As with other goods, the quantity of money demanded will depend on its opportunity cost. Most goods or resources can be bought with money, so it might seem difficult to specify the sacrifice associated with money holdings. These sacrifices, however, take the form of either interest forgone from income-earning assets not held (the Keynesian view) or forgone consumer goods and services (the classical view).
• The Classical View
The amount of consumption you sacrifice by holding a dollar falls as the cost of living rises. For example, if the price of a candy bar jumps from $0.50 to $1, then the candy you sacrifice to hold $1 drops from two bars to only one bar. You previously learned that comparing nominal values (e.g., dollars) requires deflating for inflation, that is, dividing the nominal value by the price level. Thus, the real subjective value of a dollar in exchange for consumer goods from the vantage point of a typical consumer is roughly the reciprocal of the price level ($1/P). If the price level rises, you must hold more dollars to consummate given amounts of “real” transactions. This implies a negative relationship between the quantity of money demanded and the reciprocal of the price level, as shown in Panel A of Figure 4. This cost of holding money is at the root of traditional classical monetary theory.
But relationships between the cost of living and the quantity of money demanded are not quite this simple. Suppose we experienced inflation for a substantial period and that you expected it to continue. Fearing a decline in value of money, you would want to reduce your dollar holdings and purchase more goods. (Dollars buy more today than you expect them to in the future). Consequently, new classical theory posits a negative relationship between expected inflation and the demand for money. We will explore this relationship more in a moment.
• The Keynesian View
Keynesians perceive the interest rate as the cost of holding money, because they view stocks or bonds that pay interest as the closest alternatives to money as an asset. You receive no interest on cash holdings and relatively low interest rates on demand deposits. If interest rates are relatively high on nonmonetary assets, you are more likely to hold your wealth in stocks or bonds than if interest rates are low, when money is a more attractive asset. This Keynesian emphasis on interest rates (reflected in Panel B of Figure 4) differs from the traditional classical view that the costs of holding money are the goods that might be enjoyed were the money spent.