There are two main approaches to explain the demand for money: 1) the classical approach, and 2) the Keynesian approach. Related to classical approach is the neo-classical theory, which is based on the same assumptions but different determinants when compared to the classical theory.
The Classical Approach
This theory is often associated with economists like J.S. Mill and Irving Fisher. According to them, people demand money because every individual and business firm gets money by selling goods and services (including factor services) and in turn use this money for the purchase of goods and, services produced by others. Hence, from the view point of classical economists, people wish to hold cash balances in order to carry out day-to-day transactions. The amount of money demanded by an individual or a business firm therefore, depends upon the volume of transactions. Since there is a fairly stable relationship between the level of income and the volume of transactions, the former is taken as an approximation for the latter.
The Neo-classical Theory
The early neo-classical theory of the demand for money was put forward by the Cambridge economists Alfred Marshall and A.C. Pigou. That is why the neo-classical theory is also called the 'Cambridge Equation Approach'.
According to Cambridge approach, a proportionate relationship exists between the 'demand for money' (Md) and the 'money value of national output' (Y).
A comparison of the classical and neo-classical theories of demand for money reveals
that, though the basic assumptions of these theories are similar, yet they differ from, each other in one important way: the classical approach was concerned with the volume of total transactions, while the Cambridge approach focused primarily on the level of income.
Keynesian Theory
John Maynard Keynes gave his own formulation of demand for money in his well-known book, The General Theory of Employment Interest and Money. Some of the economists who agreed with the Keynesian framework of analysis helped in further development of Keynesian theory of demand for money.
Keynes began by asking the following two inter-related questions:
i) Why is money demanded?
ii) What influences the demand for money?
His answers to these questions gave.us the Keynesian Theory of demand for money, Now let us study the answers to these questions.
