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Chapter 22. Demand for MoneyQuantity Theory of Money Keynes & Liquidity Preference Friedman’s Modern Quantity Theory Friedman vs. Keynes Empirical Evidence
Monetary Theory link between MS and other economic variablesprice level output
I. Quantity Theory of Moneyclassical economists Irving Fisher relates quantity of money to nominal income
equation of exchange MV = PY where M = quantity of moneyP = price level Y = real output = real income V = velocity = # times money used to purchase output
2 assumptions V is constant in short-rundepends on institutions, technology that change slowly Y is at full employment level also constant in short-run
MV = PY if V, Y constant thenA change in M must cause an equal % change in P Quantity Theory of Money
money demand MV = PY M = (1/V)PY M = kPY let (1/V) = kMd = M in equilibrium Md = kPY Md is depends on income NOT interest rates
Is V constant? NO.
II. Liquidity PreferenceKeynes 1936 3 motives to holding money transactions motive precautionary motive speculative motive
transactions motive people hold money to buy stuff as income rises,Md rises
precautionary motive people hold money for emergencies car breakdownjob loss Md rises with income
speculative motive suppose store wealth as money or bondshigh interest rates bonds more attractive, hold less money Md negatively related to interest rate
real quantity of money M/Pif prices rise, must hold more money to buy same amount of stuff
money demand (M/P) depends on income interest rates M/P = f(i,Y)
Keynes & 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
Tobin & money demand further extended Keynes approachtransaction 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 theoryMilton 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 pe = expected inflation
rb - rm = relative return on bondspe = expected return on goods
increase in Yp will increase Mdincrease in relative returns of bonds, equity or money decrease Md
Friedman vs. Keynes Friedman: multiple rates of returnrelative returns money & goods are substitutes Yp more important than current income
stability of Md Friedman’s Md function is more stableYp more stable than current income spread between returns is more stable than returns -- interest rates have little impact on Md
IV. empirical evidence which Md function is right? Keynes or Friedmantest how does Md respond to i? how stable is Md?
Md is sensitive to interest ratesa lot of research reaches same conclusion sensitivity does not change over time
stability 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?
up until mid 1970s, Md very stableafter 1974, Md becomes less stable (M1) old relationships overpredicting Md financial innovations changed behaviors Md stability for M2 breaks down in 1990s
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