Chapter 12: Learning Objectives

1
Chapter 12Learning Objectives

• The Demand for Money The Micro View
• Cash Management An Inventory Approach
• Theories of Money Demand
• Quantity Theory
• Friedmans Approach
• Velocity of Circulation The Institutionalist
  Approach

2
The Microfundations of Money

• Money (M1) is held for transactions purposes and
  incurs an opportunity cost and potentially a loss
  of purchasing power (1/P)
• The demand for money is a demand for real
  balances (M/P)
• A simple model

mtd f(ct, Rt)
3
An Inventory Model of Cash ManagementThe
Baumol-Tobin Model

• Assume, initially, that income is paid at the
  beginning of the period
• Assume, initially, that consumption spending
  occurs at a constant rate throughout the period
• Figure 12.1 illustrates graphically
• Assume a constant opportunity cost of money and
  fixed transactions costs of obtaining money

4
Optimal Cash Management Inventory Approach
(A) Constant Expenditures Through
Monthly/bimonthly pay
2000
Md (income 2000)
1000
Md (income 1000)
500
1 1/2
1
1/2
5
Optimal Cash Management Inventory Approach
(b) Variable Expenditures through a Monthly pay
period
2
1
2000
1000
500
6
The Mathematics of the Inventory Model
Average Cash Holdings Md Y/2n
Opportunity cost of holding cash R(Y/2n)
Marginal cost of another trip to the bank b
Optimum money demand is solution to b (RY/2n2 )
Optimum money demand is Md P (b/2P).5 y.5 R-.5
7
The Quantity Theory of Money

• Is perhaps one of the oldest economic theories
  and links the price level to the quantity of
  money in circulation
• If velocity of money (V) and real income (y) are
  constant then changes in Ms lead to proportional
  changes in P

Ms V P y
8
Friedmans extension

• Money is but one of many assets in a portfolio,
  including human capital
• Various simplifications lead to a theory, not
  supported by empirical results, which links the
  demand for money to permanent income

9
Money Demand in Canada
Full Sample
Post World War II
10
Money Demand in Canada (contd)
Pre World War II
Post World War II
11
Velocity of Circulation in Canada the
Institutionalist Hypothesis
12
Summary

• The demand for money arises because of
  transactions in a monetary economy and is
  constrained by opportunity cost and transactions
  costs considerations
• Money can be viewed as being held in an inventory
• The quantity theory of money expresses the
  proportional relationship between the money
  supply and the price level
• understanding velocity can help us understand the
  role of financial innovations over time