The Demand for Money

1
The Demand for Money

• Unit 3

2
Why do people hold money?

• People tend to carry some money around with them
  for the purpose of making purchases more
  convenient. We call this the transactions motive.
• At other times, people hold more or less cash
  than usual, depending on their expectations about
  the economy. We call this the speculative motive.

3
Money Demand

• When we analyze money demand, we must have some
  way of representing the money balances that
  people hold for transaction purposes.
• The term we will use is real money balances.

4
Money Demand

• The purchasing power of money changes over time.
  Its true that a 10 bill buys 10 worth of goods
  today, but that same 10 would have bought more
  in the past it will also likely buy less in the
  future.
• The purchasing power of a given amount of money
  changes as the price level in the economy changes.

5
Real Money Balances

• Because we recognize that the value of money
  depends on how much it will buy at the current
  price level, we must include a term for the price
  level in our analysis.
• Real Money Balances
• Money supply/Price level or M/P

6
The Velocity of Money

• We also recognize that a given stock of money
  (the actual, physical bills and coins) changes
  hands many times over a given period.
• Irving Fisher (Yale) developed a model of money
  demand which includes a term for velocity, which
  is intended to represent the number of times a
  dollar is spent in the economy in a year.

7
The Velocity of Money

• Velocity is defined as
• V PY/M
• Where
• V Velocity
• P Price level
• Y Output (Income)
• M Money supply

8
A side note Factors affecting velocity.

• Velocity can be affected in three ways By
  changes in payment system factors, changes in
  interest rates, and changes in portfolio
  allocation.
• Payments system factors -- substitutes for cash,
  such as credit or debit cards, influence velocity.

9
The Velocity of Money and the Equation of
Exchange

• Remember V PY/M
• If we multiply both sides of the equation by M,
  we get
• MV PY
• We call this the equation of exchange.

10
The Equation of Exchange

• The equation of exchange serves as the basis for
  the quantity theory of money.
• Note -- We can rearrange MV PY to get
• M/P (1/V)Y
• This equation says that real money balances
  depends on Y (income).

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The Equation of Exchange

• This makes sense because as peoples real incomes
  rise they tend to spend more, so will demand more
  money for transaction purposes.
• The same holds true if we aggregate individuals
  into the entire nation.
• Essentially, the quantity theory of money says
  that money demand is driven by transactions!

12
Keyness Liquidity Preference Theory

• In contrast to Fisher, Keynes argued that money
  demand is not determined by a transactions
  motive, but rather a speculative motive.
• His liquidity preference theory links money
  demand to interest rates (rather than income, as
  Fisher did).

13
Keyness Liquidity Preference Theory

• In Keyness theory there are two assets, money
  and bonds.
• Peoples desire to hold one or the other depends
  on their expectations about future interest
  rates.
• If people expect that rates will rise, they know
  that bond prices will fall, so they will lose
  money if they invest in them. Instead, they will
  hold cash.

14
Keyness Liquidity Preference Theory

• Keyness called this motive for holding cash the
  speculative motive.
• He also recognized the transactions motive as
  outlined by Fisher, et al.
• However, he added the precautionary motive in
  which people hold cash to pay for unexpected
  transactions.

15
Keyness Liquidity Preference Theory

• Remember that Fisher posited that money demand
  was a function of income. In contrast, Keynes
  argued that money demand is a function of income
  and interest rates.
• Specifically,
• M/P L(Y,i)
• Where L liquidity preference

16
Keyness Liquidity Preference Theory

• M/P L(Y,i)
• Demand for real money balances (M/P) increases as
  income increases, so M/P and Y are positively
  related.
• A higher interest rate raises the opportunity
  cost of holding money and decreases money demand,
  so M/P is negatively related to i.

17
Friedmans Alternative

• Milton Friedman argued that
• Money holdings were determined by income, but not
  just the income from one period. Instead, people
  based their money demand on their permanent
  income, or average income over a lifetime.
• The demand for money is dependent on not only its
  value as an asset (vs. other financial assets),
  but also its expected return vs. inflation.

18
Friedmans Alternative

• Friedmans Model is as follows
• M/P L(Y, i - im , pe - im)
• Where
• Y Permanent Income
• i - im E(R) financial assets - E(R)
• pe - im Expected inflation - E(R)

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Friedmans Alternative

• The demand for real money balances
• Increases as Y increases.
• Decreases as i - im and pe - im (opportunity cost
  of holding money) increases.
• The opposite is true for each case!

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Keynes vs. Friedman

• Keynes considered only short-run income, while
  Friedman considered permanent (lifetime) income.
• Keyness portfolio only included money and other
  financial assets. Friedman included money,
  financial assets and durable goods, and thus
  inflation.
• Keynes viewed the rate of return on money as
  zero Friedman did not.

21
General Model for Households

• We will adopt a model for money demand which
  includes components of other models.
• Specifically
• M/P L(Y, S, i - im)
• Where
• Y Income
• S Payments system factors
• i - im E(R) financial assets - E(R)

22
Summary

• In this unit, we have explained various theories
  about individuals demand for money.
• In the next unit (4) we will combine this
  understanding with a look at business and
  government demand for funds as we study the
  Loanable Funds Theory of interest rate
  determination.