Chapter 22. Demand for Money

Chapter 22. Demand for Money • Quantity Theory of Money • Keynes & Liquidity Preference • Friedman’s Modern Quantity Theory • Friedman vs. Keynes • Empirical Evidence

Monetary Theory • link between MS and other economic variables • price level • output

I. Quantity Theory of Money • classical economists • Irving Fisher • relates quantity of money to nominal income

equation of exchange • MV = PY • where • M = quantity of money • P = price level • Y = real output = real income • V = velocity = # times money used to purchase output

2 assumptions • V is constant in short-run • depends on institutions, technology that change slowly • Y is at full employment level • also constant in short-run

MV = PY • if V, Y constant then A change in M must cause an equal % change in P • Quantity Theory of Money

money demand • MV = PY • M = (1/V)PY • M = kPY let (1/V) = k • Md = M in equilibrium • Md = kPY • Md is depends on income NOT interest rates

Is V constant? NO.

II. Liquidity Preference • Keynes 1936 • 3 motives to holding money • transactions motive • precautionary motive • speculative motive

transactions motive • people hold money to buy stuff • as income rises, • Md rises

precautionary motive • people hold money for emergencies • car breakdown • job loss • Md rises with income

speculative motive • suppose store wealth as money or bonds • high interest rates • bonds more attractive, hold less money • Md negatively related to interest rate

real quantity of money • M/P • if prices rise, must hold more money to buy same amount of stuff

money demand (M/P) • depends on • income • interest rates M/P = f(i,Y)

Keynes & velocity • MV = PY • M/P = Y/V • M/P = f(i,Y) • Y/V = f(i,Y) • V = Y/f(i,Y) • velocity fluctuates with the interest rate -- both are procyclical

Tobin & money demand • further extended Keynes approach • transaction demand negatively related to the interest rate • people hold money even when is has a lower return, b/c it is less risky

III. Friedman’s modern quantity theory • Milton Friedman • Md as asset demand -- wealth -- return relative to other assets

Yp = permanent income • rb = expected bond return • rm = expected money return • re = expected equity return • pe = expected inflation

rb - rm = relative return on bonds • pe = expected return on goods

increase in Yp will increase Md • increase in relative returns of bonds, equity or money • decrease Md

Friedman vs. Keynes • Friedman: • multiple rates of return • relative returns • money & goods are substitutes • Yp more important than current income

stability of Md • Friedman’s Md function is more stable • Yp more stable than current income • spread between returns is more stable than returns -- interest rates have little impact on Md

IV. empirical evidence • which Md function is right? • Keynes or Friedman • test • how does Md respond to i? • how stable is Md?

Md is sensitive to interest rates • a lot of research reaches same conclusion • sensitivity does not change over time

stability of Md • what does that mean? • relationship between Md, income, interest rates does not change over time • does Md function of 1930s still predict Md in 1950s?

up until mid 1970s, Md very stable • after 1974, Md becomes less stable (M1) • old relationships overpredicting Md • financial innovations changed behaviors • Md stability for M2 breaks down in 1990s

Chapter 22. Demand for Money