Keynes liquidity theory unnecessarily bifurcated aggregate demand for money into transactions demand and speculative demand.
The transaction demand depends upon the level of income and Keynes assumed a constant relation between money-holding and income. The speculative demands is based on portfolio approach which considers the yields of assets and compete with money in the individual’s portfolio. Keynes limits his analysis to two assets: money and bonds. The combination of demand motives with two different approaches is inconsistent.
In the post-Keynesian period, two major attempts have been made to correct this inconsistency. (a) William Baumol and James Tobin applied the portfolio analysis to the transactions demand, and (b) Milton Friedman attempted to blur the sharp distinction between motives of holding money balances, emphasising that money is held for many purposes and that demand for money is sensitive to various economic variables.
Baumol’s Analysis
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Baumol maintains that transactions demand for money also depends on the rate of interest. In fact, holding of cash involves two types of costs:
(a) Interest costs – When cash balances are held, we forgo interest-income by not holding other forms of interest-yielding assets.
(b) Non-interest Costs – When bonds are converted into cash, certain costs like brokerage fee, postage charges, etc. accrue.
Baumol developed his algebric model of the demand for transaction balances at the micro level. He assumes that an individual invests his money income in interest-bearing bonds and these bonds are converted for money in equal lots of amount M each to finance his expenditure.
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It is also assumed that the individual has uniform expenditures or transactions to make over a given time period. Each conversion will involve a brokerage fee.
The total brokerage fee will be equal to the number of conversions into money times the brokerage fee, or b (T/M). Where T represents total transactions, M, the amount of bonds converted to money and b, the brokerage fee.
Baumol’s model suggests a number of conclusions:
(i) The demand for real cash balances (M/P) will rise by less than the real income (or real expenditures), implying that there are economies of scale in holding money balances. This further implies that income velocity should rise over time with real income.
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(ii) The demand for real balances is invariant with respect to changes in the price level and, thus, inflation can affect the demand for money only by altering the rate of interest.
(iii) The power of the monetary policy has been greatly increased. With an increase in money supply, the model implies that for a given interest rate, nominal income must rise by the square of any increase in nominal balances before equilibrium can be restored.
(iv) Transactions demand has been formally recognised with the speculative demand. Now, an individual, when deciding whether to hold wealth in money or bond form, must consider the market rate of interest.