1. Overview of Chapter 19 The Demand for Money
We have learned a bit about the money supply, how it is determined, and what role the Federal Reserve (FED) plays in it.
Now we are going to learn the role of the money supply in determining the price level and total production of goods and services (aggregate output) in the economy.
The study of the effect of money on the economy is called monetary theory.

2. Overview of Chapter 19 The Demand for Money
When economists mention supply, the word demand is sure to follow.
The supply of money is an essential building block in understanding how monetary policy affects the economy.
Another essential part of monetary theory is the demand for money – the focus of this chapter.

3. VOCABULARY and NEW TERMS
Aggregrate = total
Monetary theory = study of effect of money
Velocity of Money = the average amount of time the dollar is spent for goods in a year
Quantity theory of money
Liquidity Preference Theory
Transactions Motive
Precautionary Motive
Speculative Motive

4. VOCABULARY and NEW TERMS
Proportional = a part of, or a percentage of
Fluctuate = goes up and down
Incentives = a reward
Expansionary = growing, expanding
Liquidity trap
Ultrasensitive = super sensitive

5. Overview of the Money Supply Process
Money supply is influenced by 4 players
Federal Reserve
Depositors
Banks
Borrowers

6. The Key Players in the Money Supply Process
Federal Reserve influences the money supply by controlling the required reserve ratio
Depositors influence the money supply process through:
Decisions about the currency ratio

7. The Key Players in the Money Supply Process
Banks influence the money supply process through:
Their decisions about the excess reserve ratio
Some of which is affected by their expected deposit outflows
Expected deposit outflows is affected also by individuals (depositors)

8. Interest Rates and the Money Supply Process
Market interest rates influence the money supply process through:
The excess reserve ratio

9. MONETARY THEORY Monetary Theory
The study of the effect of money on the economy
Talking about how the theories of the demand for money have evolved
Central question in monetary theory is does it have an effect on interest rates?
If it does, then how much of an effect will it have?

10. Quantity Theory of Money
Developed late 19th century early 20th century
Quantity Theory of Money is a theory of how the nominal (does not include inflation)value of aggregate (total) income is determined
This theory actually suggests that the interest rate has no effect on the demand for money

11. Velocity of Money
American economist Irving Fisher wanted to examine the relationship between money supply (M) and the total amount of spending on goods and services produced in the economy (P x Y) (nominal GDP-which does not include inflation).
The concept that provides the link between M and (P x Y) is called velocity of money

12. Velocity of Money Velocity of Money
The average number of times per year (turnover) that a dollar is spent in buying the total amount of goods and services produced in the economy
Rate at which money is exchanged from one transaction to another
Rate at which money in circulation is used for purchasing goods and services.
This helps investors gauge how robust the economy is

13. Velocity of Money
If nominal GDP (P x Y) in a year is $5 trillion and the quantity of money (money supply) is $1 trillion
The velocity is 5 – meaning that the average dollar bill is spent five times in purchasing final goods

14. Equation of Exchange Multiply both sides of the equation by M
Now have the equation of exchange
Equation of Exchange
Relates nominal income (GDP) to the quantity of money and velocity

15. Equation of Exchange
States that the number of times that this money is spent in a given year must equal the total amount spent on goods and services in that year (GDP – output)

16. Equation of Exchange
Fisher took the view that institutional and technological features of the economy would affect the velocity of money
But only slowly over time
It is reasonable to assume that velocity would be reasonably constant in the short-run

17. Quantity Theory
Fisher’s view that velocity is fairly constant in the short run transforms the equation of exchange into Quantity Theory of Money
Quantity Theory of Money
Nominal income is determined only by movements in the quantity of money

18. M changes to $2 trillion – then GDP doubles to $10 trillion
Quantity Theory
To see how this works, assume the V = 5, GDP = $5 trillion, and M = $1 trillion
M changes to $2 trillion – then GDP doubles to $10 trillion

19. Quantity Theory
Back in the old days, it was thought that wages and prices were flexible
The believed that the level of aggregate output (Y) (goods and services) produced in the economy during normal times would remain at the full-employment level
So Y in the equation of exchange could also remain constant

20. Quantity Theory
Quantity theory of money then implies that if the money supply (M) doubles, P (prices) must also double

21. Quantity Theory
It provides an explanation of movements in the price level:
Movements in the price level result solely from changes in the quantity of money

22. Quantity Theory of Money Demand
Because the quantity theory of money tells us how much money is held for a given amount of GDP (aggregate income)
It is a theory of the demand for money
See this by dividing both sides of the equation by V to solve for M

23. Quantity Theory of Money Demand
When the money market is in equilibrium, the quantity of money M that people hold equals the quantity of money demanded
M = Md
Remember V is constant, so 1 / V is constant
Represented by k

24. Quantity Theory of Money Demand

25. Keynes’s Liquidity Preference Theory
John Maynard Keynes realized that velocity was not a constant and developed a theory of money demanded that focuses on the importance of interest rates
Theory of demand for money is called liquidity preference theory
Asks the question, “why do people hold money?

26. Keynes’s Liquidity Preference Theory
He said there were 3 motives behind the demand for money:
Transactions motive
Precautionary motive
Speculative motive

27. Transactions Motive Hold money to carry out everyday transactions
The amount of transactions we make on a daily basis is determined by our level of income
Proportional

28. Precautionary Motive
People hold money as a cushion against an unexpected need
Precautionary money balances people want to hold are determined primarily by the level of transactions that they expect to make in the future
Those transactions are proportional to income
He is assuming that the demand for precautionary money balances is proportional to income

29. Speculative Motive People also hold money as a store of wealth
Called this reason speculative motive
Our amount of wealth is closely tied with income, therefore, this component of money demand is also related to income
Not just income that affects why hold money as a store of wealth

30. Speculative Motive
Interest rates would also have an affect on the amount of money we hold in wealth
Store wealth in assets. Keynes will assume that there are only 2 categories:
Money and Bonds
Assumes that individuals believe that interest rates will move toward some normal value

31. Speculative Motive
If interest rates are below this normal level, then individuals will expect them to rise
As interest rates rise, the price of bonds will decrease and they will suffer a capital loss
Individuals are more likely to hold their wealth as money rather than bonds
Money demand is negatively related to the level of interest rates

32. Putting All 3 Together
Keynes distinguishes between real quantities and nominal quantities
Money is valued in terms of what it can buy
For example, all prices in the economy double, the same nominal quantity of money will be able to buy only half as many goods
Keynes assumed that people want to hold a certain amount of real money balances
Quantity of money in real terms

33. Putting All 3 Together
The demand for real money balances is a function (related to) interest rates and real income

34. Putting All 3 Together
Keynes conclusion that the demand for money is related not only to income but also to interest rates is a major departure from Fisher’s view of money demand, in which interest rates have no effect on the demand for money

35. Putting All 3 Together
Once we take into account all of Keynes’s motives, velocity is not constant, but depends on interest rates and on one’s level of income
When interest rates rise, it will encourage people to hold lower real money balances
Rate at which money will turn over will rise
Velocity will rise
As interest rates fluctuate, so will the velocity of money

36. Putting All 3 Together
Interest rates are pro-cyclical, meaning that they rise in expansions and fall during recessions
Interest rates rise in expansions, velocity of money rises in expansions
Movements in interest rates can cause instability in the velocity of money because higher interest rates also mean capital losses on bonds, more people will want to hold money (speculative motive)
Demand for money will increase, and velocity will fall

37. Friedman’s Modern Quantity Theory of Money
Milton Friedman – 1956
Pursued the question of why people chose money
Keynes analyzed specific motives, Friedman will simply state that the demand for money must be influenced by the same factors that influence the demand for any asset

38. Friedman’s Modern Quantity Theory of Money
Applies the theory of asset demand to money
Theory of asset demand indicates that the demand for money is a function of their wealth and the expected returns on other assets relative to the expected return on money
Also recognized that people want to hold real money balances

39. Friedman’s Modern Quantity Theory of Money
= demand for real money balances
= measure of wealth (permanent income)
= expected return on money
= expected return on bonds
= expected return on equity (common stocks)
= expected inflation rate

40. Friedman’s Modern Quantity Theory of Money
= measure of wealth (permanent income)
The demand for any asset is positively related to wealth
Wealth and the demand for money have a positive relationship

41. Friedman’s Modern Quantity Theory of Money
Friedman says that an individual can hold wealth in other forms besides money: bonds, equity, and goods
Incentives for holding these assets rather than money are represented by the expected return on each relative to the expected return on money

42. Friedman’s Modern Quantity Theory of Money
= expected return on money
Influenced by:
Services provided by banks – the more services, the expected return increases
Interest payments from holding deposits – the more interest is paid, the expected return increases

43. Friedman’s Modern Quantity Theory of Money
=expected return on bonds
= expected return on equity (common stocks)
Represent the expected return on bonds and equity relative to money – as they rise the expected return for money falls, demand for money falls

44. Friedman’s Modern Quantity Theory of Money
= expected inflation rate
That represents the expected return on goods relative to money
If expected inflation is 10%, that means the price of goods increases by 10% and expected return is 10%
When the above part rises, expected return on goods relative to money rises and demand for money falls

45. Distinguishing b/w Friedman and Keynesian
Friedman did not take the expected return on money to be constant
It fluctuates with interest rates
Interest rates will rise in an expansion
During expansionary times, banks are making more loans and they need to attract deposits to support those loans
Attract deposits by offering higher interest rates

46. Distinguishing b/w Friedman and Keynesian
The expected return on money held as deposits increases with higher interest rates
Higher interest rates on loans will also cause higher interest rates on bonds
Therefore, will remain relatively constant

47. Distinguishing b/w Friedman and Keynesian
Friedman’s demand for money is essentially one where wealth is primary determinant of money demand
Any rise in the expected return of an asset: bonds, equity, goods would be matched by a rise in the expected return of money
For Friedman, velocity is relatively constant
Highly predictable

48. Distinguishing b/w Friedman and Keynesian
Since Friedman believes that changes in interest rates have little effect on the expected return on other assets relative to money –
The demand for money is insensitive to interest rates
Demand for money is relatively stable since it does not shift with interest rates

49. VELOCITY & QUANTITY OF MONEY
Since velocity is relatively predictable and mostly a function of wealth, a change in quantity of money will produce a predictable change in aggregate spending
Because the quantity theory of money tells us how much money is held for a given amount of GDP (aggregate income)
It is a theory of the demand for money
Fisher’s quantity theory of money suggests that the demand for money is purely a function of income

50. Evidence on the Demand for Money
Which theory is an accurate description of the real world?
2 primary issues that distinguish the different theories of money demand:
Interest rates
Stability

51. Interest Rates and Money Demand
If interest rates do not affect the demand for money, velocity is more likely to be constant (Fisher + Friedman theory)
Aggregate spending is determined by the quantity of money is more likely to be true
However, (2nd situation) The more sensitive the demand for money is to interest rates, the more unpredictable velocity will be
Less clear the link will be between money supply and aggregate spending

52. Interest Rates and Money Demand
The more sensitive demand for money is to interest rates
Unpredictable and the link between the two is unclear – a change in money supply has no effect on the change in interest rates
If that link is unclear then it is hard to direct and implement monetary policy to achieve a goal
Because monetary policy will have no effect on spending, because a change in monetary supply has no change in interest rates

53. Interest Rates and Money Demand
When this happens – the economy will fall into what is called the liquidity trap
If demand for money is ultrasensitive to interest rates, then a small change in interest rates will produce a large change in money supply.

54. Stability of Money Demand
If money demand is unstable and undergoes substantial shifts, then velocity will be unstable and unpredictable
And the money supply may not be linked to aggregate spending
When conducting monetary policy, should the Fed target interest rates or money supply
Is money demand stable? It has implications of how monetary policy should be conducted

55. Summary Chapter 19 Demand for Money
1. Irving Fisher developed a transactions-based theory of the demand for money in which the demand for real balances is proportional (related) to real income and not to interest rate movements. This theory says that velocity, the rate at which money turns over, is constant or remains the same. Aggregate, or total spending is determined by movements in the quantity of money.

56. Summary Chapter 19 Demand for Money
2. John Maynard Keynes suggested 3 motives for holding money, the transactions motive, the precautionary motive, and the speculative motive. His liquidity preference theory views the transactions and precautionary motives of money demand as proportional to income. However, the speculative motive of money demand is sensitive to interest rates. This theory states that velocity is unstable (goes up and down) and cannot be treated as a constant.

57. Summary Chapter 19 Demand for Money
3. Milton Friedman’s theory of the demand for money treats money like any other asset. The demand for money is a function of the expected returns on other assets relative to the expected return on money and permanent income. Different from Keynes, Friedman believes the demand for money is stable and does not change because of interest rate movements and money is the primary determinant of aggregate spending

58. Summary Chapter 19 Demand for Money
4. There are 2 main conclusions from the research on the demand for money. The demand for money IS sensitive to interest rates. Since 1973, money demand has found to be unstable (it is always changing), with the most likely source of the instability being the rapid pace of financial innovation

59. Chapter 19 Study Questions
1. Suppose the money supply (M) has been growing at 10% per year, and nominal GDP (PY) has been growing at 20% per year. The data is as follows: M PY 1,000 1,200 1,440 Calculate the velocity in each year. At what rate is velocity growing? 2. Calculate what happens to nominal GDP if velocity remains constant at 5 and the money supply increases from $200 billion to $300 billion. 3. What happens to nominal GDP if the money supply grows by 20% but velocity declines by 30%

60. Chapter 19 Study Questions
4. (5.)If velocity and aggregate output are constant what happens to the price level when the money supply increases from $1 trillion to $4 trillion? 5. (6.) If velocity and aggregate output remain constant at 5 and 1,000, what happens to the price level if the money supply declines from $400 billion to $300 billion