Monetary Economics I

Lecture 4: Demand for Money

Undergraduate Program
Faculty of Economics and Business
Universitas Gadjah Mada

2021
Learning Objectives of Meeting 4

§ STUDENTS CAN DESCRIBE WHAT MONEY IS AND THE

KEY FUNCTIONS OF MONEY

§ STUDENTS CAN IDENTIFY DIFFERENT TYPES OF

PAYMENT SYSTEMS

§ STUDENTS CAN IDENTIFY THE FACTORS UNDERLYING

THE DEMAND FOR MONEY
Demand for Money

Basic Concept

Money and Payment System

Demand for Money

Definition

To economists, the word money has a different meaning than

income or wealth.
§ Money: anything that is generally accepted as payment for goods or
services or in the repayment (settlement) of debts.
§ Income: a flow of earnings per unit of time.
§ Wealth: the total collection of pieces of property that serve to store value.
Definition

To economists, the word money has a different meaning than

income or wealth.
§ Money: anything that is generally accepted as payment for goods or
services or in the repayment (settlement) of debts.
§ Income: a flow of earnings per unit of time.
§ Wealth: the total collection of pieces of property that serve to store value.
History of Money
§ Evidence suggests that people in China were using metallic coins in the
year 1000 B.C., and people in Greece were using them in 700 B.C.
§ For centuries thereafter, buyers and sellers used coins minted from
precious metals, such as gold, silver, and copper, as money.
§ An economy’s reliance on gold and silver coins alone makes for a
cumbersome payments system; people had difficulty transporting large
numbers of gold coins to settle transactions and ran the risk of being
robbed.
§ To get around this problem, beginning around the year A.D. 1500 in
Europe, governments and private firms—early banks—began to store
gold coins in safe places and issue paper certificates.
§ Anyone receiving a paper certificate could claim the equivalent amount
of gold. As long as people had confidence that the gold was available if
they demanded it, the paper certificates would circulate as a medium of
exchange. In effect, paper currency had been invented.
Do We Need Money?

§ In the discussions of supply and demand, production, competition,

and other microeconomic topics, money may not have been
mentioned.
§ But the fact that you can tell the basic story of how a market system
operates without mentioning money suggests that the services that
money provides to households and firms are not always obvious.
Barter System

The use of money helps

There are four main sources of inefficiency in a
facilitate trade since in the barter economy.
absence of money, trade has
1. A buyer or seller must spend time and effort
to proceed through barter.
searching for trading partners (i.e. the
transactions costs) and there must be a
Barter is a system of exchange double coincidence of wants.
in which individuals trade 2. Each good has many prices.
goods and services directly for 3. A lack of standardization.
other goods and services.
4. The difficulty of accumulating wealth.
Double Coincidence of Wants
A (1,3) A is endowed with one unit of
the goods 1 and
A wants to consume 3
§ Let individuals A, B, and C are
endowed with one unit of the goods
1, 3, and 2, respectively.
§ But A, B, and C want to consume 3,
2, and 1, respectively.
§ No direct exchange is possible
between two individuals each
wanting to consume the other’s
B (3,2) C (2,1) good.
§ There is a lack of double
B is endowed with one unit of
the goods 3 and
C is endowed with one unit of
the goods 2 and
coincidence of wants.
B wants to consume 2 C wants to consume 1
Double Coincidence of Wants
A (1,3) A is endowed with one unit of
the goods 1 and
A wants to consume 3
§ Let individuals A, B, and C are
endowed with one unit of the goods
1, 3, and 2, respectively.
2 § But A, B, and C want to consume 3,
2, and 1, respectively.
1
§ The problem can be solved by
indirect exchange where A
exchanges good 1 for good 2 with
C and then, in the next step, uses
B (3,2) C (2,1)
good 2 in an exchange for good 3
B is endowed with one unit of C is endowed with one unit of
with B.
Here good 2 serves as a medium of
the goods 3 and the goods 2 and
B wants to consume 2 C wants to consume 1 §
exchange.
Double Coincidence of Wants
A (1,3) A is endowed with one unit of
the goods 1 and
A wants to consume 3
§ Let individuals A, B, and C are
endowed with one unit of the goods
1, 3, and 2, respectively.
2 2 § But A, B, and C want to consume 3,
2, and 1, respectively.
3
§ The problem can be solved by
indirect exchange where A
exchanges good 1 for good 2 with
C and then, in the next step, uses
B (3,2) C (2,1)
good 2 in an exchange for good 3
B is endowed with one unit of C is endowed with one unit of
with B.
Here good 2 serves as a medium of
the goods 3 and the goods 2 and
B wants to consume 2 C wants to consume 1 §
exchange.
Double Coincidence of Wants
A (1,3) A is endowed with one unit of
the goods 1 and

Extending the example to a

A wants to consume 3
§
situation with n goods, we have
that exchange without money
2
2 (i.e., barter) requires:
1
3 ! !−1
2
§ Exchange with money, in the
B (3,2) C (2,1) form of modern paper money,
requires only n markets
B is endowed with one unit of C is endowed with one unit of
the goods 3 and the goods 2 and
B wants to consume 2 C wants to consume 1
Double Coincidence of Wants
A (1,3) A is endowed with one unit of
the goods 1 and

The reason that a market

A wants to consume 3
§
economy uses money is that
money facilitates trade
2
2 enormously, thereby reducing
3 1 transaction costs.
§ Money helps an economy to
avoid the need for a “double
B (3,2) C (2,1) coincidence of wants”.

B is endowed with one unit of C is endowed with one unit of

the goods 3 and the goods 2 and
B wants to consume 2 C wants to consume 1
Function of Money
Primary functions § It is widely agreed that the functions of
money can be divided into three layers
Medium of exchange (primary and secondary), where each layer
reflects the descending degree of direct
functionality but increasing degree of
Money

generality and transcendence that money

Unit of account plays.
§ The primary functions relate to it as a
medium of exchange and measure of
Store of value economic value.
§ The secondary functions reflect its store of
Secondary function value (and standard for payments).
Function of Money

Medium of exchange
Money as a medium of exchange helps an
economy avoid the problem of double
Money

coincidence of wants that arises in a barter

Unit of account economy, and thus lowers transaction costs
and encourages specialization and the division
of labor.
Store of value
Function of Money

An asset is suitable to use as a medium of

exchange if it is:
Medium of exchange
§ Acceptable
§ Standardized in terms of quality, so that any
Money

two units are identical

Unit of account § Durable, so that it does not quickly become
too worn out to be usable.
§ Valuable relative to its weight, so that
Store of value amounts large enough to be useful in trade
can be easily transported.
§ Divisible.
Function of Money

Medium of exchange
Money as a unit of account reduces
Money

the number of prices needed in an

Unit of account
economy, which also reduces
transaction costs.

Store of value
Function of Money

Medium of exchange
Money

Unit of account
Money also functions as a store of
value, it is a repository of purchasing
power available over time.
Store of value
Money offers liquidity, the relative ease
and speed with which an asset can be
converted into a medium of exchange.
Demand for Money

Basic Concept

Money and Payment System

Demand for Money

Payments System

We can obtain a better picture of the functions of money and the

forms it has taken over time by looking at the evolution of the
payments system, the method of conducting transactions in the
economy.
Payments System

Money facilitates transactions in the economy. The mechanism for

conducting such transactions is known as a payments system

Commodity Money
§ A good used as money that also has value independent of its use as money
§ Precious metals (principally gold and silver) have characteristics that may
make them naturally suited for the functions of money.

The problem with a payments system based exclusively on precious metals is

that such a form of money is very heavy and is hard to transport from one place
to another.
Payments System

Money facilitates transactions in the economy. The mechanism for

conducting such transactions is known as a payments system

Fiat Money
§ Fiat money is intrinsically worthless. It has no use other than as
money.
§ Fiat money is inconvertible. Fiat money does not carry with it a
promise to convert it into any good which is not intrinsically worthless.

Major drawbacks of paper currency and coins are that they are easily
stolen and can be expensive to transport in large amounts because of
their bulk.
Payments System

Money facilitates transactions in the economy. The mechanism for

conducting such transactions is known as a payments system

Check
An instruction from you to your bank to transfer money from your
account to someone else’s account when she deposits the check.
Two problems of using checks:
1. It takes time to get checks from one place to another, a particularly
serious problem if you are paying someone in a different location
who needs to be paid quickly.
2. The paper shuffling required to process checks is costly.
Payments System

Money facilitates transactions in the economy. The mechanism for

conducting such transactions is known as a payments system

Electronic Payment
Banks provide websites at which you just log
on, make a few clicks, and thereby transmit
your payment electronically
Payments System

Money facilitates transactions in the economy. The mechanism for

conducting such transactions is known as a payments system

E-money
Money that exists only in electronic form:
§ Debit card
§ Stored-value/smart card
§ E-cash
Cryptocurrencies

§ A cryptocurrency is: “a type of unregulated, digital money,

which is issued and usually controlled by its developers, and
used and accepted among the members of a specific virtual
community” (European Central Bank, 2012).
§ It makes use of cryptography to secure and verify
transactions as well as to control the creation of new units of
cryptocurrency (Franco, 2015).
§ A bitcoin is essentially an entry into a public ledger shared by
all the participants in a network.
Will Bitcoin Become the Money of
the Future?
In 2009, an anonymous programmer introduced Bitcoin, a cryptocurrency that is fully
decentralized and usable without the need for intermediaries.

Medium of exchange Bitcoin has two features that make it attractive

for conducting transactions:
BITCOIN

1. The fees for conducting transactions with

bitcoins are substantially lower than those
Unit of account associated with credit cards and debit cards.
2. Transactions made with bitcoins can be
made anonymously, which is very attractive
Store of value to those who want to preserve their privacy.
Will Bitcoin Become the Money of
the Future?
In 2009, an anonymous programmer introduced Bitcoin, a cryptocurrency that is fully
decentralized and usable without the need for intermediaries.

Medium of exchange
BITCOIN

The high volatility of the value of the bitcoin

Unit of account means that it does not function well as a
store of value; it is just too risky.

Store of value
Will Bitcoin Become the Money of
the Future?
In 2009, an anonymous programmer introduced Bitcoin, a cryptocurrency that is fully
decentralized and usable without the need for intermediaries.

Medium of exchange
BITCOIN

Unit of account
Because of this volatility, the Bitcoin has not
become a unit of account: Almost no one
Store of value quotes the prices of their products in terms
of bitcoins.
Will Bitcoin Become the Money of
the Future?
The price of Bitcoin has been extremely volatile (e.g. seven times that of the price of
gold, and over eight times that of stock market indexes).
Will Bitcoin Become the Money of
the Future?
Despite the hype, Bitcoin does not satisfy two
of the three key functions of money and thus its
use as money is likely to be quite limited.

Medium of exchange
BITCOIN

Unit of account

Store of value
Recent Issues on Cryptocurrencies

§ A new generation of cryptocurrencies – stablecoins – has caught the

attention of crypto market, becoming potential competition for central
bank money.
§ The ultimate wake-up call for monetary- and regulatory authorities was
the June 2019 announcement by Facebook that it would issue its own
stablecoin, Libra.
§ Libra belongs to the category “stablecoins,” which are crypto-assets that
have a stable value since they are backed by a basket of safe assets.
Future of Money

There have been four major developments in the last decade have
challenged and continue to challenge the status quo and have re-opened
the debate on the forms that money will take in the future:
§ The share of transactions in cash in developed countries has fallen
§ The emergence of distributed-ledger technology, or blockchain (i.e. a
decentralized, secure and unchangeable record of financial transactions)
has enabled the appearance of thousands of cryptocurrencies
§ Central banks are now contemplating the idea of creating central bank
digital currencies (CBDCs).
Future of Money
Issuer Form Transaction Example

Centralized N/A
Claeys et al (2018) proposed a
Physical
taxonomy for all forms of
Decentralized Coin, bank notes
money, traditional and recent
Gov
innovations, based on three
Centralized CBDC
criteria:
Digital
Decentralized Crypto-CBDC § Who the issuer is:
Money government or private;
Centralized N/A

Physical § What form it takes: physical

Decentralized
Commodity
Money
or digital; and
Private
§ How transactions are settled:
Centralized Bank Deposits
centralized or decentralized.
Digital
Decentralized Cryptocurrency
Demand for Money

Basic Concept

Money and Payment System

Demand for Money

Demand for Money

§ One of the central questions in the topic of money is the

stability of money demand function.
§ Money demand is the amount of money that people desire to
hold; individuals must decide how to allocate their wealth
between different kinds of assets, for example a house,
income-earning securities, a checking account, and cash.
Theories of the Demand for Money

SCHOOL OF THOUGHT APPROACHES

Fisher’s Equation of Exchange

Classical Quantity
Theory Cambridge Approach

Money demand Keynesian Theory Keynes Liquidity Preference

theories
The portfolio choice theory of money demand

Post-Keynes Inventory-theoretic Approach

Theories
Precautionary Demand for Money Approach
Asset Approach
Theories of the Demand for Money

SCHOOL OF THOUGHT APPROACHES

Fisher’s Equation of Exchange

Classical Quantity
Theory Cambridge Approach

Money demand Keynesian Theory Keynes Liquidity Preference

theories
The portfolio choice theory of money demand

Post-Keynes Inventory-theoretic Approach

Theories
Precautionary Demand for Money Approach
Asset Approach
Equation of Exchange

§ Fisher, based on his paper “the Purchasing Power of Money (1911)”,

wanted to examine the link between the total quantity of money and the
total amount of spending on final goods and services produced in the
economy.
§ The link is expressed in the following identity equation, called the
equation of exchange:
!" = $%
Money × (transcations) Velocity = Price × Transactions

“The more money people need for making transactions, the more money they hold”
Equation of Exchange

Knowing that in reality the number of transactions T is difficult to measure;

we replace it by the total output of the economy:
!" = $%
!" = $&
Equation of Exchange

Knowing that in reality the number of transactions T is difficult to measure;

we replace it by the total output of the economy:
!" = $%
!" = $&

To convert the equation of exchange (an identity) into a theory of how

nominal income is determined, we must first understand the factors that
determine velocity.
Demand for Money

Knowing that in reality the number of transactions T is difficult to measure;

we replace it by the total output of the economy:
!" = $%
$&
"=
!
§ If, for example, nominal GDP (P*Y) in a year is $10 trillion and the quantity of
money (M) is $2 trillion, we can calculate velocity as V = 5.
§ The value of 5 for velocity means that the average dollar bill is spent five times in
purchasing final goods and services in the economy.
Determinant of Velocity

Irving Fisher reasoned that (") velocity is determined by the institutions in

an economy that affect the way individuals conduct transactions:
§ If people use charge accounts and credit cards to conduct their transactions, and
consequently use money less often when making purchases, less money is required
to conduct the transactions generated by nominal income and velocity will increase
§ Conversely, if it is more convenient for purchases to be paid for with cash or checks
(both of which are money), more money is used to conduct the transactions
generated by the same level of nominal income, and velocity will fall.
Determinant of Velocity

Irving Fisher reasoned that (") velocity is determined by the institutions in

an economy that affect the way individuals conduct transactions.

Fisher took the view that the institutional and technological features of the
economy would affect velocity only slowly over time, so velocity would
normally be reasonably constant in the short run.
Demand for Money

Fisher’s quantity theory can also be interpreted in terms of the demand for
money, the quantity of money that people want to hold:
!" = $%
$%
!=
"
&
$%
When the money market is in
! =
equilibrium, money supply equals
money demand, so we can replace !
"
by !& .
Demand for Money

Fisher’s quantity theory can also be interpreted in terms of the demand for
money, the quantity of money that people want to hold:
!" = $%
$%
!=
"
&
$%
! = (
where ) = '
" ' is a constant that tells us how much money
Deriving demand for money !& = ' $% people want to hold for every dollar of income
Demand for Money

Fisher’s quantity theory can also be interpreted in terms of the demand for
money, the quantity of money that people want to hold:
!" = $%
$%
!=
"
&
$%
! =
" Fisher’s theory suggests that the demand for
Deriving demand for money !& = ' $% money is purely a function of income, and
interest rates have no effect on the demand for
money.
Theories of the Demand for Money

SCHOOL OF THOUGHT APPROACHES

Fisher’s Equation of Exchange

Classical Quantity
Theory Cambridge Approach

Money demand Keynesian Theory Keynes Liquidity Preference

theories
The portfolio choice theory of money demand

Post-Keynes Inventory-theoretic Approach

Theories
Precautionary Demand for Money Approach
Asset Approach
Is Velocity a Constant?

The classical economists" conclusion that nominal income is determined by

movements in the money supply rested on their belief that velocity could be
treated as reasonably constant.
Is Velocity a Constant?

Change in the Velocity of M1 and M2 in the US from Year to Year, 1915-2008

Even in the short run, velocity
fluctuates too much to be viewed as
a constant.
§ Prior to 1950, velocity exhibited
large swings up and down. This
may reflect the substantial
instability of the economy in this
period (e.g. world wars and the
Great Depression)
§ After 1950, velocity appears to
have more moderate fluctuations,
yet there are large differences in
the growth rate of velocity from
year to year.
Is Velocity a Constant?

§ Until the Great Depression, economists did not recognize that velocity
declines sharply during severe economic contractions.
§ Why did the classical economists not recognize this fact?
Is Velocity a Constant?

§ Until the Great Depression, economists did not recognize that velocity
declines sharply during severe economic contractions.
§ Why did the classical economists not recognize this fact?
Unfortunately, accurate data on GDP and the money supply did not exist before World
War II. Consequently, economists had no way of knowing that their view of velocity as a
constant was demonstrably false.
§ After the Great Depression, economists began to search for other factors
influencing the demand for money that might help explain the large
fluctuations in velocity.
Keynes’s Liquidity Preference Theory

§ John Maynard Keynes, based on his book “the General Theory of

Employment, Interest and Money (1936)”, abandoned the classical view
that velocity was a constant and developed a theory of money demand
that emphasized the importance of interest rates.
§ His theory of the demand for money, which he called the liquidity
preference theory, asked the question:
“Why do individuals hold money?”
Keynes’s Liquidity Preference Theory

He postulated that there are three motives behind the demand for money:

“Why do individuals hold money?”

The The
The speculative
transactions precautionary
motive
motive motive
Keynes’s Liquidity Preference Theory

He postulated that there are three motives behind the demand for money:

“Why do individuals hold money?”

The The
The speculative
transactions precautionary
motive
motive motive
§ Individuals are assumed to hold money because it
is a medium of exchange that can be used to carry
out everyday transactions.
§ Because these transactions were proportional to
income, transactions component of the demand for
money is proportional to income.
Keynes’s Liquidity Preference Theory

He postulated that there are three motives behind the demand for money:

“Why do individuals hold money?”

The The
The speculative
transactions precautionary
motive
motive motive
§ People hold money as a cushion against an unexpected need.
§ Keynes believed that the precautionary money balances people
want to hold are determined primarily by the level of transactions
that they expect to make in the future and that these transactions
are proportional to income.
§ Therefore, the demand for precautionary money balances is
proportional to income.
Keynes’s Liquidity Preference Theory

He postulated that there are three motives behind the demand for money:

“Why do individuals hold money?”

The The
The speculative
transactions precautionary
motive
motive motive
§ People choose to hold money as a store of wealth.
§ Keynes looked at other factors that influence the decisions
regarding how much money to hold as a store of wealth,
especially interest rates:
§ As the interest rate i rises, the opportunity cost of money
rises (it becomes more costly to hold money relative to
bonds), vice versa.
Keynes’s Liquidity Preference Theory

He postulated that there are three motives behind the demand for money:

“Why do individuals hold money?”

The The
The speculative
transactions precautionary
motive
motive motive

!" = $(&) !" = $(&) !" = $(()

Keynes’s Liquidity Preference Theory

In putting the three motives for holding money balances together into a
demand for money equation, Keynes define the demand for real money
balances:
!"
= %(', ))
#
− +

Demand for real money is related not only to income but also to interest rates.
Velocity is Not Constant

By deriving the liquidity preference function for velocity PY/M, we can see
that Keynes's theory of the demand for money implies that velocity is not
constant, but instead fluctuates with movements in interest rates:
! 1
# =
" &((, *)
!* *
Multiplying both sides of this equation by Y and
=
recognizing that "# can be replaced by M.
" &((, *)
* Keynesian theories of the demand for money indicate that
,= velocity undergoes substantial fluctuations as well.
&((, *)
Theories of the Demand for Money

SCHOOL OF THOUGHT APPROACHES

Fisher’s Equation of Exchange

Classical Quantity
Theory Cambridge Approach

Money demand Keynesian Theory Keynes Liquidity Preference

theories
The portfolio choice theory of money demand

Post-Keynes Inventory-theoretic Approach

Theories
Precautionary Demand for Money Approach
Asset Approach
Theory of Portfolio Choice &
Demand for Asset

§ Milton Friedman, based on his paper “The Quantity Theory of Money: A

Restatement, (1956)”, developed the theory of portfolio choice which was
related with the demand for an asset.
§ The theory of portfolio choice then indicates that the demand for the
money assets will rise and the demand for real money balances will be
higher.
Demand for Asset

Asset is a piece of property

ASSET
that is a store of value.

Financial market Non-financial

MONEY
products market products

§ Currency, coins § Bond § Land

§ Checkable deposits § Stock § Houses
§ Farm equipment, and manufacturing
machinery.
Demand for Asset

Asset is a piece of property

ASSET
that is a store of value.

Financial market Non-financial

MONEY
products market products

Wealth: the total Expected return: Risk: The degree of Liquidity: The
resources owned The return expected uncertainty ease and speed
by the individual over the next period associated with the with which an
on one asset return on one asset asset can be
turned into cash
Theory of Portfolio Choice

The theory of portfolio choice states that the demand for an asset is
positively related to wealth, the expected return on the asset relative to other
assets, and relative liquidity, whereas it is negatively related to its risk
relative to other assets.

!""#$ % = '()#*+$ℎ, #./#0$#1 2#$324, 25"6, +573515$8)

+ − − −
Summary: The Demand for Money
Portfolio theories of money demand indicate that the demand for money is determined not only by
interest rates, income, and payment technology, but also by wealth, riskiness of other assets, inflation
risk, and liquidity of other assets.
Final Remark

§ The demand for money is sensitive to interest rates, but little evidence
exists that it is or ever has been ultrasensitive (liquidity trap).
§ Since 1973, money demand has been found to be unstable, with the
most likely source of the instability being the rapid pace of financial
innovation.
§ Because the money demand function is found to be both unstable and
sensitive to interest rates, velocity cannot be viewed as constant and is
not easily predicted. These conclusions have led to a downgrading of the
focus on money supply and a greater emphasis on interest rates in the
conduct of monetary policy.
THANK YOU