1. 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

2. The Microfundations of Money
Money (M1 or 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:
mtd = f(ct, Rt)

3. 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

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

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

6. The Mathematics of the Inventory Model
Average Cash Holdings: Md = 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/2n2 )
Optimum money demand is: Md = P (b/2P).5 y.5 R-.5

7. 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 Ms lead to proportional changes in P
Ms V = P y

8. Md/P=f(RB,RE,π, Wh/Wn,y,u)
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
Md/P=f(RB,RE,π, Wh/Wn,y,u)
-, -, -, , + , ?

9. Money Demand in Canada: 1960-2004

10. Velocity of Circulation in Canada & the Institutionalist Hypothesis

11. 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