Money Demand. Standard specification: (M/P) = f(Y, r) M = Monetary aggregate P = Price level Y = income r = interest rate Why money demand? Why does.

MONETARY ECONOMICS

Money Demand

Money Demand Representation

Standard specification:(M/P) = f(Y, r)

M = Monetary aggregateP = Price levelY = incomer = interest rate

Why money demand?

Why does money demand depend on income and interest rate?

Are there any other determinant of money demand function?

Is money demand stable?

Why Money Demand?

Monetary policy affects policy objectives (output, employment and price level) through financial markets (particularly banks).

The channel is through shift in the interest rate, which has important bearings on interest-sensitive components of aggregate expenditure.

As such, policymakers need to gauge the level of money demand such that the level of money supply can be set. In this way, interest rate will not be too high or too low.

At the same time, other determinants of money demand need to be identified such that policymakers can counter any shift in money demand.

Stability of money demand is a pre-requisite for monetary aggregate targeting framework.

Theories of Money Demand

Quantity Theory of Money Cambridge approach to Money Demand Keynes’s Liquidity Preference Theory Baumol-Tobin Transactions Demand for

Money Friedman’s Restatement of the Quantity

Theory Tobin’s Portfolio Balance Model

Quantity Theory of Money

The foundation of the QTM is the equation of exchange

Equation of Exchange: MV = PY P = Price M = Quantity of money Y = Income V = Velocity Velocity is the average number of times per year

a Ringgit is spent. This is the early theory of price determination. Namely, Fisher views V to be constant and Y is

relatively constant in the short run, the quantity of money is the sole determinant of the price level.

Fisher’s QTM VS Cambridge

QUANTITY THEORY CAMBRIDGE MONEY DEMAND

From the QTM, we have M = (1/V)PY

Md = kPY The monetary holding is

determined by the amount of transactions (PY)

There is no room for the interest rate to affect money demand.

The institutional factor also affects Md through its effect on velocity

Similar simulation: Md = kPY However, the Cambridge theory

acknowledges the role of wealth in addition to transactions, both of which are proportional to nominal income (PY).

Money is a part of wealth. Thus, the store of value function is recognized.

Individuals decide to hold wealth in the form of money, proportional to nominal income.

k is allowed to fluctuate in conjunction with the decision of economic agents to hold other assets as well.

Accordingly, velocity can fluctuate.

Keynes’s Liquidity Preference

Motives for monetary holdings Transaction motive – a medium of

exchange to carry out transactions Precautionary motive – a cushion against

an unexpected event Speculative motive – a store of wealth

that allows individuals to reallocate wealth between money and bonds

(Md/P) = f (Y, r)

Friedman’s Restatement of the QTM

According to Friedman, money demand is influenced by the same factors as those influencing assets.

Yp is permanent income, which is the expected average long run income.

Implications: - interest rate will have only marginal impact on money demand - money demand is a stable function

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𝑃= 𝑓 (𝑌𝑝 ,𝑟 𝑏−𝑟𝑚 ,𝑟𝑒−𝑟𝑚 ,𝜋−𝑟𝑚)

Portfolio Balance Theory(Tobin)

Tobin’s portfolio balance theory considers MONEY and BONDS (non-money assets collectively termed bonds) as alternative assets in wealth portfolio.

Money is viewed to yield no return and it is risk free.

Meanwhile, bonds give positive returns and risky Individuals try to balance their portfolios

considering risk-return tradeoff such that satisfaction is maximum.

Thus, Tobin theory is based on mean-variance optimization.

Portfolio Balance Theory(Tobin)

Consider: - Money ~ (0, 0); (1 – B): share of money - Bonds ~ (µ, 2); B: share of bonds Portfolio mean: Portfolio risk: From portfolio mean and risk, we can

construct mean return – risk line faced by individuals:

That is: Individuals: performing mean-variance

optimization subject to the above line.

Portfolio Balance theoryGraphical representation

Money demand issues?

Is velocity stable? Is Money demand stable? Will interest-free “money” be stable? Why is there breakdown in the money

demand function? What is the role of recent financial

uncertainty on money demand? How does money demand interacts with

the money supply process?