Chapter 22
The Demand for Money
In previous chapters, we studied the supply of money. In this chapter, we examine
the theories of money demand.
1- Quantity Theory of Demand:
(Developed by the classical economists in the nineteenth century, based on the work
of Fisher of 1911). The most important feature of this theory is that it suggests that
interest rate have no effect on the demand for money. And in general, the classical
point of view, individuals are assumed to hold money because it is a medium of
exchange that can be used for everyday transactions.
Velocity of Money and Equation of Exchange:
Fisher (1911) wanted to examine the relationship between total quantity of money
(Money supply: M), and the total amount of spending on final goods and services
(P x Y);
where P: is the price level and Y: is the aggregate output (and income; or nominal
GDP).
The money supply (M) and (P x Y) are connected through the concept of Velocity:
the rate of turnover of money, which means also the average number of times per
year that a KD is spent in buying the total amount of goods and services produced
in the economy. We can define Velocity (V) as
V= (P x Y ) / M --- (1)
If GDP = (KD 5), quantity of money = (KD1), the V = 1, which means that the
average dinar bill is spent five times in purchasing final goods and services in the
economy.
Multiplying both sides of equation (1) by (M), we get the “Equation of exchange”:
M x V = P x Y --- (2)
This equation relates nominal income to the quantity of money (M) and velocity (V):
the quantity of money (M) multiplied by the number of times that this money is
spent (V) in a given year must equal nominal income (P x Y).
Classical economists assumed that (V) is constant and (Y) is constant too since the
economy operated at full employment. Therefore:
Movements in the price level result FROM changes in the quantity of money.
From equation (2), since both (V) and Y are constant, then changes in (M) leads to
changes in P in same direction.
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Quantity Theory of Money Demand:
Since the quantity theory of money tells us how much money is held (M) for a given
amount of aggregate income (Y), it is a theory of demand for money. Rearranging
equation (2):
M = (1/V)(P x Y)
The quantity of money that people hold (M) = the quantity of money demanded
(Md):
Let M=Md , k=(1/V), then:
Md = k x PY --- (3)
Since (1/V) is constant, then k is constant too. This means that the level of
transactions generated by a fixed level on nominal income (PY) determines the
quantity of money (Md) that people demand.
Fisher’s quantity theory of money suggests:
Demand for money is a function on income (Y), and that interest rates have no effect
on demand for money (Md).
This means that people hold money only to conduct transaction, and the demand of
money is determined by:
1) The level of transactions generated by the level of nominal income (PY)
2) k.
2- Keynes’s Liquidity Preference Theory:
Keynes abandoned the classical view that (V) is constant and developed a theory of
money demand that emphasized the importance of interest rate. His theory
“Liquidity preference theory” asked the following question: Why do people hold
money? There are three motives:
1) Transaction motives
2) Precautionary motives
3) Speculation motives.
1- Transaction Motive: Keynes assumed (like the classical approach) that
transactions were proportional to income. Therefore, demand for money is also
proportional to income.
2- Precautionary Motive: In addition to holding money to carry out transactions,
people hold money for unexpected needs. The amount of precautionary money
balances people want to hold is determined the level of transactions they expect to
make in the future and these transactions are proportional to income. Therefore, the
demand fore precautionary money balances is proportional to income.
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3- Speculative Motive: The most important contribution of Keynes’s theory is that
he added the idea that since money is a store of wealth and since wealth is related to
income, then people do hold money for speculative motive. Keynes divided the assets
people use to store wealth into two categories: money and bonds. He asked the
following question: why do individuals decide to hold their wealth in the form of
money rather than bonds?
People want to hold money if the expected return (cash or checkable deposits, pay
no interest) was greater than the expected return from holding bonds (two
components: interest rate payment and expected rate of capital gains).
Note: As interest rate rises, price of bond falls, and if you expect interest rate to rise,
you will expect bond’s price to fall.
At higher interest rate, demand for money will be low since return on bonds is
higher. Therefore, money demand is negatively related to the level of interest rate.
Putting the Three Motives Together
Demand for money equations: “The Liquidity Preference Function”:
Md / P = f( i , Y) ---(4)
This equation states that demand for real money balances (Md/P) is negatively
related to interest rate and positively related to (real) income.
Equation (4) can be rewritten as:
P / Md = 1 / (f( i , Y)
Multiplying both sides by (Y), and recall that V = (PY)/M, then:
V = (PY) / Md =Y / [ f( i ,Y)] ---(5)
Therefore, because interest rates have substantial fluctuations, the liquidity
preference theory implies that interest rates have substantial fluctuations as well.
Then, V is not constant (as assumed in classical view).
Friedman’s Modern Quantity Theory of Money:
Friedman (1956) recognized that people want and do in fact hold money for other
motives:
Md/P = f(Yp, rb - rm, re - rm, πe - rm) ---(6)
+
Md/P = demand for real money balances
Yp= present discounted value of all expected future income, or expected average
long-run income, known as permanent income.
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rb= expected return on bonds
rm = expected return on money
re = expected return on equity (common stock)
πe = expected inflation rate.
Friedman’s theory suggests that changes in interest rates should have little effect on
demand for money.
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