive: This motive explains that the reason for holding money is to carry out everyday transactions because it is a medium of exchange. Keynes here followed the view of the classical theorists that the transactions people want to do, determines the amount of money that will be held for this purpose. Thus, the demand for money for this motive is determined by the income level of the individual, such that the higher the income level, the higher the amount that will be kept for this motive and the lower the income, the lower the amount kept to carry out everyday transactions. Therefore, income and money set aside for everyday transactions are directly proportional to each other.
Precautionary Motive: This is another motive for holding money. Precautionary motive explains that money is held by individuals to guard against and help them in times of unforeseen circumstances. Unexpected problems can occur at any point in time and these could bring about unusual costs. Keynes however believed that the amount of money held for this motive is determined by the level of transactions people expect to make in the future. Thus, precautionary demand for money is directly proportional to income such that the higher the income, the greater and higher the amount people will keep for this purpose, and vice versa.
Speculative Motive: This describes that money is held to take advantage of opportunities. Money is a store of wealth but there are factors that influence the decisions of people on how much money that can be held as a store of wealth, such as interest rate. Thus, interest is a reward for parting with liquidity. No interest is earned when money is saved, because by saving, an individual may just put aside a part of his income, put in a container, under a mattress, or wherever he deems fit. But by investing, that part of the income that has been put aside is invested or used to take good advantage of opportunities, such that the principal will yield interest. Thus, money kept as a store of wealth is affected by the rate of interest.
In relating this theory to the Nigerian economy, one will find that some of Keynes postulations can also be seen in the country. For instance, money is still being kept aside for various purposes and they are either affected by the rate of inflation or the level of income. Therefore, looking at the Nigerian market, one will find that Nigerians still go liquid, as they keep cash to solve their numerous problems. This also ensure good circulation of money and keeps the economy afloat but then the main problem with Keynesian approach to the demand for money is that it suggests that individuals should, at any given time, hold all their liquid assets either in money or in bonds, but not some of each. This is obviously not true in reality.
3. TOBIN PORTFOLIO APPROACH
Tobin argues that with the increase in the rate of returns on bonds, individuals will be attracted to hold a greater proportion of their wealth in bonds and less in the form of ready money. Tobin’s liquidity preference theory has been found to be true by the empirical studies conducted to measure interest elasticity of the demand for money as an asset. Tobin’s model of liquidity preference deals with this problem by showing that if the return on bonds is uncertain, that is, bonds are risky, then the investor worrying about both risk and return is likely to do best by holding both bonds and money.
Portfolio theories like the one presented by Tobin emphasizes the role of money as a store of value. In Tobin’s theory, like that of Keynes, “the speculative demand for money varies inversely with the interest rate. The reason is that an increase in the rate of interest implies an increase in the payment received for taking more risk. When the interest rate increases, the investor is eager to put a larger proportion of his portfolio into the risky asset, bonds — and thus a smaller proportion into the safe asset — money’’ (Diptimai Karmakar, 2018). With Diptimai’s explanation above, we find that this is relational to the Nigerian environment and economy, where investors are known to harness higher interest rates, and would not mind so much the risks, so long as there is a promise of a high rate interest. For the economy, bonds can be a potential hedge against an economic slowdown or deflation.
Question 2. The formulation and implementation of monetary policy in the country by the Central Bank is expected to align with the theoretical postulations of the Monetarist. However, on many occasions, this is not always the case. Do you agree? If yes, why? If no, why? Discuss extensively.
Answer
I agree that on many occasions, it is not the case that the formulation and implementation of monetary policy in the country by the Central Bank is expected to align with the theoretical postulations of the Monetarist. I will discuss my thoughts under the following:
i. Monetary Policy
ii. Theoretical Postulations of the Monetarist of Monetary Policy
iii. Limitations of the Monetarist Theory of the Monetary Policy
Monetary Policy
Monetary policy is a set of tools that a nation’s central bank has available to promote sustainable economic growth by controlling the overall supply of money that is available to the nation’s banks, its consumers and its businesses. In other words, monetary policy refers to the credit control measures adopted by the central bank of a given country. The central bank’s objectives for this policy is to control inflation (low inflation) or achieve price stability, ensure full employment and growth in aggregate income; among others.
Theoretical Postulations of the Monetarist of Monetary Policy
Monetarism is associated with the Nobel Prize winning economist, Milton Friedman. Friedman in his seminal work, A Monetary History of the United States, 1867-1960, argued that poor monetary policy by the US central bank (the Federal Reserve) was the primary cause of the Great Depression in the US in the 1930s. Thus, they failed to offset forces that were putting downward pressure on the money supply and its actions to reduce the stock of money- which they should have done. Thus, Friedman was about keeping inflation low and stable by controlling the money supply as the greatest danger to an economy; which happens when the money supply falls either too low or rises too high for a given economic environment. For example, with less money circulating during high inflation, the principles or interacting forces of supply and demand will bring down inflation.
According to Motley Staff (2016); “Monetarists think the monetary base should be expanded to prevent a damaging deflationary spiral. As a result in both cases, interest rate will move to appropriate levels to either encourage or discourage borrowing, keeping aggregate supply and aggregate demand in balance.”
Monetarism simply put is a “macro-economic theory which states that governments can foster economic stability by targeting the growth rate of the money supply. Essentially, it is a set of views based on the belief that the total amount of money in an economy is the primary determinant of economic growth.” (Momoh, O., 2021).
Monetarism theory then centers on the use of monetary policy to manage aggregate demand over fiscal policy. It views velocity as generally stable, which means that nominal income is largely a function of money supply, and when/if monetarist theory works in practice, it means that the central bank which controls the levers of monetary policy can exert much power over economic growth rates.
Limitations of the Monetarist Theory of the Monetary Policy
I agree that it is not always the case that the formulations and implementations of monetary policy in the country by the Central Bank of Nigeria is expected to align with the theoretical postulations of the Monetarist. This is because there are limitations to the Monetarist theory which is evident in the country too.
Monetarism emphasizes the importance of money supply which does not take financial asset computation, like stocks and equity, which individuals invest in for promising returns and the money supply does not provide a measurement for such asset clarifications. Now, a rise in stock market (returns) will encourage consumer spending because it makes people believe that they have gained wealth. This leads to increased spending, and an increase in demand which in turn encourages economic growth. Here, economic growth is not a direct result of the central bank’s control.
Another limitation which makes me agree that it is not always the case that the CBN aligns with the theoretical postulations of the Monetarists is the case of deflation. During deflationary periods, the Central Bank reduces its policy rates to as low as zero, but then the economy cannot be stimulated beyond this point. There is a liquidity trap when interest rates are close to zero and savings rate are high. This renders the monetary policy ineffective. Consumers then choose to avoid purchasing treasury securities and keep their funds in savings because of the prevailing belief that interest rates will soon rise. A rise in the interest rate will cause a decrease in bond prices.
Furthermore, the Monetarists believe that money supply is the major determinant of economic growth and favors monetary policy over fiscal policy. However, both policy tools- monetary and fiscal policy tools are important to attain the growth that we envision in Nigeria.
Moreover, the existence of foreign owned commercial banks in Nigeria can also render the CBN’s monetary policy ineffective. These banks do not follow the CBN monetary policy by selling foreign assets and drawing money from their head offices when the CBN has its own policy.
Finally, I will add that some wealthy people do not always deposit their monies with banks. They would rather invest in real estate or buy gold/jewelry with promising returns. In this case, their money flow lies outside the control of the central bank’s monetary policy since their monies are not deposited in banks. Therefore, I agree that the Central Bank of Nigeria does not always align with the theoretical postulations of the Monetarist.
Ezeobi Victor Daniel
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