Money Demand
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Standard specification:
(M/P) = f(Y, r)
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M = Monetary aggregate
P = Price level
Y = income
r = interest rate
Why money demand?
Why does money
demand depend on
income and interest
rate?
Are there any other
determinant of money
demand function?
Is money demand
stable?
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Monetary policy affects policy objectives (output,
employment and price level) through financial markets
(particularly banks).
The channel is through shift in the interest rate, which has
important bearings on interest-sensitive components of
aggregate expenditure.
As such, policymakers need to gauge the level of money
demand such that the level of money supply can be set. In
this way, interest rate will not be too high or too low.
At the same time, other determinants of money demand
need to be identified such that policymakers can counter
any shift in money demand.
Stability of money demand is a pre-requisite for monetary
aggregate targeting framework.
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Quantity Theory of Money
Cambridge approach to Money Demand
Keynes’s Liquidity Preference Theory
Baumol-Tobin Transactions Demand for
Money
Friedman’s Restatement of the Quantity
Theory
Tobin’s Portfolio Balance Model
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The foundation of the QTM is the equation of
exchange
Equation of Exchange: MV = PY
P = Price
M = Quantity of money
Y = Income
V = Velocity
Velocity is the average number of times per year a
Ringgit is spent.
This is the early theory of price determination.
Namely, Fisher views V to be constant and Y is
relatively constant in the short run, the quantity of
money is the sole determinant of the price level.
QUANTITY THEORY
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From the QTM, we have
M = (1/V)PY
Md = kPY
The monetary holding is
determined by the amount
of transactions (PY)
There is no room for the
interest rate to affect
money demand.
The institutional factor
also affects Md through its
effect on velocity
CAMBRIDGE MONEY
DEMAND
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Similar simulation:
Md = kPY
However, the Cambridge theory
acknowledges the role of wealth in
addition to transactions, both of which
are proportional to nominal income
(PY).
Money is a part of wealth. Thus, the
store of value function is recognized.
Individuals decide to hold wealth in
the form of money, proportional to
nominal income.
k is allowed to fluctuate in conjunction
with the decision of economic agents
to hold other assets as well.
Accordingly, velocity can fluctuate.
Motives for monetary holdings
 Transaction motive – a medium of exchange to
carry out transactions
 Precautionary motive – a cushion against an
unexpected event
 Speculative motive – a store of wealth that
allows individuals to reallocate wealth between
money and bonds
(Md/P) = f (Y, r)
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According to Friedman, money demand is
influenced by the same factors as those influencing
assets.
𝑀𝐷
= 𝑓(𝑌𝑝 , 𝑟𝑏 − 𝑟𝑚 , 𝑟𝑒 − 𝑟𝑚 , 𝜋 − 𝑟𝑚 )
𝑃
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Yp is permanent income, which is the expected
average long run income.
Implications:
- interest rate will have only marginal impact on money
demand
- money demand is a stable function
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Tobin’s portfolio balance theory considers
MONEY and BONDS (non-money assets
collectively termed bonds) as alternative assets in
wealth portfolio.
Money is viewed to yield no return and it is risk
free.
Meanwhile, bonds give positive returns and risky
Individuals try to balance their portfolios
considering risk-return tradeoff such that
satisfaction is maximum.
Thus, Tobin theory is based on mean-variance
optimization.
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Consider:
- Money ~ (0, 0); (1 – B): share of money
- Bonds ~ (µ, 2); B: share of bonds
Portfolio mean: 𝜇𝑝 = 𝜇 × 𝐵
Portfolio risk: 𝜎𝑝2 = 𝜎 𝑤 × 𝐵2
From portfolio mean and risk, we can construct
mean return – risk line faced by individuals:
That is:𝜇𝑝 = 𝜎𝑝 ×
𝜇
𝜎
Individuals: performing mean-variance
optimization subject to the above line.
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Is velocity stable?
Is Money demand stable?
Will interest-free “money” be stable?
Why is there breakdown in the money demand
function?
What is the role of recent financial uncertainty
on money demand?
How does money demand interacts with the
money supply process?