MONETARY ECONOMICS

CHAPTER 4
THE DEMAND FOR
MONEY
1
 Introduction
• 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.
• This chapter describes how the theories of the demand for money have evolved.
• Important feature that differentiates money from other assets are
◄Unlike bonds, money does not yield interest to its possessors.
◄Unlike equities, it does not promise dividends.
◄ It also does not yield services which make real assets such as land, house, machine,
etc.
• People nevertheless hold money, Why do people demand money?
• Different schools forward different explanations

2
Quantity Theory of Money
• The demand for money primarily depended up on the level of aggregate
transactions.
• It tells us how much money is held for a given amount of income.
 How much money would you need to purchase the economy’s annual output of
goods and services?
• The quantity theory of money is a theory of how the nominal value of
aggregate income is determined.
• Because it also tells us how much money is held for a given amount of
aggregate income, it is a theory of the demand for money.

3
 Quantity…
– Suppose GDP (P*Y) was $14 trillion
– Would you need a money supply of $14 trillion to buy all this output over the course
of a year?
– No! Each dollar is used multiple times.
• You would need considerably less M than P*Y
• Fisher examined the link between the total quantity of money M (the money supply) and
the total amount of spending (P × Y), (aggregate nominal income or nominal GDP.)
• The concept that provides the link between M and (P×Y) is called the velocity of money.
• i.e. the average number of times per year that a dollar is spent in buying the total
amount of goods and services produced in the economy.
• Velocity (V) is defined as total spending (P×Y) divided by the quantity of money M:

4
 Quantity…
• e.g., if nominal GDP (P×Y) = $5 billion and M = $1 billion, velocity is 5.
• i.e., the average dollar is spent five times in purchasing final goods and services in the
economy.
• By multiplying both sides by M, we obtain the equation of exchange, which relates
nominal income to M and V (called the equation of exchange):

• The equation of exchange states that the quantity of money multiplied by its velocity must
be equal to nominal income.
• Fisher reasoned that velocity is determined by the institutions in an economy that affect
the way individuals conduct transactions.
• If people use less cash to pay for their purchases V increases.
• 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.
5
Quantity…
• Because V is constant in the short run, the equation of exchange states that nominal
income is determined solely by movements in M.
• When M doubles, M×V doubles and so must P×Y,
• Classical economists: wages and prices were completely flexible, the level of aggregate
output Y produced in the economy during normal times would remain at the full-
employment level, so Y in the equation of exchange could also be treated as reasonably
constant in the short run.
• For the classical economists, movements in the price level result solely from changes in
the quantity of money.
• A change in M must cause an equal % change in P.
• Because the quantity theory of money tells us how much money is held for a given
amount of aggregate income, it is in fact a theory of the demand for money.

6
Quantity…
• dividing both sides of the equation of exchange by V, thus rewriting it as:

• Using k to represent the quantity 1/V (a constant, because V is a constant) and

• Given equilibrium condition:
• we can rewrite the equation as:

☻This Equation tells us that because k is a constant:

1. The level of transactions generated by a fixed level of nominal income PY
determines the quantity of money Md that people demand.
2. By the institutions in the economy that affect the way people conduct
transactions and thus determine velocity and hence k.

7
Quantity…
3. Therefore, Fisher’s quantity theory of money suggests that the
demand for money is purely a function of income, and
interest rates have no effect on the demand for money.
4. Stability of demand function according to this school, there is
little scope for variation in the amount of money demanded
relative to the volume of transaction being conducted as both
the velocity of money and national output are assumed to be
constant.
• Thus, if money demand shows a constant elasticity to change in
nominal income, stability in demand function would be true.
8
The Cambridge approaches
• According to this school: there are two properties of money motivate
people to hold money:
1. its utility as a medium of exchange………….For transaction.
2. its service as a store of wealth (value)
• Both the transaction demand for money and store of wealth demand for
money are proportional to nominal income.
• Thus, expressed the demand for money function as:
• Md = KPY, were k is constant

9
Keynes’s Liquidity Preference Theory
• In the liquidity preference theory, Keynes asked the question:
• Why do individuals hold money?
• He postulated that there are three motives behind the demand for
money:
I. The transactions motive
II. The precautionary motive
III.The speculative motive

10
I. Transactions Motive
• Money is used as a medium of exchange
• People keep money for purpose of making daily transaction i.e.
– to purchase different goods and services daily
• Primarily determined by the level of people’s transactions which
is proportional to income, like the classical economists.
• He took the transactions component of the demand for money to
be proportional to income.

11
II. Precautionary Motive
• People will keep money on hand just in case some unforeseen
emergency arises e.g., shop sales, an unexpected bill, say for car
repair or hospitalization.
• Keynes believed that the amount of precautionary money
balances people want to hold is determined primarily by the
level of transactions that they expect to make in the future.
• Thus these transactions are proportional to income.

12
III. Speculative Motive
• Keynes took the view that money is a store of wealth and called this reason for
holding money the speculative motive.
• Keynes looked more carefully at the factors that influence the decisions regarding
how much money to hold as a store of wealth, especially interest rates.
• Keynes divided the assets that can be used to store wealth into two categories: money
and bonds.
• People would want to hold money if its expected return it was greater than the
expected return from holding bonds.
• Keynes assumed that the expected return on money was zero because in his time,
unlike today, most checkable deposits did not earn interest.
• For bonds, there are two components of the expected return:
– the interest payment
– the expected rate of capital gains

13
 Speculative…
• Price of bonds are linked with rate of interest and is negative related with one
another.
• This is because when interest rates rise, investors can get a better rate of return
elsewhere, so the price of original bonds adjust downward to yield at the current rate.
• Keynes assumed that individuals believe that interest rates gravitate to some normal
value (an assumption less plausible in today’s world).
• If interest rates are below this normal value, individuals expect the interest rate on
bonds to rise in the future, bond prices to fall, and so expect to suffer capital losses on
them.
• As a result, individuals will be more likely to hold their wealth as money rather than
bonds.
• Thus, the demand for money will be high.

14
 Speculative…
• when interest rates are above the normal value, people will expect interest rates to fall,
bond prices to rise, and capital gains to be realized.
• At higher interest rates, they are more likely to expect the return from holding a bond to
be positive.
• Thus, exceeding the expected return from holding money.
• They will be more likely to hold bonds than money, and the demand for money will be
quite low.
• i.e. If market rate of interest is low, bond price in market is high and at high bond price
people will not purchase bond, and people will keep more money in their pocket for
purpose of speculation and vice versa
• Conclusion:
• As interest rates rise, the demand for money falls, and therefore money demand is
negatively related to the level of interest rates.
15
Speculative
• In the speculative demand for money curve, there is a minimum critical
rate of interest at which it is assumed by every one to have fallen in to
their minimum level.
• At this point (r*) every investor expects interest rate to rise – they will
all hold their entire asset in the form of money. This situation is called
liquidity trap.
• At this point the speculative demand for money would be perfectly
elastic and at this point money is a perfect substitute of bonds and further
decline in interest rate impossible through the action of the authorities.

16
Speculative

17
Putting the Three Motives Together

• If prices rise, must hold more money to buy same amount of stuff
• The demand for real money balances is related to real income Y
and to interest rates i

– The demand for real money balances is negatively related to

the interest rate i, positively related to real income Y.

18
 Velocity in Liquidity Preference Theory
• is Velocity constant?
– Keynes’s theory of the demand for money implies that velocity is not constant,
but instead fluctuates with movements in interest rates.
• Proof
this can be written as P/Md=1/f (i, Y)
• Multiplying both sides of this equation by Y and Assuming money market
equilibrium , we solve for velocity:
• when i goes up, f (i,Y) declines, and V rises
• A rise in interest rates encourages people to hold lower real money balances for a
given level of income; therefore V must be higher.

19
Generally
• Practically Four Influences on the Demand for Money
• Four generalizations:
1. As interest rates rise, people tend to hold less money.
2. As the rate of inflation rises, people tend to hold more
money
3. As the level of income rises, people tend to hold more
money
4. As credit availability increases, people tend to hold less
money
20
Further Developments in the Keynesian Approach
• A key focus of research after World War II, was to understand better the
role of interest rates in the demand for money.
• Transaction Demand:
• The conclusion of the Baumol-Tobin analysis:
• As interest rates increase, the amount of cash held for transactions
purposes will decline, which in turn means that velocity will increase as
interest rates increase.
• Put in another way, the transactions component of the demand for
money is negatively related to the level of interest rates, i.e.,the
transactions demand for money will be sensitive to interest rates

21
 Further…
• Precautionary Demand:
• As interest rates rise, the opportunity cost of holding
precautionary balances rises, and so the holdings of these money
balances fall.
• We then have a result similar to the one found for the Baumol-
Tobin analysis.
• The precautionary demand for money is negatively related to
interest rates.

22
 Further…
• Speculative Demand:
• Unless having same return, no diversified portifolio. Unrealistic and thus a serious
shortcoming.
• Tobin’s idea:
• people cares both on expected returns and risks when they decide what to hold in their
portfolio
• Accordingly, people are risk-averse.
• Return on money is certain (assumed zero) while the return on bonds fluctuates(-, 0, +)
so risky.
• The Tobin analysis also shows that people can reduce the total amount of risk in a
portfolio by diversifying; that is, by holding both bonds and money.
• This is good improvement but only partly successful as it was not unable clearly show
the speculative demand even exists.
23
Further…
• To sum up,
• Further developments of the Keynesian approach have attempted
to give a more precise explanation for the transactions,
precautionary, and speculative demand for money though attempt
to improve Keynes’s rationale for the speculative demand for
money has been only partly successful.
• Keynes’s proposition that the demand for money is sensitive to
interest rates—suggesting that velocity is not constant and that
nominal income might be affected by factors other than the
quantity of money—is still supported.
24
 Friedman’s Modern Quantity Theory of Money
• Instead of analyzing the specific motives for holding money, as Keynes did, Friedman
simply stated that the demand for money must be influenced by the same factors that
influence the demand for any asset.
• Friedman then applied the theory of asset demand to money.
• The theory of asset demand indicates that the demand for money should be a function of
the resources available to individuals (their wealth) and the expected returns on other
assets relative to the expected return on money.
• Friedman expressed his formulation of the demand for money as follows:

– where Md/P = demand for real money balances

– Yp = Friedman’s measure of wealth, known as permanent income
– Rm = expected return on money, rb = expected return on bonds
– re = expected return on equity (common stocks), pe = expected inflation rate
25
 Friedman’s …
• Money demand is positively related to Friedman’s wealth concept, permanent income,
which has much smaller short run fluctuations
• Friedman categorized other assets into three: bonds, equity, and goods.
• The incentives for holding these assets rather than money are represented by the expected
return on each of these assets relative to the expected return on money.
• As each relative return rises, the demand for money will fall.
• Friedman recognized more than one interest rate in his demand for money function,
• However, Keynes lumped financial assets other than money into one bonds because he
felt that their returns generally move together.
• Friedman viewed money and goods as substitutes; that is, people choose between them
when deciding how much money to hold.
• Friedman did not take the expected return on money to be a constant, as Keynes did.

26
 Friedman’s …
• Unlike Keynes’s theory, which indicates that interest rates are an important
determinant of the demand for money, Friedman’s theory suggests that
changes in interest rates should have little effect on the demand for money,
such that his money demand equation can be approximated by:

☻In Friedman’s view, the demand for money is insensitive to interest

rate
☻Friedman stressed the stability of the demand for money function and
suggested that random fluctuations in the demand for money are small and
that the demand for money can be predicted accurately by the money demand
function.
27
Friedman’s …
• Velocity is highly predictable.
• We can see this by writing down the velocity that is implied by the
money demand equation:

• If velocity is predictable, a change in the quantity of money will

produce a predictable change in aggregate spending.
• Therefore, Friedman’s theory of money demand is indeed a
restatement of the quantity theory, because it leads to the same
conclusion about the importance of money to aggregate spending.

28
WOOOOOOOOOOOWOOOWWOOOO!!!

THE END
? ANY QUESTION?
THANK YOU FOR TIME!
29