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Lecture 14

THEORIES OF MONEY DEMAND


(Chapter 22)


I. Introduction to Monetary Theory

Monetary Theory is a specific area of general macroeconomic theory.

1. The Two Basic Theoretical Constructs

The 2 basic theoretical constructs about how money affects real
output/income and the average price level are:
Monetarist/Classical theory
versus
Keynesian theory
These 2 approaches to monetary theory conflict and compete with each
other.

However, they do have one thing in common:

They are both concerned with how money affects the aggregate demand
for goods & services.

(As opposed to how money affects aggregate supply)

aggregate demand (AD): the economy's willingness to purchases
real GDP

aggregate supply (AS): the economys willingness & ability to
produce real GDP

2. Their Basic Characteristics

2.1 Monetarist Theory:

1) Does not distinguishes between the different components of
AD. AD is amorphous
2) AD is stable
3) Fluctuations in AD & the price level are the result of
imbalances between the demand for money & the supply of
money

2.2 Keynesian Theory:

1) Distinguishes between the different components of AD (= C
+ I + G + X - Im) & analyzes the different determinants of
their spending.
ECN 303, L14, Money Demand Theories, 2
2) Concludes that AD is unstable and can be affected by a
number of factors (i.e. business & consumer confidence).
3) Gives money an important but lesser role in the
determination of AD & prices.

3. The Macroeconomic Models

1) Monetarist Theory is based on the Quantity Theory of Money
which was first introduced in the 1700s as a result of European
inflation following the influx of New World gold & silver. The
Quantity Theory of Money is a component of the Classical Model

2) Keynesian theory is based on the Income/Expenditure Model & the
IS/LM Model first introduced in the 1930s as a result of the
Great Depression
3) Both theories can be presented using the Aggregate Demand /
Aggregate Supply model.


II. The Quantity Theory of Money Approach to Money Demand

1. The Equation of Exchange

M
S
V PY

where: M
S
= the money supply
V = the Velocity of money
P = the price level
Y = real GDP
M
S
V = the total value of transactions in
purchasing nominal GDP
PY = nominal GDP

The velocity of money:

1) the number of times the money supply is used to purchase
nominal GDP
or
2) the average number of times per year that a dollar is
spent of final goods and services

S
M
PY
V

nominal GDP: the current market value of all final goods and services
produced within the domestic economy during a given period of time

real GDP the quantity all final goods and services produced within the
domestic economy during a given period of time
ECN 303, L14, Money Demand Theories, 3
2. Calculating the Velocity of Money

In 1996: GDP = $7,636.0 billion
M1 = $1,081.1billion
M2 = $3,821.8 billion

V
1
=
$1081.1
0 . 7636 $
= 7.063 & V
2
=
8 . 3821 $
0 . 7636 $
= 1.998

where V
1
= the velocity of M1
V
2
= the velocity of M2

3. The Original Equation of Exchange

The equation of exchange was first introduced by Irving Fisher, a
classical economist during the late 1800s and early 1900s.

Fishers original equation of exchange:

M
S
V
T
PT

T = total transactions on goods, services, & assets
V
T
= the transaction velocity of money

4. The Classical Quantity Theory of Money

Accepted by the earlier classical economists.

Restated by Fisher using the equation of exchange.

4.1 The weaker statement of the Q Theory:

Assumption: V is fairly constant

V is determined by habits and institutions of carrying out
transactions.

If V is constant, then nominal income (PY) is determined by
M
S
.

M
S
=

,
_

V
1
PY
implies
M
S
PY

4.2 The Quantity Theory of Money:

Additional Assumption: Y is fairly constant

ECN 303, L14, Money Demand Theories, 4
This assumption is based on the classical theory belief that
flexible wages & prices would allow output (Y) to always be
at or near its full employment level.

If both V & Y are constant, then the price level is strictly
determined by M
S


M
S
=

,
_

V
Y
P
implies
M
S
P

In the classical Q Theory of Money, P is fully determined by
M
s
with the result that a 50% increase in Money will lead to a
50& in prices.

5. Money Demand in the Quantity Theory

Given money market equilibrium:

M
D
= M
S
, then M
D
=

,
_

V
1
PY

The implication of this money demand statement is that the interest
rate plays no role in determining the amount of money people wish
to hold.

Money demand in the Classical Q Theory follows from its
mathematical statement using the equation of exchange and there is
no need or attempt to identify the factors that determine the
demand for money.


III. The Cambridge Equation & the Debate of Money Demand

1. The Cambridge Equation

At Cambridge, England, Alfred Marshall and Arthur Cecil (A.C.)
Pigou identified two motives (reasons) for holding money:

1) as a medium of exchange

The amount of money held as a medium of exchange is a
function of nominal income (PY)

2) as a store of wealth

The amount of money held as a store of wealth is also a
function of nominal income (PY)

ECN 303, L14, Money Demand Theories, 5
This lead to the demand for money being expressed by the Cambridge
Equation:
M
D
= kPY
k = the constant of proportionality or the constant
proportion of nominal income that people hold as money.

The Cambridge equation indicates that money demand is proportional
to nominal income.

If you consider that k can be written as 1/V & that both k & V are
treated as constant, the Cambridge equation & the classical money
demand function appear to be identical.

However, a major difference, in addition to analyzing the motives
behind money demand, is in the role that the interest rate plays in
money demand.

Although the interest rate does not appear in the Cambridge
equation, interest rate changes could cause short-run fluctuations
in k.

2. The Debate Over Velocity

Even though the Cambridge equation looks like Quantity Theory (k =
1/V), it is significantly different.

The Cambridge equation marks the beginning of an ongoing debate
about the behavior of V.

2.1 The classical economists (& monetarists) on velocity:

1) V is constant or stable
2) V is independent of i

2.2 The Cambridge economists (& Keynesians) on velocity:

1) V is unstable
2) V is affected by i

2.3 The empirical evidence on velocity:

1) Classical economists had no data to observe the actual
behavior of V.

2) When data became available after the Great Depression,
economists realized velocity far from constant.

Go to Handout
ECN 303, L14, Money Demand Theories, 6
IV. Keynes Liquidity Preference Theory

1. The Three Motives Behind the Demand for Money

Since Keynes was at Cambridge, his theory is built in the Cambridge
tradition by starting with motives behind (reasons for) the demand
for money:

1) Transactions Motive

Holding money to carry out planned or expected transactions.

,
_

income
real
consumption

,
_

ns transactio
planned more
out carry to
money more hold


Money demand is a positive function of real income (Y) not
nominal income (PY)

2) Precautionary Motive

Holding money to carry out unplanned or unexpected
transactions.

,
_

income
real
consumption

,
_

ns transactio unplanned more


out carry to money more hold


3) Speculative Motive

Refer back to the liquidity preference model constructed in a
previous lecture.

Money & bonds are the only two types of assets that can serve
as a store of wealth.

Wealth = money + bonds = M + B

wealth

,
_

assets all
for demand

'

D
D
B
M


However, as a store of wealth, money can be used to carry out
transactions but does not earn any income.

In order to explain why people would store some of their
wealth in the form of money, Keynes developed the following
argument:

ECN 303, L14, Money Demand Theories, 7
Suppose there is some normal interest rate (i
N
) & some normal
price of bonds (
N
B
P ). P
B
= the actual price of bonds.

If i>i
N
then P
B
<
N
B
P :

,
_

B
P
ect exp
people

,
_

gain
capital
ect exp

,
_

money with
bonds buy


If i<i
N
then P
B
>
N
B
P :

,
_

B
P
ect exp
people

,
_

loss
capital
ect exp

,
_

money hold
&
bonds sell


The conclusion of this argument is that interest rates & money
demand are negatively related.

As interest rates rise, people will be prompted to convert
their money holdings into bond holdings.

,
_

high is
when i

,
_

bonds into money


convert people
M
D


As interest rates fall, people will be prompted to convert
their bond holdings into money holdings.

,
_

low is
when i

,
_

money into bonds


convert people
M
D


2. The Keynesian Money Demand Function

As indicated by his motives or reasons for holding money, Keynes
believed that the demand for money should be stated in real terms.

This is because he believed that the amount of money that people
would hold would be the amount they would need to purchase the
desired quantity of goods and services and this would be a
function of their real income.

D
P
M
= f(
+
Y ,

i)

where:
D
P
M
= real money demand

ECN 303, L14, Money Demand Theories, 8
Keynesian money demand is also referred to as:

the demand for liquidity
the liquidity preference function
the demand for real money balances.

3. Velocity & Keynesian money demand

Substituting the Keynesian money demand equation into the
definition of Velocity shows that velocity is not constant but
fluctuates with interest rates. In equilibrium:

) i , Y ( f
Y
P
M
Y
P
M
Y
M
Y P
V
D S S



The implication is that any increase in interest rates will cause
an increase in velocity:

i f(Y,i) V

This occurs because at the higher i, people will want to hold less
money and the smaller money supply will have to turn over faster.

Connecting this to the bond market:

i P
B
B
D
& M
D



V. Later work on Keynesian M
D


1. Problems with the Speculative Demand For Money

There were problems with basing the relationship between money
demand & interest rates on Keynes speculative demand:

1) The implication of the speculative demand argument is
that people will either hold all bonds or all money with
no diversification. This was a serious short-coming.

2) The very existence of the speculative demand is
questionable

These problems prompted later efforts to explain money demand as a
function of interest rates without relying on the questionable
speculative demand.

ECN 303, L14, Money Demand Theories, 9
2. The Baumol-Tobin Model of the Transactions Demand for Money

William Baumol & James Tobin, independently developed models of
money demand in which the transactions demand for money is
sensitive to the interest rate.

People have an incentive to economize on transaction money balances
when interest rates rise, thus:

i

,
_

money holding to
due income lost
M
D


Similar models of precautionary demand produced a similar tradeoff
between additional income versus convenience of precautionary
balances

3. The Tobin Model of the Speculative Demand for Money

A second Tobin model introduced risk and assumed that people want
high returns but are risk averse.

If bonds have risk, even at high interest rates people will always
hold some money.

A problem with the second Tobin model, in addition to the fact that
the speculative demand may not exist:

There are assets that have virtually no risk (T-bills, money
market mutual funds) but have a higher return than money.

The only advantage of money is transactions costs and even that is
virtually zero for MMMFs.


VI. The Monetarist Approach To Money Demand

1. Milton Friedman's Money Demand Function

Friedman uses the theory of asset demand and his concept of
permanent income to make money demand a function of wealth and the
relative return of other assets

[ ] ) r (p ) r (r r r f
P
M
m
e
m e m b p
D
Y , ), ( ,

where: Y
P
= permanent income
r
b
-r
m
= the difference between the return on bonds &
the return on money
ECN 303, L14, Money Demand Theories, 10
r
e
-r
m
= the difference between the return on equity
& the return on money
p
e
-r
m
= the difference between the expected
inflation rate & the return on money

1) Permanent income

People base their demand for money on their expectations of
their permanent income. People demand more money as their
permanent income grows:

(Y
P
) M
D


Since permanent income is constant or grows at a stable
predictable rate, Y
P
should have little or no short-run effect
on M
D
.

Current income (Y) which fluctuates over the short-run
business cycle, is not a factor in Friedmans money demand
function.

2) The difference between the returns on bonds & money

(r
b
-r
m
) M
D


3) The difference between the return on equities & money

(r
e
-r
m
) M
D


4) The difference between the expected inflation rate & the
return on money

(p
e
-r
m
) M
D


An increase in the expected inflation rate prompts people to convert their
cash into inflation safe real assets (real estate, gold, commodities)

2. Characteristics of Friedmans Money Demand that differ from
Keynesian Money Demand (6)

1) People hold other assets besides money & bonds, namely
equities & real goods

2) The return on money (r
m
) is not constant

r
b
&/or r
e
r
m
as banks offer:
a. more services for checking account owners
b. higher interest on interest earning checkable
accounts
ECN 303, L14, Money Demand Theories, 11
3) Given 2), interest rates have little effect on M
D

,
_

,
_


D
implying m e m b
M on effect
little has

constant remain
) r r ( & ) r r (
i


4) Given 3) & the fact that Y
P
is stable over the business cycle
(as opposed to Y)

both )
-
( f
i
Y
P
M
D
,
+
&is
) f(Y
Y
V
P
are stable

5) If Y fluctuates around Y
P
, the relationship between Y & Y
P
is
predictable. Combining this with 4) implies that V is
predictable. This leads to the Q Theory of money view that
changes in M
s
lead to predictable changes in nominal income,
PY

6) Holding (buying) real goods as an alternative to other assets,
especially money, implies that the quantity of money has a
direct effect on spending (aggregate demand).

M
S
M
S
> M
D
spending AD


VII. The Modern Quantity Theory Of Money

>>>Mentioned in Chapter 24<<<

1. Problems with the Classical Quantity Theory of Money

1) Velocity is not constant
2) Real GDP (Y) is not constant at Y
F
but exhibits short-run
fluctuations around Y
F
, the business cycle.

2. The Modern quantity theory of Money

However, empirical evidence does indicate a strong correlation
between the money supply & inflation.

This strong correlation resulted in the quantity theory being
resurrected in the Modern Quantity Theory of Money

Assumptions of the Modern Q Theory

1) V is stable & therefore predictable
2) Y can vary in the short-run, however, in the long run Y
gravitates to its full-employment level (Y
F
)

ECN 303, L14, Money Demand Theories, 12
Given that PY
V
1
M
S

,
_

; if V is stable & therefore predictable, it


follows that: M
S
(PY)

Secondly, since Y = Y
F
in the long-run:

P
V
Y
S
M

,
_

implies M
S
P


VIII. Empirical Evidence on Money Demand

1. Interest Sensitivity of Money Demand

M
D
is sensitive to the interest rate, but there is no evidence that
there has ever been a liquidity trap.

2. Stability of Money Demand

1) (M1)
D
stable till 1973, after 1973 it became unstable

2) 1974-82:
a. (M1)
D
function over predicted the demand for M1, i.e.
(M1)
D
grew more slowly than predicted.
b. over predicting (M1)
D
means that velocity was under
predicted, i.e. velocity rose faster than predicted.
c. This situation was dubbed the "Case of the Missing Money."

3) After 1982, a velocity slowed down but this was under predicted
by (M1)
D


4) When (M1)
D
became unstable, attention shifted to (M2)
D
which
remained more stable in 1980s. However, (M2)
D
became unstable
in 1990s.

5) The broad consensus is that the most likely source of
instability in money demand is the rapid pace of financial
innovation occurring after 1973. Financial innovation creates
new types of money that are not included in the money supply
definitions

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