The demand for money theory is the main element of the monetary economics theory and an essential part in the macroeconomic theory. At the same time, each country’s government, policy maker and economist takes it seriously on economic control. From the 1970, the western countries experienced a worse situation of increasing inflation. A lot of economists considered that demand for money function was unstable due to financial innovation, and it became difficult to control by monetary department. Then, it led to a rush of research the demand for money which includes the Keynes system, monetary system, rational expected system and so on. In this part, I will discuss three theories of the demand for money. They are the classics theory, the modern quantity theory and Keynes theory. In additional, two empirical works will be looked into – An economic analysis of UK money demand by Milton Friedman and Anna J. Schwartz; and the demand for broad money in the United Kingdom by Hendry, Ericsson and Prestwich.

The classic theory

At present of the money theory came from two different theories: one is quantity theory which belongs to the classic theory; the other is Keynesian theory. (Handa, 2000, p25). In the classic theory, the economy always keeps the full-employment level and price can adjust any time to keep the balance in the market. Although the classic theory did not mention the demand for money, it was noticed on transactions velocity of circulation of money.

Irving Fisher’s version of the quantity theory

In 1911 Irving Fisher’s published a book- “power of money” which emphasized money’s function was the medium of exchange. (Fisher, 1911). The book shows the equation about the quantity of commodity transaction being equal to the quantity of currency transaction. Fisher tried to use the quantity equation to discuss the quantity theory in that book. In the equation (1): M is the quantity of money, V is the number of times it turns over, P is the price level, and T is the volume of transaction. PT is the total value of commodity transaction or nominal national income; MV is the total value of currency transaction. “The quantity of money (M) is determined independently of any of the three other variables and at any time can be taken as given.”( Laidler,1985,p.44). In the long run, economy with full employment level, the T can be taken as given too. Fisher assumes that it has a fixed ratio between volume of transactions and level of output. The V is also treated like M, that is, independently of any other variables. Therefore, the value of variable P is dependent on the interaction of other variables. In another word, according to Laidler (1985,p45): “The demand for nominal money depends on the current value of the transaction to be conducted in the economy and is equal to a constant fraction of those transactions.”

MV=PT (1)

Cambridge approach

The British economists Marshall and Pigou analyzed the demand for money in another way. Rather than discussing function provided by Fisher’s work, they discussed what decision people wish to hold the amount money in the trading. They emphasized that peoples’ behavior when they choosing.

In the Pigou’s article “the value of money” shows he analyzed the legal tender which included the currency and demand deposits in the banks. He considered that people hold the currency and demand deposits because it has two purposes. Firstly is the “provision of convenience”. When people hold cash, they can easily to do their daily business. Secondly is the “provision of security”. It can prevent him to face the unexpected demand or the some commodities price increasing. (Handa, 2000, p.31). Therefore, the two purposes would bring the demand for currency and deposit.

The demand for money determined by the proportion of wealth that the people choose it. Hence, Pigu (1971) considered that people direct concerned about the proportion of cash in their whole resources, and not the demand for the currency and deposit. Further, “this ration of money demand to resources is a function of the internal rate of return on investment and of the marginal satisfaction forgone form less consumption.” ( Handa, 2000, p31). Under the other thing constant, the nominal money demand and nominal expenditure became a proportion. The equation is : Md/Y=k(r) (1)

The r represents the internal rate of return on investment. Y is nominal expenditure, Md nominal money demand.

The equation can change to : Md=k(r )Y(2)

Also Y= py. P is the price , y is the real amount of goods

Md=k(r )py(3)

Md *1/k(r )= py ,(4)

Use V= 1/k(r), (5) the V means velocity. In the equation (5) shows the Velocity determined by the interest rate “r”. In the Cambrian model, it already showed the interest rate a variable has an important factor for the demand for money.

Keynesian theory

Keynes showed the liquidity preference theory in 1936. He advanced the problem of demand for money from Cambridge approach and made a more careful analyzed about motivation that people to hold money. (Laidler 1985, p50). He considered that people like to hold money because it can keep the flexibility on payment. He stressed the role of interest rate and gave up the classic theory about velocity. The Keynesian theory divided into transaction demand, precautionary demand and speculative demand.