Chapter 11–The Demand for Money

Quantity Theory

  • 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

Quantity Theory of Money Demand

  • Demand for money is determined by:

–The level of transactions generated by the level of nominal income PY

–The institutions in the economy that affect the way people conduct transactions and thus determine velocity and hence k

Keynes’s Liquidity Preference Theory

  • Why do individuals hold money?

–Transactions motive

–Precautionary motive

–Speculative motive

  • Distinguishes between real and nominal quantities of money
  • Velocity is not constant:

–The procyclical movement of interest rates should induce procyclical movements in velocity.

–Velocity will change as expectations about future normal levels of interest rates change

Further Developments in the Keynesian Approach

  • Transactions demand

–Baumol Tobin model

–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

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

Speculative Demand

  • Implication of no diversification
  • Only partial explanations developed further (Tobin)

–Risk averse people will diversify its portfolio and hold some money as a store of wealth

–Do not provide a definite answer as to why people hold money as a store of wealth

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 proved by banks on deposits

–The interest payment on money balances

Differences between Keynes’s and Friedman’s Model

  • Friedman

–Includes alternative assets to money

–Viewed money and goods as substitutes

–The expected return on money is not constant; however, rb rm does stay constant as interest rates rise

–Interest rates have little effect on the demand for money

Empirical Evidence

  • 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

Chapter 11 the demand for money

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