Chapter 12: Learning Objectives  The Demand for Money: The Micro View  Cash Management: An Inventory Approach  Theories of Money Demand: Quantity Theory Friedman’s Approach  Velocity of Circulation: The Institutionalist Approach

The Microfundations of Money  Money (M1) is held for transactions purposes and incurs an opportunity cost and potentially a loss of purchasing power (1/P)  The demand for money is a demand for “real balances” (M/P)  A simple model: m t d = f(c t, R t )

An Inventory Model of Cash Management: The Baumol-Tobin Model  Assume, initially, that income is paid at the beginning of the period  Assume, initially, that consumption spending occurs at a constant rate throughout the period Figure 12.1 illustrates graphically  Assume a constant opportunity cost of money and fixed transactions costs of obtaining money

Optimal Cash Management: Inventory Approach (A) Constant Expenditures Through Monthly/bimonthly pay 1/2 11 1/2 $500 $1000 $2000 M d (income = $2000) M d (income = $1000)

Optimal Cash Management: Inventory Approach (b) Variable Expenditures through a Monthly pay period 1 2 $500 $1000 $2000

The Mathematics of the Inventory Model Average Cash Holdings: M d = Y/2n Opportunity cost of holding cash: R(Y/2n) Marginal cost of another trip to the bank: b Optimum money demand is solution to: b =(RY/2n 2 ) Optimum money demand is: M d = P (b/2P).5 y.5 R -.5

The Quantity Theory of Money  Is perhaps one of the oldest economic theories and links the price level to the quantity of money in circulation  If velocity of money (V) and real income (y) are constant then changes in M s lead to proportional changes in P M s V = P y

Friedman’s extension  Money is but one of many assets in a portfolio, including “human” capital  Various simplifications lead to a theory, not supported by empirical results, which links the demand for money to permanent income

Money Demand in Canada Full Sample Post World War II

Money Demand in Canada (cont’d) Pre World War IIPost World War II

Velocity of Circulation in Canada & the Institutionalist Hypothesis

Summary  The demand for money arises because of transactions in a monetary economy and is constrained by opportunity cost and transactions costs considerations  Money can be viewed as being held in an inventory  The quantity theory of money expresses the proportional relationship between the money supply and the price level  understanding velocity can help us understand the role of financial innovations over time