Chapter 22. Demand for MoneyChapter 22. Demand for MoneyChapter 22. Demand for MoneyChapter 22. Demand for Money

• Quantity Theory of Money

• Keynes & Liquidity Preference

• Friedman’s Modern Quantity Theory

• Friedman vs. Keynes

• Empirical Evidence

• Quantity Theory of Money

• Keynes & Liquidity Preference

• Friedman’s Modern Quantity Theory

• Friedman vs. Keynes

• Empirical Evidence

Monetary TheoryMonetary TheoryMonetary TheoryMonetary Theory

• link between MS and other economic variables• price level• output

• link between MS and other economic variables• price level• output

I. Quantity Theory of MoneyI. Quantity Theory of MoneyI. Quantity Theory of MoneyI. Quantity Theory of Money

• classical economists• Irving Fisher

• relates quantity of money to nominal income

• classical economists• Irving Fisher

• relates quantity of money to nominal income

equation of exchangeequation of exchangeequation of exchangeequation of exchange

• MV = PY

• where• M = quantity of money• P = price level• Y = real output = real income• V = velocity

= # times money used to purchase output

• MV = PY

• where• M = quantity of money• P = price level• Y = real output = real income• V = velocity

= # times money used to purchase output

2 assumptions2 assumptions2 assumptions2 assumptions

• V is constant in short-run• depends on institutions,

technology that change slowly

• Y is at full employment level• also constant in short-run

• V is constant in short-run• depends on institutions,

technology that change slowly

• Y is at full employment level• also constant in short-run

MV = PYMV = PYMV = PYMV = PY

• if V, Y constant then

A change in M must cause an equal % change in P• Quantity Theory of Money

• if V, Y constant then

A change in M must cause an equal % change in P• Quantity Theory of Money

money demandmoney demandmoney demandmoney demand

• MV = PY

• M = (1/V)PY

• M = kPY let (1/V) = k

• Md = M in equilibrium• Md = kPY• Md is depends on income NOT

interest rates

• MV = PY

• M = (1/V)PY

• M = kPY let (1/V) = k

• Md = M in equilibrium• Md = kPY• Md is depends on income NOT

interest rates

Is V constant?Is V constant?Is V constant?Is V constant? NO.NO.

II. Liquidity PreferenceII. Liquidity PreferenceII. Liquidity PreferenceII. Liquidity Preference

• Keynes 1936

• 3 motives to holding money• transactions motive• precautionary motive• speculative motive

• Keynes 1936

• 3 motives to holding money• transactions motive• precautionary motive• speculative motive

transactions motivetransactions motivetransactions motivetransactions motive

• people hold money to buy stuff• as income rises,• Md rises

• people hold money to buy stuff• as income rises,• Md rises

precautionary motiveprecautionary motiveprecautionary motiveprecautionary motive

• people hold money for emergencies• car breakdown• job loss

• Md rises with income

• people hold money for emergencies• car breakdown• job loss

• Md rises with income

speculative motivespeculative motivespeculative motivespeculative motive

• suppose store wealth as money or bonds

• high interest rates• bonds more attractive, hold less

money

• Md negatively related to interest rate

• suppose store wealth as money or bonds

• high interest rates• bonds more attractive, hold less

money

• Md negatively related to interest rate

real quantity of moneyreal quantity of moneyreal quantity of moneyreal quantity of money

• M/P

• if prices rise, must hold more money to buy same amount of stuff

• M/P

• if prices rise, must hold more money to buy same amount of stuff

money demand (M/P)money demand (M/P)money demand (M/P)money demand (M/P)

• depends on• income• interest rates

M/P = f(i,Y)

• depends on• income• interest rates

M/P = f(i,Y)

Keynes & velocityKeynes & velocityKeynes & velocityKeynes & velocity

• MV = PY• M/P = Y/V

• M/P = f(i,Y)

• Y/V = f(i,Y)

• V = Y/f(i,Y)• velocity fluctuates with the interest rate

-- both are procyclical

• MV = PY• M/P = Y/V

• M/P = f(i,Y)

• Y/V = f(i,Y)

• V = Y/f(i,Y)• velocity fluctuates with the interest rate

-- both are procyclical

Tobin & money demandTobin & money demandTobin & money demandTobin & money demand

• further extended Keynes approach• transaction demand negatively

related to the interest rate• people hold money even when is

has a lower return, b/c it is less risky

• further extended Keynes approach• transaction demand negatively

related to the interest rate• people hold money even when is

has a lower return, b/c it is less risky

III. Friedman’s modern quantity III. Friedman’s modern quantity theorytheoryIII. Friedman’s modern quantity III. Friedman’s modern quantity theorytheory

• Milton Friedman• Md as asset demand

-- wealth

-- return relative to other assets

• Milton Friedman• Md as asset demand

-- wealth

-- return relative to other assets

• Yp = permanent income

• rb = expected bond return

• rm = expected money return

• re = expected equity return

e = expected inflation

• Yp = permanent income

• rb = expected bond return

• rm = expected money return

• re = expected equity return

e = expected inflation

• rb - rm = relative return on bonds

e = expected return on goods

• rb - rm = relative return on bonds

e = expected return on goods

• increase in Yp will increase Md

• increase in relative returns of bonds, equity or money• decrease Md

• increase in Yp will increase Md

• increase in relative returns of bonds, equity or money• decrease Md

Friedman vs. KeynesFriedman vs. KeynesFriedman vs. KeynesFriedman vs. Keynes

• Friedman:• multiple rates of return• relative returns• money & goods are substitutes• Yp more important than current

income

• Friedman:• multiple rates of return• relative returns• money & goods are substitutes• Yp more important than current

income

stability of Mdstability of Mdstability of Mdstability of Md

• Friedman’s Md function is more stable• Yp more stable than current income• spread between returns is more

stable than returns

-- interest rates have little impact on Md

• Friedman’s Md function is more stable• Yp more stable than current income• spread between returns is more

stable than returns

-- interest rates have little impact on Md

IV. empirical evidenceIV. empirical evidenceIV. empirical evidenceIV. empirical evidence

• which Md function is right?• Keynes or Friedman

• test• how does Md respond to i?• how stable is Md?

• which Md function is right?• Keynes or Friedman

• test• how does Md respond to i?• how stable is Md?

Md is sensitive to interest ratesMd is sensitive to interest ratesMd is sensitive to interest ratesMd is sensitive to interest rates

• a lot of research reaches same conclusion

• sensitivity does not change over time

• a lot of research reaches same conclusion

• sensitivity does not change over time

stability of Mdstability of Mdstability of Mdstability of Md

• what does that mean?• relationship between Md, income,

interest rates does not change over time• does Md function of 1930s still

predict Md in 1950s?

• what does that mean?• relationship between Md, income,

interest rates does not change over time• does Md function of 1930s still

predict Md in 1950s?

• up until mid 1970s, Md very stable

• after 1974, Md becomes less stable (M1)• old relationships overpredicting Md• financial innovations changed

behaviors

• Md stability for M2 breaks down in 1990s

• up until mid 1970s, Md very stable

• after 1974, Md becomes less stable (M1)• old relationships overpredicting Md• financial innovations changed

behaviors

• Md stability for M2 breaks down in 1990s