THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 590

558

PA R T V I I Monetary Theory
in our analysis of money demand in Chapter 5 and in Chapter 22 that describes
the ISLM model. Because money demand is negatively related to the interest rate,
a fall in i leads to a rise in the quantity of money demanded Md, and so the money
demand curve is downward sloping as in Figure 5-8 (page 98). Keynes s conclusion that the demand for money is related not only to income but also to interest
rates is a major departure from Fisher s view of money demand, in which interest
rates have no effect on the demand for money.
By deriving the liquidity preference function for velocity PY/M, we can see that
Keynes s theory of the demand for money implies that velocity is not constant but
instead fluctuates with movements in interest rates. The liquidity preference equation can be rewritten as
1
P
=
d
f
(i,
Y)
M
Multiplying both sides of this equation by Y and recognizing that M d can be
replaced by M because they must be equal in money market equilibrium, we solve
for velocity:
PY
Y
V =
=
(5)
M
f (i, Y)
We know that the demand for money is negatively related to interest rates; when

i goes up, f (i, Y ) declines, and therefore velocity rises. In other words, a rise in
interest rates encourages people to hold lower real money balances for a given
level of income; therefore, the rate at which money turns over (velocity) must be
higher. This reasoning implies that because interest rates have substantial fluctuations, the liquidity preference theory of the demand for money indicates that
velocity has substantial fluctuations as well.
An interesting feature of Equation 5 is that it explains some of the velocity
movements in Figure 21-1 (page 555), in which we noted that when recessions
occur, velocity falls or its rate of growth declines. What fact regarding the cyclical
behaviour of interest rates that we discussed in Chapter 5 might help us explain
this phenomenon? You might recall that interest rates are procyclical, rising in
expansions and falling in recessions. The liquidity preference theory indicates that
a rise in interest rates will cause velocity to rise also. The procyclical movements
of interest rates should induce procyclical movements in velocity, and that is
exactly what we see in Figure 21-1.
Keynes s model of the speculative demand for money provides another reason why velocity might show substantial fluctuations. What would happen to
the demand for money if the view of the normal level to which interest rates
gravitate changes? For example, what if people expect the future normal interest rate to be higher than the current normal interest rate? Because interest rates
are then expected to be higher in the future, more people will expect the prices
of bonds to fall and will anticipate capital losses. The expected returns from
holding bonds will decline, and money will become more attractive relative to
bonds. As a result, the demand for money will increase. This means that f (i, Y )
will increase and so velocity will fall. Velocity will change as expectations about
future normal levels of interest rates change, and unstable expectations about
future movements in normal interest rates can lead to instability of velocity. This
is one more reason why Keynes rejected the view that velocity could be treated
as a constant.
To sum up, Keynes s liquidity preference theory postulated three motives for
holding money: the transactions motive, the precautionary motive, and the spec-