(8) Theory of Money Demand

Chapter 20

Theory of Money Demand

© 2013 Pearson Education, Inc. All rights reserved. 20-2

Quantity Theory of Money

M = the money supplyP = price level

Y = aggregate output (income)P Y aggregate nominal income (nominal GDP)

V = velocity of money (average number of times per year that a dollar is spent)

V P YM

Equation of ExchangeM V P Y

•Velocity of Money and The Equation of Exchange


Quantity Theory of Money (cont’d)

• 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



• Demand for money: To interpret Fisher’s quantity theory in terms of the demand for money…

Divide both sides by V

When the money market is in equilibriumM = Md

Let

Because k is constant, the level of transactions generated by a fixed level of PY determines the quantity of Md.

The demand for money is not affected by interest rates

PYV

M 1

Vk 1

PYkM d



• From the equation of exchange to the quantity theory of money– Fisher’s view that velocity is fairly constant in the

short run, so that , transforms the equation of exchange into the quantity theory of money, which states that nominal income (spending) is determined solely by movements in the quantity of money M

P Y M V


Quantity Theory and the Price Level

• Because the classical economists (including Fisher) thought that wages and prices were completely flexible, they believed that the level of aggregate output Y produced in the economy during normal times would remain at the full-employment level – Dividing both sides by , we can then write the

price level as follows:

M VPY

Y


Quantity Theory and Inflation

• If M doubles, P must also double in the short run, because V and Y are constant.

• Movements in the price level result solely from changes in the quantity of money.


Figure 2 Annual U.S. Inflation and Money Growth Rates, 1965–2010

Sources: FRED, Federal Reserve Economic Data, Federal Reserve Bank of St. Louis; Bureau of Labor Statistics, http://research.stlouisfed.org/fred2/categories/25; accessed September 30, 2010.


Keynesian Theories of Money Demand

• Keynes’s Liquidity Preference Theory• Why do individuals hold money? Three

Motives– Transactions motive– Precautionary motive– Speculative motive

• Distinguishes between real and nominal quantities of money


Transactions Motive

• Keynes initially accepted the quantity theory view that the transactions component is proportional to income

• Later, he and other economists recognized that new methods for payment, referred to as payment technology, could also affect the demand for money


Precautionary Motive

• Keynes also recognized that people hold money as a cushion against unexpected wants

• Keynes argued that the precautionary money balances people want to hold would also be proportional to income


Speculative Motive

• Keynes also believed people choose to hold money as a store of wealth, which he called the speculative motive.

• If interest rates are too low, people expects interest rates on bonds to rise in the future, and so expect to suffer capital losses.

• People will hold more money than bonds – demand for money will be high.


Speculative motive (cont.)

• If interest rates are too high, people expects interest rates to fall, bond price to rise, and capital gains to be realised.

• They will hold more bonds than money, and demand for money will be low.


Putting the Three Motives Together

M d

P f (i,Y ) where the demand for real money balances is

negatively related to the interest rate i, and positively related to real income Y

RewritingP

M d

1f (i,Y )

Multiply both sides by Y and replacing M d with M

V PYM

Y

f (i,Y )


Putting the Three Motives Together (cont’d)

• Velocity is not constant:– The movement of interest rates should induce

movements in velocity.– Velocity will change as expectations about future

normal levels of interest rates change


Friedman’s Modern Quantity Theory of Money

• Instead of analyzing the specific motives for holding money, as Keynes did, Friedman simply stated that the demand for money must be influenced by the same factors that influence the demand for any asset. Friedman then applied the theory of asset demand to money.

• The theory of asset demand indicates that the demand for money should be a function of the resources available to individuals (their wealth) and the expected returns on other assets relative to the expected return on money.



• Friedman expressed his formulation of the demand for money as follows:

+ - - -

• Md/P= f (Yp , rb - rm, re - rm, πe - rm)• where Md/P = demand for real money balances• Yp = Friedman’s measure of wealth, known as

permanent income • Rm = expected return on money• rb = expected return on bonds• re = expected return on equity (common stocks)• Π e = expected inflation rate



• Money demand is positively related to Friedman’s wealth concept, permanent income, which has much smaller short-run fluctuations.

• Friedman categorized other assets into three: bonds, equity, and goods.

• The incentives for holding these assets rather than money are represented by the expected return on each of these assets relative to the expected return on money. As each relative return rises, the demand for money will fall


Keynes vs. Friedman

• Friedman recognized more than one interest rate in his demand for money function, Keynes, lumped financial assets other than money into one bonds because he felt that their returns generally move together.

• Friedman viewed money and goods as substitutes; that is, people choose between them when deciding how much money to hold.

• Friedman did not take the expected return on money to be a constant, as Keynes did.


Keynes vs. Friedman

• Unlike Keynes’s theory, which indicates that interest rates are an important determinant of the demand for money, Friedman’s theory suggests that changes in interest rates should have little effect on the demand for money, such that his money demand equation can be approximated by:

Md/p = f(Yp)• Friedman stressed the stability of the demand for

money function and suggested that random fluctuations in the demand for money are small and that the demand for money can be predicted accurately by the money demand function.


Keynes vs. Friedman

• Velocity is highly predictable. We can see this by writing down the velocity that is implied by the money demand equation:

V = Y/f (Yp )• If the velocity is predictable, a change in the

quantity of money will produce a predictable change in aggregate spending. Therefore, Friedman’s theory of money demand is indeed a restatement of the quantity theory, because it leads to the same conclusion about the importance of money to aggregate spending.

(8) Theory of Money Demand

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