Short Essay on the Classical Theory of Demand for Money

The classical theory of demand for money is presented in the classical quantity theory of money and has two approaches: the Fisherman approach and the Cambridge approach.

1. Fisherian Approach:

To the classical economists, the demand for money is transactions demand for money. Money is demanded by the people not for its own sake, but as a medium of exchange. Thus, the demand for money is essentially to spend or for carrying on transactions and thus is determined by the total quantity of goods and services to be transacted during a given period.

Further, the demand for money also depends upon velocity of circulation of money. In Fisher’s equation, PT = MV, the demand for money (M_d) is the product of the volume of transactions over a period of time (T) and the price level (P). Thus,

M = PT

In Fisherian approach, the demand for money is defined only in a mechanical sense and no attention is paid to various motives for which money is demanded.

2. Cambridge Approach:

While Fisher’s transactions approach emphasized the medium of exchange function of money, the Cambridge cash-balance approach is based on the store of value function of money.

According to the Cambridge economists, the demand for money comes from those who want to hold it for various motives and not from those who want to exchange it for goods and services.

This amounts to the same thing as saying that the real demand for houses comes from those who want to live in them, and not from those who simply want to construct and sell them. Thus, in the Cambridge approach, the demand for money implies demand for cash balances.

The Cambridge economists considered a number of factors which tend to influence the demand for holding money. They are as follows:

(i) People tend to hold money for transactions motive. Money is generally acceptable in exchange for goods and services and thus holding of money avoids the inconveniences of barter transactions.

(ii) Money is also demanded for precautionary motive since money holding provides a degree of security against future uncertainties.

(iii) Given the transactions and precautionary motives for holding money, the amount of money which an individual will choose to hold depends upon income and wealth forming the budget constraints for the individual.

(iv) Within the absolute constraint set by wealth and income, the actual proportion held in money form depends, among other things, upon the opportunity cost of holding money as opposed to other assets.

For Cambridge School, the opportunity cost of holding money consists of rate of interest, the yield on real capital and the expected rate of inflation.

(v) Other factors influencing money demand according to the Cambridge School are habits of the individual, the system of payments in the community, the availability of money substitutes, the density of population, the system of communication, the general level of confidence, etc.

After recognising the importance of the above factors, the Cambridge economists, however, simplified the demand for money function by assuming, that the demand for money holdings (M_d) is a constant proportion (K) of money income (PY) alone. Thus,

M, = KPY

The value of K has been assumed to be stable in the sense that the determinants of K donot change significantly in the long run. The purpose of this simplification of the demand for money function by the Cambridge economists was to show that K in the Cambridge equation was just the reciprocal of V in Fisher’s equation (i.e., K = 1/V).

In the end, the classical theory of demand for money may be summarised as under:

(i) Money is only a medium of exchange.

(ii) The ratio of desired money balances to nominal income is assumed to be constant at its minimum, or, in other words, velocity of money is constant at its maximum (because K = 1/V).

(iii) The public holds a constant fraction of its nominal income in non-interest-earning cash balances for transactions and precautionary motives.

(iv)Hoarding, i.e., holding money above the minimum desired for transaction purposes, is considered irrational because money in itself has no value.

(v) Quantity of money demanded is directly related to the price level.