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,
_
V
1
PY
implies
M
S
PY
4.2 The Quantity Theory of Money:
Additional Assumption: Y is fairly constant
ECN 303, L14, Money Demand Theories, 4
This assumption is based on the classical theory belief that
flexible wages & prices would allow output (Y) to always be
at or near its full employment level.
If both V & Y are constant, then the price level is strictly
determined by M
S
M
S
=
,
_
V
Y
P
implies
M
S
P
In the classical Q Theory of Money, P is fully determined by
M
s
with the result that a 50% increase in Money will lead to a
50& in prices.
5. Money Demand in the Quantity Theory
Given money market equilibrium:
M
D
= M
S
, then M
D
=
,
_
V
1
PY
The implication of this money demand statement is that the interest
rate plays no role in determining the amount of money people wish
to hold.
Money demand in the Classical Q Theory follows from its
mathematical statement using the equation of exchange and there is
no need or attempt to identify the factors that determine the
demand for money.
III. The Cambridge Equation & the Debate of Money Demand
1. The Cambridge Equation
At Cambridge, England, Alfred Marshall and Arthur Cecil (A.C.)
Pigou identified two motives (reasons) for holding money:
1) as a medium of exchange
The amount of money held as a medium of exchange is a
function of nominal income (PY)
2) as a store of wealth
The amount of money held as a store of wealth is also a
function of nominal income (PY)
ECN 303, L14, Money Demand Theories, 5
This lead to the demand for money being expressed by the Cambridge
Equation:
M
D
= kPY
k = the constant of proportionality or the constant
proportion of nominal income that people hold as money.
The Cambridge equation indicates that money demand is proportional
to nominal income.
If you consider that k can be written as 1/V & that both k & V are
treated as constant, the Cambridge equation & the classical money
demand function appear to be identical.
However, a major difference, in addition to analyzing the motives
behind money demand, is in the role that the interest rate plays in
money demand.
Although the interest rate does not appear in the Cambridge
equation, interest rate changes could cause short-run fluctuations
in k.
2. The Debate Over Velocity
Even though the Cambridge equation looks like Quantity Theory (k =
1/V), it is significantly different.
The Cambridge equation marks the beginning of an ongoing debate
about the behavior of V.
2.1 The classical economists (& monetarists) on velocity:
1) V is constant or stable
2) V is independent of i
2.2 The Cambridge economists (& Keynesians) on velocity:
1) V is unstable
2) V is affected by i
2.3 The empirical evidence on velocity:
1) Classical economists had no data to observe the actual
behavior of V.
2) When data became available after the Great Depression,
economists realized velocity far from constant.
Go to Handout
ECN 303, L14, Money Demand Theories, 6
IV. Keynes Liquidity Preference Theory
1. The Three Motives Behind the Demand for Money
Since Keynes was at Cambridge, his theory is built in the Cambridge
tradition by starting with motives behind (reasons for) the demand
for money:
1) Transactions Motive
Holding money to carry out planned or expected transactions.
,
_
income
real
consumption
,
_
ns transactio
planned more
out carry to
money more hold
Money demand is a positive function of real income (Y) not
nominal income (PY)
2) Precautionary Motive
Holding money to carry out unplanned or unexpected
transactions.
,
_
income
real
consumption
,
_
,
_
assets all
for demand
'
D
D
B
M
However, as a store of wealth, money can be used to carry out
transactions but does not earn any income.
In order to explain why people would store some of their
wealth in the form of money, Keynes developed the following
argument:
ECN 303, L14, Money Demand Theories, 7
Suppose there is some normal interest rate (i
N
) & some normal
price of bonds (
N
B
P ). P
B
= the actual price of bonds.
If i>i
N
then P
B
<
N
B
P :
,
_
B
P
ect exp
people
,
_
gain
capital
ect exp
,
_
money with
bonds buy
If i<i
N
then P
B
>
N
B
P :
,
_
B
P
ect exp
people
,
_
loss
capital
ect exp
,
_
money hold
&
bonds sell
The conclusion of this argument is that interest rates & money
demand are negatively related.
As interest rates rise, people will be prompted to convert
their money holdings into bond holdings.
,
_
high is
when i
,
_
,
_
low is
when i
,
_
i)
where:
D
P
M
= real money demand
ECN 303, L14, Money Demand Theories, 8
Keynesian money demand is also referred to as:
the demand for liquidity
the liquidity preference function
the demand for real money balances.
3. Velocity & Keynesian money demand
Substituting the Keynesian money demand equation into the
definition of Velocity shows that velocity is not constant but
fluctuates with interest rates. In equilibrium:
) i , Y ( f
Y
P
M
Y
P
M
Y
M
Y P
V
D S S
The implication is that any increase in interest rates will cause
an increase in velocity:
i f(Y,i) V
This occurs because at the higher i, people will want to hold less
money and the smaller money supply will have to turn over faster.
Connecting this to the bond market:
i P
B
B
D
& M
D
V. Later work on Keynesian M
D
1. Problems with the Speculative Demand For Money
There were problems with basing the relationship between money
demand & interest rates on Keynes speculative demand:
1) The implication of the speculative demand argument is
that people will either hold all bonds or all money with
no diversification. This was a serious short-coming.
2) The very existence of the speculative demand is
questionable
These problems prompted later efforts to explain money demand as a
function of interest rates without relying on the questionable
speculative demand.
ECN 303, L14, Money Demand Theories, 9
2. The Baumol-Tobin Model of the Transactions Demand for Money
William Baumol & James Tobin, independently developed models of
money demand in which the transactions demand for money is
sensitive to the interest rate.
People have an incentive to economize on transaction money balances
when interest rates rise, thus:
i
,
_
money holding to
due income lost
M
D
Similar models of precautionary demand produced a similar tradeoff
between additional income versus convenience of precautionary
balances
3. The Tobin Model of the Speculative Demand for Money
A second Tobin model introduced risk and assumed that people want
high returns but are risk averse.
If bonds have risk, even at high interest rates people will always
hold some money.
A problem with the second Tobin model, in addition to the fact that
the speculative demand may not exist:
There are assets that have virtually no risk (T-bills, money
market mutual funds) but have a higher return than money.
The only advantage of money is transactions costs and even that is
virtually zero for MMMFs.
VI. The Monetarist Approach To Money Demand
1. Milton Friedman's Money Demand Function
Friedman uses the theory of asset demand and his concept of
permanent income to make money demand a function of wealth and the
relative return of other assets
[ ] ) r (p ) r (r r r f
P
M
m
e
m e m b p
D
Y , ), ( ,
where: Y
P
= permanent income
r
b
-r
m
= the difference between the return on bonds &
the return on money
ECN 303, L14, Money Demand Theories, 10
r
e
-r
m
= the difference between the return on equity
& the return on money
p
e
-r
m
= the difference between the expected
inflation rate & the return on money
1) Permanent income
People base their demand for money on their expectations of
their permanent income. People demand more money as their
permanent income grows:
(Y
P
) M
D
Since permanent income is constant or grows at a stable
predictable rate, Y
P
should have little or no short-run effect
on M
D
.
Current income (Y) which fluctuates over the short-run
business cycle, is not a factor in Friedmans money demand
function.
2) The difference between the returns on bonds & money
(r
b
-r
m
) M
D
3) The difference between the return on equities & money
(r
e
-r
m
) M
D
4) The difference between the expected inflation rate & the
return on money
(p
e
-r
m
) M
D
An increase in the expected inflation rate prompts people to convert their
cash into inflation safe real assets (real estate, gold, commodities)
2. Characteristics of Friedmans Money Demand that differ from
Keynesian Money Demand (6)
1) People hold other assets besides money & bonds, namely
equities & real goods
2) The return on money (r
m
) is not constant
r
b
&/or r
e
r
m
as banks offer:
a. more services for checking account owners
b. higher interest on interest earning checkable
accounts
ECN 303, L14, Money Demand Theories, 11
3) Given 2), interest rates have little effect on M
D
,
_
,
_
D
implying m e m b
M on effect
little has
constant remain
) r r ( & ) r r (
i
4) Given 3) & the fact that Y
P
is stable over the business cycle
(as opposed to Y)
both )
-
( f
i
Y
P
M
D
,
+
&is
) f(Y
Y
V
P
are stable
5) If Y fluctuates around Y
P
, the relationship between Y & Y
P
is
predictable. Combining this with 4) implies that V is
predictable. This leads to the Q Theory of money view that
changes in M
s
lead to predictable changes in nominal income,
PY
6) Holding (buying) real goods as an alternative to other assets,
especially money, implies that the quantity of money has a
direct effect on spending (aggregate demand).
M
S
M
S
> M
D
spending AD
VII. The Modern Quantity Theory Of Money
>>>Mentioned in Chapter 24<<<
1. Problems with the Classical Quantity Theory of Money
1) Velocity is not constant
2) Real GDP (Y) is not constant at Y
F
but exhibits short-run
fluctuations around Y
F
, the business cycle.
2. The Modern quantity theory of Money
However, empirical evidence does indicate a strong correlation
between the money supply & inflation.
This strong correlation resulted in the quantity theory being
resurrected in the Modern Quantity Theory of Money
Assumptions of the Modern Q Theory
1) V is stable & therefore predictable
2) Y can vary in the short-run, however, in the long run Y
gravitates to its full-employment level (Y
F
)
ECN 303, L14, Money Demand Theories, 12
Given that PY
V
1
M
S
,
_
implies M
S
P
VIII. Empirical Evidence on Money Demand
1. Interest Sensitivity of Money Demand
M
D
is sensitive to the interest rate, but there is no evidence that
there has ever been a liquidity trap.
2. Stability of Money Demand
1) (M1)
D
stable till 1973, after 1973 it became unstable
2) 1974-82:
a. (M1)
D
function over predicted the demand for M1, i.e.
(M1)
D
grew more slowly than predicted.
b. over predicting (M1)
D
means that velocity was under
predicted, i.e. velocity rose faster than predicted.
c. This situation was dubbed the "Case of the Missing Money."
3) After 1982, a velocity slowed down but this was under predicted
by (M1)
D
4) When (M1)
D
became unstable, attention shifted to (M2)
D
which
remained more stable in 1980s. However, (M2)
D
became unstable
in 1990s.
5) The broad consensus is that the most likely source of
instability in money demand is the rapid pace of financial
innovation occurring after 1973. Financial innovation creates
new types of money that are not included in the money supply
definitions