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Explain the Keynesian theory of money demand. What motives did Keynes think determined
money demand? What are the two reasons why Keynes thought velocity could not be treated as a
constant?
Answer: Keynes believed the demand for money depended on income and interest rates. Money
was held to facilitate normal transactions and as a precaution for unexpected transactions. For
both of these motives, money demand depended on income. People also held money as an asset,
for speculative purposes. The speculative motive depends on income and interest rates. People
hold more money for speculative purposes when they expect bond prices to fall, generating a
negative return on bonds. Since money demand varies with interest rates, velocity changes when
interest rates change. Also, since money demand depends upon expectations about future interest
rates, unstable expectations can make money demand, and thus velocity, unstable.
Diff: 2 Type: SA Page Ref: 533 - 534
Skill: Recall
Objective List: 21.2 Define the theories of the demand for money
Explain the transactions motive for holding money in Keynes's liquidity preference theory
Answer: Following the classical approach, Keynes emphasized that the transactions component
of the demand for money is determined primarily by the level of people's transactions. Because
he believed that these transactions were proportional to income, like the classical economists he
took the transactions component of the demand for money to be proportional to income.
Diff: 1 Type: SA Page Ref: 556
Skill: Recall
Objective List: 21.2 Define the theories of the demand for money
Explain the precautionary motive for holding money in Keynes's liquidity preference theory
Answer: Keynes went beyond the classical analysis by recognizing that people in addition to
holding money to carry out current transactions, they also hold money as a cushion against an
unexpected need. These money balances are useful when consumers find unexpected
opportunities for purchases of goods and services in the case of sales etc. Also precautionary
money is helpful when consumers need money to pay an unexpected bill. Keynes, postulated that
precautionary money demand is proportional to income.
Diff: 2 Type: SA Page Ref: 556
Skill: Recall
Objective List: 21.2 Define the theories of the demand for money