THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 586

554

PA R T V I I Monetary Theory
Equation 3 tells us that because k is a constant, the level of transactions generated by a fixed level of nominal income PY determines the quantity of money Md
that people demand. Therefore, Fisher s quantity theory of money suggests that
the demand for money is purely a function of income, and interest rates have no
effect on the demand for money.3
Fisher came to this conclusion because he believed that people hold money
only to conduct transactions and have no freedom of action in terms of the amount
they want to hold. The demand for money is determined (1) by the level of transactions generated by the level of nominal income PY and (2) by the institutions in
the economy that affect the way people conduct transactions that determine velocity and hence k.

APP LI CAT IO N

Testable Theoretical Implications of the
Quantity Theory of Money Demand
A convenient linearization of Equation 3 is achieved if we write it in logarithmic
form as (ignoring the d superscript here)
log M = log k + log 1PY 2
log P log Y ,
=

(3-A)

where a
log k. Using Equation 3-A, we can clearly see the testable theoretical
implications of the quantity theory of money demand.
In particular, Equation 3-A implies that the price level elasticity of the demand
for nominal money balances, denoted h (M, P), is
d log M

= 1,
d log P
and that the real income elasticity of the demand for real money balances, denoted
h (M/P, Y), is
d log (M/P)
M
h a , Yb =
= 1.
P
d log Y
Equation 3-A also suggests that the demand for money is purely a function of
income and that interest rates have no effect on the demand for money. In other
words, the (nominal) interest rate elasticity of the demand for real money balances,
denoted h (M/P, i), is
d log (M/P)
M
= 0.
h a , ib =
P
d log i
These are the testable theoretical implications of the quantity theory of money
demand.*
h1M, P2 =

* Regarding the testable implications of some of the other money demand theories discussed in this
chapter, see Apostolos Serletis, The Demand for Money: Theoretical and Empirical Approaches
(Springer, 2007).

3

While Fisher was developing his quantity theory approach to the demand for money, a group of classical economists in Cambridge, England, came to similar conclusions, although with slightly different
reasoning. They derived Equation 3 by recognizing that two properties of money motivate people to
hold it: its utility both as a medium of exchange and as a store of wealth.