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**Chapter 22. Demand for Money**

Quantity Theory of Money Keynes & Liquidity Preference Friedman’s Modern Quantity Theory Friedman vs. Keynes Empirical Evidence

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**Monetary Theory link between MS and other economic variables**

price level output

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**I. Quantity Theory of Money**

classical economists Irving Fisher relates quantity of money to nominal income

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**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

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**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

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**MV = PY if V, Y constant then**

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

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**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

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Is V constant? NO.

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**II. Liquidity Preference**

Keynes 1936 3 motives to holding money transactions motive precautionary motive speculative motive

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

Md rises

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**precautionary motive people hold money for emergencies car breakdown**

job loss Md rises with income

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**speculative motive suppose store wealth as money or bonds**

high interest rates bonds more attractive, hold less money Md negatively related to interest rate

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**real quantity of money M/P**

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

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

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**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

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**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

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**III. Friedman’s modern quantity theory**

Milton Friedman Md as asset demand -- wealth -- return relative to other assets

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

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**rb - rm = relative return on bonds**

pe = expected return on goods

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**increase in Yp will increase Md**

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

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**Friedman vs. Keynes Friedman: multiple rates of return**

relative returns money & goods are substitutes Yp more important than current income

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**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

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**IV. empirical evidence which Md function is right? Keynes or Friedman**

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

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**Md is sensitive to interest rates**

a lot of research reaches same conclusion sensitivity does not change over time

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**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?

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**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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