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. It’s 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).

11. The Equation of Exchange • This makes sense because as people’s 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. Keynes’s 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. Keynes’s Liquidity Preference Theory • In Keynes’s theory there are two assets, money and bonds. • People’s 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. Keynes’s Liquidity Preference Theory • Keynes’s 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. Keynes’s 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. Keynes’s 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. Friedman’s 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. Friedman’s Alternative • Friedman’s 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) $

19. Friedman’s Alternative • The demand for real money balances: • Increases as Y* increases. • Decreases as i - imandpe - im (opportunity cost of holding money) increases. • The opposite is true for each case!

20. Keynes vs. Friedman • Keynes considered only short-run income, while Friedman considered permanent (lifetime) income. • Keynes’s 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.