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Chapter 22. Demand for Money

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1 Chapter 22. Demand for Money
Quantity Theory of Money Keynes & Liquidity Preference Friedman’s Modern Quantity Theory Friedman vs. Keynes Empirical Evidence

2 Monetary Theory link between MS and other economic variables
price level output

3 I. Quantity Theory of Money
classical economists Irving Fisher relates quantity of money to nominal income

4 equation 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

5 2 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

6 MV = PY if V, Y constant then
A change in M must cause an equal % change in P Quantity Theory of Money

7 money 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

8 Is V constant? NO.

9 II. Liquidity Preference
Keynes 1936 3 motives to holding money transactions motive precautionary motive speculative motive

10 transactions motive people hold money to buy stuff as income rises,
Md rises

11 precautionary motive people hold money for emergencies car breakdown
job loss Md rises with income

12 speculative motive suppose store wealth as money or bonds
high interest rates bonds more attractive, hold less money Md negatively related to interest rate

13 real quantity of money M/P
if prices rise, must hold more money to buy same amount of stuff

14 money demand (M/P) depends on income interest rates M/P = f(i,Y)

15 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

16 Tobin & 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

17 III. Friedman’s modern quantity theory
Milton Friedman Md as asset demand -- wealth -- return relative to other assets

18 Yp = permanent income rb = expected bond return rm = expected money return re = expected equity return pe = expected inflation

19 rb - rm = relative return on bonds
pe = expected return on goods

20 increase in Yp will increase Md
increase in relative returns of bonds, equity or money decrease Md

21 Friedman vs. Keynes Friedman: multiple rates of return
relative returns money & goods are substitutes Yp more important than current income

22 stability 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

23 IV. empirical evidence which Md function is right? Keynes or Friedman
test how does Md respond to i? how stable is Md?

24 Md is sensitive to interest rates
a lot of research reaches same conclusion sensitivity does not change over time

25 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?

26 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

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