the demand for money

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Chapter 21
The Demand for Money
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Velocity of Money and Equation of Exchange
M = the money supply
P = price level
Y= aggregate output (income)
P x Y = aggregate nominal income (nominal GDP)
V= velocity of money (average number of times per year
that a dollar is spent)
M
PxY
V =
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Quantity Theory of Money
•
Velocity fairly constant in short run
•
Aggregate output at full-employment level
•
Changes in money supply affect only
the price level
•
Movement in the price level results solely
from change in the quantity of money
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Quantity Theory of Money Demand
Divide both sides by V
M= (1/V) x PY
When the money market is in equilibrium M = M
d
Let k = 1/V
M
d
= k x PY
•
Because k is constant, the level of transactions
generated by a fixed level of PY determines the
quantity of M
d
•
The demand for money is not affected by interest
rates
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Is Velocity a Constant?
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Keynes’s Liquidity Preference Theory
•
Transactions Motive
–
Positively related to income
•
Precautionary Motive
–

Positively related to income
•
Speculative Motive
–
Negatively related to interest rate
•
Distinguishes between real and nominal
quantities of money
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The Three Motives I
),(
1
M
P
Rewriting
),(
d
Yif
Y
if
P
M
d
=
=
+
−
),( Yif
Y

M
PY
V ==
Multiple both sides by Y and replace Md with M
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The Three Motives II
•
Pro-cyclical movements in interest rates should
induce pro-cyclical movements in velocity
•
Velocity will change as expectations about future
nominal levels of interest rates change
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Transactions Demand
•
Baumol – Tobin approach theorized money balances held
for transactions purposes are sensitive to interest rates
•
There is an opportunity cost and benefit
to holding money
•
The transaction component of the demand for money is
negatively related to the level of interest rates
Further Developments in the Keynesian Approach
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Cash Balances in the Baumol-Tobin Model
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Precautionary Demand
•
Similar to transactions demand
•
As interest rates rise, the opportunity cost of
holding precautionary balances rises
•
The precautionary demand for money is
negatively related to interest rates
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Speculative Demand
•
Keynes’s speculative demand motive implied
very little diversification
–
People held wealth as either money or bonds but
rarely both.
•
Only partial explanations developed further
–
Risk averse people will diversify
–
Did not explain why money is held as a store of
wealth
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M
d

/P = f( Y
p
, r
b
- r
m
, r
e
- r
m
, π
e
- r
m
)
where:
M
d
/P = demand for real money balances
Y
p
= permanent income (measure of wealth)
r
m
= expected return on money
r
b
= expected return on bonds
r
e

= expected return on equities
π
e
= expected return on equities
Friedman’s
Modern Quantity Theory of Money
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Variables in the Money Demand Function
•
Permanent income (average long-run income) is
stable, the demand for money will not fluctuate much
with business cycle movements
•
Wealth can be held in bonds, equity and goods;
incentives for holding these are represented by the
expected return on each of these assets relative to the
expected return on money
•
The expected return on money is influenced by:
–
The services provided by banks on deposits
–
The interest payment on money balances
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Differences Between Keynes’s and Friedman’s
Model I
•
Friedman

–
Includes alternative assets to money
–
Viewed money and goods as substitutes
–
The expected return on money is not constant;
however, r
b
– r
m
does stay constant as interest rates
rise
–
Interest rates have little effect on the demand for
money
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Differences Between Keynes’s and Friedman’s
Model II
•
Permanent income is the primary determinant of
money demand
M
d
/P = f( Y
p
)
•
Velocity of money is predictable since relationship
between Y and Y

p
is predictable
V = Y/ f( Y
p
)
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Empirical Evidence on the Demand for
Money
•
Interest rates and money demand
–
Consistent evidence of the interest sensitivity of the demand
for money
–
Little evidence of liquidity trap
•
Stability of money demand
–
Prior to 1970, evidence strongly supported stability of the
money demand function
–
Since 1973, instability of the money demand function has
caused velocity to be harder to predict
•
Implications for how monetary policy should be
conducted