Major differences between quantity and the Keynesian Liquidity preference theories of money demand

The Quantity Theory of Money (Theory of Exchange) looks at money
largely from the supply side while Keynesian approach is from the demand perspective (the desire for people to hold their wealth in cash balances instead of interest – earning assets such as treasury bills and bonds) Early quantity theorists maintained that he quantity of money (M) is exogenously determined (eg. the quantity of notes printed), and that the velocity (v) and the volume of transactions (T) are constant. This means that in the equation of exchange (MV = PT) if the money supply (M) is doubled the price level (P) is going to increase proportionately, thus the assertion of the quantity theorists that the price level varies in direct proportion to changes in the quantity of money, leaving real variables (such a aggregate demand & unemployment) unchanged.

By keeping the velocity of money constant, money appears as a technical input to spending, that is, a certain quantity of money is required per unit of spending; there is no indication that the velocity of circulation of money might be affected the decisions of people themselves to hold money.

The Keynesian view, however, maintains that the more people tend to want to keep their wealth in liquid form (eg. cash and cheques/current/sight accounts) rather than time deposits or long-term loans, the smaller the proportion of the existing stock of money that can be lent out financial institutions to be spent borrowers. Thus, the more people wish to hold reserves of liquidity in money balances the lower will tend to be the velocity
of circulation of money.

Keynes argued in the General Theory of Employment, Interest and Money (1936) that velocity (V) can be unstable as money shifts in and out of ‘idle’ money balances reflecting changes in people’s liquidity preference. The supply of money is exogenously determined the monetary authority and therefore interest – inelastic, and what actually causes changes in real economic variables is the frequency of change in the velocity of money an argument which the Quantity Theory of money doesn’t recognize, since it holds constant the velocity of money (V).

Other than for transactions purposes, Keynes argued that the demand for money depends on the wave of pessimism concerning real world prospects which could precipitate a ‘retreat into liquidity’ as people seek to increase their money holdings. This increase in money holding would lower the
velocity of circulation of money and thus aggregate demand would fall bringing about economic recession.

The demand for money, according to Keynes, is for three motives:
transactions, precautionary and speculative motives, arguing that the demand for money is positively related to income and negatively related to interest rate, which should not fall below the investors’ normal rate of interest.



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