16
The Demand for Money
FOCUS OF THE CHAPTER
• We all hold moneyeither in currency/cash, in our pockets, or as deposits in a bank. In
studying the demand for money, we try to discover why people hold money, and what
determines the amount of money they hold.
• Our main goal is to find some function that tells us the amount of money people will hold for a
known level of income and a known interest rate. You will recall, no doubt, that we need to
know this to construct the LM curve.
• Both theory and empirical evidence suggest that an increase in people’s incomes makes them
want to hold more money, and that an increase in the interest rate makes them want to hold
less.
SECTION SUMMARIES
1.
Components of the Money Stock
Money consists of the stock of assets held as cash, checking accounts, and other, closely related
assets, not generic wealth or income. There are four different measures of the money supply: M1,
M2, M3, and L. M1 consists of those assets that are the most liquidmost easily used to pay for
goods and services. L consists of those assets that are least liquid, but which can still be
converted into a form acceptable to creditors. The components of each measure of money are
listed below:
M1
currency, demand deposits, travelers checks, and other checkable deposits
M2
M1 plus shares in money market mutual funds, money market deposit accounts,
savings deposits, and small time deposits
M3
M2 plus repurchase agreements, Eurodollars, large time deposits, and institutional
money market mutual fund holdings
L
M3 plus savings bonds, bankers acceptances, commercial paper, and short-term
Treasury securities
174
THE DEMAND FOR MONEY
2.
175
The Functions of Money
Money has traditionally been thought to have four functions:
A medium of exchange. Money is used to pay for goods and services, and enables us to
avoid the “double coincidence of wants” required in a barter economy.
A store of value. Money retains its value over time; money we receive today can be stuck
under our mattresses or placed in our checking account and used to purchase goods and
services at a later date.
A unit of account. Prices are quoted in dollars and cents rather than chickens, avocados, or
visits to the dentist.
A standard of deferred payment. Money is used in long-term transactions; you might
borrow $100 from a friend, for example, and promise to pay him back $105 at a later date.
The most important thing to know about money is that it is whatever people generally accept as a
payment for goods and services. As such, it can take many forms.
3.
The Demand for Money: Theory
Why would we ever choose to hold money instead of some other, interest-bearing asset? Keynes
suggested three different motives:
The transactions motive. We wish to avoid having to cash in another asset every time we
make a purchase. (Imagine what a nuisance that would be!)
The precautionary motive. “Just in case.” We never know our spending plans exactly; it
pays to keep a little extra money around in case the urge for a hot fudge sundae hits at a
time when your stockbroker is playing golf and cannot liquidate any of your assets.
The speculative motive. While money doesn’t have a very high return, it is less risky than
other assets. Speculative demand for money is actually demand for a safe asset.
An increase in the rate of return on other assets reduces the demand for money, whatever one’s
motive for holding it. An increase in the amount of uncertainty we have about our future
spending plans increases the people’s demand for money, when that demand is based on the
precautionary motive.
We model the demand for real rather than nominal money balances here ( M P rather than M);
we assume that, because people hold money for its purchasing power, they do not care about
their nominal money holdings. For this to hold, people must be free of money illusionthe
belief that changes in nominal wages and prices are meaningful.
176 CHAPTER 16
4.
Empirical Evidence
Empirical research has settled four key points about money demand:
1) When the real interest rate increases, the demand for real money balances falls.
2) When income increases, money demand also increases.
3) It takes time for money demand to fully adjust to changes in income and the interest
rate.
4) If the price level doubles, so will nominal money demand. Real money demand will be
unaffected; there is no money illusion.
High inflation can also induce people to hold less money. With sufficiently high rates of
inflation, people may not wish to hold financial assets at all, holding food, other goods (especially
gold) and foreign money instead. This phenomenon is known as flight out of (domestic) money.
5.
The Income Velocity of Money
The income velocity of money is the number of times the stock of money is turned over, or reused
each year to finance all of the purchases that occur. If people purchased $1,000,000 of goods and
services in a particular year, and the (nominal) money supply were $1,000,000, for example, the
velocity of money would be equal to 1; each dollar would be used an average of one time. If
people purchased $1,000,000 of goods and services in a particular year, and the (nominal) money
supply were $500,000, the velocity of money would be equal to 2; each dollar would be used an
average of two times.
The income velocity of money is defined as:
V =
P´ Y
Y
=
M
M P
The quantity theory of money uses this definition to explain how and why the price level and the
money stock are connected:
M ´ V = P ´ Y.
The classical incarnation of this theory assumes that both V and Y are fixed and, based on those
assumptions, argues that any change in the money supply will cause a proportional change in the
price level.
Appendix
The Baumol-Tobin formula for the transactions demand for money,
THE DEMAND FOR MONEY
M* =
177
tcY
2i
uses some basic intuition and a small bit of math to find a formula for the amount of money
people want to hold for the purpose of buying goods and services.
First, notice that a person’s average balance (M) over a given period will be equal to 1 2 the
amount of money they spend over that period divided by the number of times (n) they convert
their other assets into money (e.g., withdraw cash from their savings account):
Y
2n
Next, observe that the opportunity cost of holding money is equal to the value of the next best
opportunitythe rate of interest (i) paid by other assets. Each transfer is also assumed to cost an
amount tc.
M =
The total cost of holding average balances Y 2n, then is:
( n ´ tc )
+
iY
2n
The best number of transactions is, of course, the one that minimizes this total cost. That number
(n*), it turns out, is given by the following formula:
n
*
=
iY
.
2tc
Plugging this into our original equation M = Y 2n , we find that people will find it optimal, or
best to hold average money balances
M* =
tcY
.
2i
KEY TERMS
money
M1
M2
M3
liquidity
medium of exchange
store of value
unit of account
standard of deferred payment
real balances
money illusion
transactions motive
precautionary motive
speculative motive
portfolio
risky asset
interest elasticity
income elasticity
flight out of money
income velocity
178 CHAPTER 16
quantity theory of money
quantity equation
classical quantity theory
GRAPH IT 16
It’s about time for a loose, relaxing exercise… don’t you think? This graph asks you to
demonstrate the essential principles of precautionary money demand by drawing some loose
wiggles on Chart 16–1.
The idea behind the precautionary demand for money is that you want to hold enough so you
don’t have to keep running to the bank, but don’t want to hold too much because of the
opportunity cost. We’ve drawn a wiggly line representing a particular cash need. Assuming that
we don't want to run out of money more than twice during the period on the graph, we took a
straightedge and drew a dashed line as low as possible, with the wiggle peeking over it no more
than twice. This solid line shows the precautionary demand for money.
Your task is to draw a cash-need wiggle, with the cash needs generally having higher peaks.
Then use a straightedge to draw in the money-demand line that is consistent with your not
wanting to run out of money any more than twice during the period covered by the graph.
Low money
demand
Time
Chart 161
THE DEMAND FOR MONEY
179
THE LANGUAGE OF ECONOMICS 16
Liquidity
An asset is liquid when it can be converted into goods or services quickly, at low cost, and with
low risk. Cash is the ultimate liquid asset; it can be directly exchanged for goods and services
anywhere. Checking accounts, or “demand deposits,” are quite liquid too.
Stocks and bonds are less liquid. Both take time to sell, and therefore cannot as easily be used to
buy goods or services. The prices of stocks and bonds also fluctuate. Imagine having to sell a
share of stock every time you get a haircut or buy groceries; you might have to sell at a loss,
simply to finance your purchase. Having to regularly convert either of these assets into goods
and services would involve considerable risk.
Ironically, one of the least liquid assets is a lake full of water. Lakes couldn’t possibly be easy to
sell on short notice.
REVIEW OF TECHNIQUE 16
Working with Natural Logarithms
Before the days of calculators, tables of logarithms were used to speed up calculations. Today
that is no longer necessary; few of us do our calculations by hand.
Natural logarithms are still useful, however, because they are intimately connected to percentage
changes: the change in the natural log of a variable is approximately equal to the percentage
change of that variable. This is particularly useful when graphing one variable against another.
If you graph the natural log of y (ln y) against the natural log of x (ln x), for example, the slope of
your line will tell you the amount that y changes, in percentage terms, when x rises by 1 percent.
A natural logarithm is formally defined as follows:
X = ln Y
if and only if
x
Y = e ,
where e is an irrational number (i.e., it goes on forever) approximately equal to 2.71828. Taking
the natural log of the function e x gives you x; raising e to the power ln x also gives you x ( e x and
ln x are inverse functions).
There are some rules that will help you to work with natural logs:
1)
ln(xy)  ln x  ln y
2)
ln(x y)  ln x  ln y
3)
ln(x y )  y  ln x
4)
ln(1  x)  x
(the symbol  means " approximat ely equal to" )
180 CHAPTER 16
FILL-IN QUESTIONS
1.
The assets which form M1 are __________________ liquid than the assets which form M2.
2.
Savings accounts are ___________________ liquid than Treasury bonds.
3.
Holding money to reduce the risk associated with your portfolio of assets is an example of
the ___________________ motive.
4.
Holding money because you’re worried that something may come up that requires you to
spend it is an example of the ___________________ motive.
5.
Holding money in order use it to buy goods and services is an example of the
___________________ motive.
6.
Ice cubes would not be a very good form of money because they would be a terrible
____________________.
7.
Giant stone slabs might not be the best form of money because they would not be a very
convenient ______________________.
8.
When high inflation induces people to hold goods instead of assets, we say there is a
_________________________.
9.
The equation M ´ V = P ´ Y is called the ________________ equation.
10.
The _______________________ of money measures the number of times the average dollar
changes hands each year.
THE DEMAND FOR MONEY
181
CROSSWORD
ACROSS
1
2 Motive for holding money, people do
3
2
not want to convert illiquid assets into
cash every time they make a purchase
5 Role of money, medium of ___
7 Motive for holding money, just in case
4
5
6
9 Type of deposit, included in M2 but
not M1
7
DOWN
8
1 Included in M1
3 Motive for holding money,
9
reduces portfolio risk
4 Measures number of times the average
dollar changes hands in a year
6 Role of money, unit of ___
8 Role of money, store of ___
TRUE-FALSE QUESTIONS
T
F
1.
Cash is the most liquid asset of all.
T
F
2.
Stocks are the most liquid asset of all.
T
F
3.
An increase in income raises money demand.
T
F
4.
Money demand adjusts immediately to changes in both income and the interest
rate.
T
F
5.
M1 is more liquid than M3.
T
F
6.
M3 is more liquid than L.
T
F
7.
People will hold as much money as they can get their hands on.
T
F
8.
It is always better to hold more money than less.
T
F
9.
If the money supply grows more quickly than output, it will cause inflation.
T
F
10.
When the real interest rate increases, the demand for real money balances falls.
182 CHAPTER 16
MULTIPLE-CHOICE QUESTIONS
1. Currency is contained in
a. M1
b. M2
c. M3
d. all of the above
2. T-bills (3-month Treasury bonds) are contained in
a. M1
b. M2
c. M3
d. all of the above
3. Which of the following is the most liquid?
a. M1
b. M2
c. M3
d. L
4. Which of the following is the least liquid?
a. M1
b. M2
c. M3
d. L
5. Which of the following is the most commonly used measure of money?
a. M1
b. M2
c. M3
d. L
6. Which of the following is not a function of money?
a. medium of exchange
b. unit of account
c. store of value
d. measure of greed
7. People will want to hold less money if there is/are
a. high inflation
b. low interest rates
c. money illusion
d. all of the above
8. In the long run, an increase in the money supply causes
a. high real interest rates
b. high output
c. inflation
d. all of the above
9. Money is:
a. bills and coins
b. bills, coins, and bank accounts
c. anything people can exchange for
goods and services.
10. In classical quantity theory,
a. output is fixed
b. velocity is fixed
c. the price level can vary
d. all of the above
THE DEMAND FOR MONEY
183
CONCEPTUAL PROBLEMS
1. Why do you hold money? (How many of the motives for holding money can you identify
with?)
2. What do you know of anything, aside from bills and coins, that has been used as money over
the years?
TECHNICAL PROBLEMS
1. If nominal GDP is $1,000,000 and the money supply (as measured by M2) is $500,000, what is
the income velocity of money?
2. If output grows at an average of 3% per year and the money supply grows at an average of 8%
per year, what must be the rate of inflation?
3. If you earn $100,000 per year, you pay $1.50 to withdraw money from your banking account,
and the interest rate is 6%, how much money does the Baumol-Tobin model of the
transactions demand for money suggest you will want to hold?