ECON3005 (EC30M ) MONETARY
ECONOMICS
UNIT 2: THE DEMAND FOR MONEY
Mishkin – Chapter 19
Money Demand
Theories of money demand include:
Fisher’s Quantity Theory of Money
Keynes’s Liquidity Preference Theory
Baumol-Tobin Model
This theory, developed by the classical economists over 100 years ago, related the amount of money in the economy to nominal income. Economist Irving Fisher is given credit for the development of this theory.
Fisher’s Quantity Theory
Fisher’s Quantity Theory of
Money
Based on the idea that people demand
money for making transactions and have no
freedom about how much they want to hold.
Examines how income impact money
demand
Suggests interest rates have no effect on
money demand
Velocity of Money
M= the money supply P =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´Y M
Equation of Exchange M ´V = P ´Y
Velocity of Money
Velocity of money is determined by institutions
that affect how individuals conduct transactions.
If people use charge accounts and credit cards to
conduct transactions M would fall and velocity would increase (and vice versa)
Velocity of money is the rate of turnover of
money.
i.e. Average number of times per year that a dollar is
spent in buying the total amount of goods and services produced in the economy.
Fisher’s Quantity Theory of
Money
Fisher assumed that the velocity of money is
fairly constant in the short run.
M x V = P x Y
Therefore, nominal income is determined
solely by movements in the quantity of money
Quantity Theory of Money: M = (1/V )PY
Md = k * PY
M/P= kY
Fisher’s Quantity Theory of
Money
Demand for money determined by:
the level of transactions generated by
nominal income PY
the institutions in the economy that affect
the way people conduct transactions and thus determine velocity
Fisher’s Quantity Theory of
Money
Is Velocity really constant?
V = PY / M
Money substitutes
The existence of money substitutes will alter the
demand for money and velocity
Interest rate
as interest rates increase, money balance will fall
and velocity increases
Portfolio decisions
Money is an asset so velocity changes over time in
response to portfolio allocation decisions
In 1936, economist John M. Keynes wrote a very
famous and influential book, The General Theory of Employment, Interest Rates, and Money. In this book he developed his theory of money demand, known as the liquidity preference theory.
Keynes’ Liquidity
Preference Theory
Keynes’s Liquidity Preference
Theory
Keynes’ theory examined three
reasons for holding money:
Transactions Motive
Determined by level of transactions
(proportional to income)
Precautionary Motive
Dependent on transactions to be made in
the future (proportional to income)
Keynes’s Liquidity Preference
Theory
Speculative Motive
Individuals hold money as a store of wealth
Individuals make choice between holding
money and holding bonds
Speculative motive of money demand
dependent on the level of income and the interest rates
Keynes’s Liquidity Preference
Theory
Combining motives:
Demand for real money balance is
related to income and interest rate.
Liquidity Preference Function:
M/P
=
f
(
Y
,
i)
Keynes’s Theory and Money
Velocity
Md
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
Rewriting
P Md =
1
f(i,Y)
Multiply both sides by Y and replacing Md with M
V = PY
M = Y f(i,Y)
Keynes’s theory implies that velocity is not constant but fluctuates with movements in interest rates
Keynes economic theories became very influential and other economists further refined his motives for
holding money. Tobin (and another economist Baumol) both developed theories on how the transactions
demand for money is also related to the interest rate.
Baumol-Tobin Model
Baumol-Tobin Model
Extension of Keynes’ model
Showed that money balances held for
transactions are also sensitive to interest
rate
Examined a hypothetical individual who
receives a payment once a period and
spends it on transactions that occur at a
constant rate throughout the period
Baumol-Tobin Model
Basic Set-up
Y = Total income = total spending
r = real interest rate on savings account
n = number of “trips” consumer makes to the
bank
to withdraw/transfer money from savings account.
k = cost of a trip to the bank
M = Average money holdings for the period
Baumol-Tobin Model
In general
Average Money Holdings, M = Y/2n Number of “Trips,” n = Y/2M
Deriving Baumol-Tobin
Money Demand Function
The Cost of Holding Money
There are two components to the cost of
holding money
Brokerage cost (cost of making the
withdrawals, which comprises bank charges, transportation cost, time, etc.)
Interest cost (opportunity cost)
Deriving Baumol-Tobin
Money Demand Function
Total cost = Interest Cost + Brokerage Cost
Interest Cost (Foregone interest) = r ´ M
Brokerage Cost of n trips to the bank = k ´ (Y/2M)
Thus,
The higher M is the fewer withdrawals so
the lower the brokerage cost but the higher the interest cost.
Deriving Baumol-Tobin
Money Demand Function
Given
Y
, r, and k, the consumer chooses
M to minimize total cost.
The cost-minimizing value of M:
Baumol-Tobin money demand depends
positively on
Y
and
k
,
and negatively on
r
.
21
r
kY
M
2
Milton Friedman (another Nobel Prize winner) developed a model for money demand based on the general theory of asset demand. Money demand, like the demand for any other asset, should be a function of wealth and the returns of other assets relative to money
Friedman’s Quantity
Theory
Friedman’s Quantity Theory of
Money
Friedman’s explanation of money demand relies
on the determinants of asset demand
Focuses on three type of assets other than
money:
Bonds
Equity (stocks) Goods
Compare the expected return on each asset to the
expected return on money
Friedman’s Quantity Theory of
Money
The demand for money depends on resources
available to individuals (Y) and expected return on assets relative to the return on money
The expected return on money is influenced by:
Services provided by banks
Interest payments on money balances
24
m
e m
e m b
p
r
r
r
r
r
Y
f
P
M
=
,
,
Friedman’s Quantity Theory
of Money
As interest rates rise it affects all assets in the
same way
So, rb – rm does stay constant
Therefore, interest rates have little effect on the
demand for money
Permanent income is the primary determinant
Conclusion:
M/P = f(Yp)
V = PY/M = Y/f(Yp)
Similarities and
Differences
Fisher Vs Keynes
Quantity Theory of Money:
Based on transactions motive for holding
money
M
= (1/
V
)P
Y
M
d= k * PY
Liquidity Preference Function:
Based on speculative and transactions motive
M/P
=
f
(
Y
,
i)
Fisher Vs Keynes
Fisher: M = (1/V )PY
Interest rate has no effect on money demand only
income
Velocity is constant
Determined by institutions that affect how individuals
conduct transactions
Keynes: M/P = f(Y, i)
Money demand dependent on income and interest rate
Velocity is not constant
fluctuates with movement in the interest rates
Baumol-Tobin
Based on speculative and transactions motive
Highlights that both speculative and transactions motive for holding money depends on the interest rate
Baumol-Tobin money demand depends
positively on
Y
and
k
,
and negatively
on
r.
r
kY
M
2
*
=
Keynes Vs Friedman
Friedman
Includes alternative assets to money (bond,
equity and goods)
Viewed money and alternative assets as substitutes 30
m
e m
e m b
p
r
r
r
r
r
Y
f
P
M
=
,
,
,
-Keynes Vs Friedman
The expected return on money is not zero as Keynes
believed
Determined by services provided by banks and interest
payments on balances (though minimal)
As interest rates rise it affects all assets in the same
way
So, rb – rm does stay constant
Therefore, interest rates have little effect on the demand for
money
Permanent income is the primary determinant
Keynes Vs Friedman
Friedman believed that the demand for money is
stable
Any change in interest rates will change expected returns on all assets including money
Stable money demand and the use of Yp implies
that velocity is predictable
Friedman makes the same conclusion as the
quantity theory that money is the primary determinant of aggregate spending
