THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 599

CHAPTER 21

The Demand for Money

567

be a function of permanent income and the expected returns on alternative
assets relative to the expected return on money. There are two major differences between Friedman s theory and Keynes s. Friedman believed that
changes in interest rates have little effect on the expected returns on other
assets relative to money. Thus, in contrast to Keynes, he viewed the demand for
money as insensitive to interest rates. In addition, he differed from Keynes in
stressing that the money demand function does not undergo substantial shifts
and so is stable. These two differences also indicate that velocity is predictable,
yielding a quantity theory conclusion that money is the primary determinant of
aggregate spending. The conclusion that money is the primary determinant of
aggregate spending was the basis of monetarism, the view that the money supply
is the primary source of movements in the price level and aggregate output.

EM PI RI CAL E VI DE NCE ON TH E DE MA ND F OR M ON E Y
As we have seen, the alternative theories of the demand for money can have
very different implications for our view of the role of money in the economy.
Which of these theories is an accurate description of the real world is an important question, and it is the reason why evidence on the demand for money has
been at the centre of many debates on the effects of monetary policy on
aggregate economic activity. Here we examine the empirical evidence in the
United States and Canada on the two primary issues that distinguish the different theories of money demand and affect their conclusions about whether the
quantity of money is the primary determinant of aggregate spending. Is the
demand for money sensitive to changes in interest rates, and is the demand for
money function stable over time?14

14

If you are interested in a more detailed discussion of the empirical research on the demand for money,
you can find it in an appendix to this chapter on this book s MyEconLab at www.pearsoned.ca/
myeconlab.

A PP LI CATI O N

Empirical Estimation of Money Demand Functions
To see what empirical estimation of money demand functions is all about, suppose that we want to estimate the quantity theory of money demand function and
test its theoretical implications.* That is, test the hypotheses that the price level
elasticity of the demand for nominal money balances, h (M, P), equals 1 and that
the real income elasticity of the demand for real money balances, h (M/P, Y),
equals 1.
The hypothesis h (M, P) * 1 can easily be tested by reformulating Equation 3-A
and estimating the following regression equation
log Pt = - a - b log Yt + g log Mt + Pt
using time series data, and testing the hypothesis
H0: * * 1.