The Demand
for Money
ECO 473 - Money & Banking - Dr. D. Foster
The Demand for Money
• The motives for holding money
• Money demand as a medium of exchange
 The Cambridge equation.
 The Inventory model.
 Friedman approach.
 Rothbard approach.
• Money demand as a store of value
 Keynes’ portfolio demand.
The Motives for Holding Money
• Transactions motive:
 To use as a medium of exchange.
 Depends upon income, consumption,
wealth.
 Not influenced very much by interest rates.
• Portfolio motive:
 To hold money as part of a wealth building strategy.
 Depends on the interest rate.
The Cambridge Equation
Money is only used for making purchases.
For some given income, Y, you plan to hold
some given fraction, k, to facilitate purchases.
As income rises (falls), the money demanded
rises (falls).
The Demand for Real Money Balances
• Md is a “nominal” value - as prices rise, we want to
hold more money, but not in real terms. So, to convert
to “real” values . . .
• Y = nominal income = (Prices) x (real income) = P•y
• md eliminates price effects on money demand.
Annual Spending
Patterns with a
Constant Rate of
Spending for
y = $36,000
$18,000
Average money holdings equals … ?
$9,000
$1,500
The Inventory Approach to Money Demand
• What is the optimal money balance to hold?
• Assumptions:

On-hand money earns no interest.

People earn a fixed amount of real income.

People buy goods and services at a constant rate.

People hold either money or bonds.

Bonds earn an interest return of r.

Converting from bonds to money costs a fee, f.

Conversion made n times/year in constant amounts.
Summarizing factors affecting md real money balances
• Real income:
 A rise in y causes an increase in md.
 A fall in y causes a decrease in md.
• The interest rate:
 An increase in r causes a decrease in md.
 A decrease in r causes an increase in md.
• The cash-conversion fee:
 An increase in f causes an increase in md.
 A decrease in f causes a decrease in md.
Friedman approach
Money demand varies with …
• Permanent Income.
 + relationship.
• Interest spread between bonds & money.
 - relationship.
• Interest spread between stocks & money.
 - relationship.
• Inflationary expectations.
 - relationship.
Rothbard approach
Money demand varies with …
• Frequency of payments.
 - relationship.
• Sophistication of the clearing system.
 - relationship.
• Confidence in money (esp. paper).
 + relationship.
• Inflationary expectations.
 - relationship.
Mises:
Phase I
Phase II
Phase III
Rothbard presentation
Money S&D in the context of the ppm:
ppm
ms ms'
In Phase I, MS rises but its
effects are offset by Md.
In Phase II, Md falls,
incorporating inflationary
expectations.
md'
d
m
md''
$
Phase III, further increases in
MS are constantly offset by
declines in Md as people
seek to have zero cash.
Keynes & the Portfolio Demand
• The speculative demand for money:
 Relates to money held as a store of value.
 We seek to maximize our wealth over time.
 Our wealth is held in the form of bonds.
 Holding money allows us to time bond purchases.
 At “high” interest rates, we expect them to fall …
raising bond prices; strategy - buy bonds now.
 At “low” interest rates, we expect them to rise …
lowering bond prices; strategy - sell bonds now.
Keynesian Money Demand
r
r
md(T)
md(S)
m
Money demanded for
transactions purposes in the
Cambridge equation isn’t
related to the interest rate.
[Also, Friedman & Rothbard.]
m
Keynes’ speculative demand
shows money is related to
the interest rate.
The Liquidity Trap
Increasing the MS doesn’t actually lower interest rates!
Or, increasing the MB doesn’t actually increase the MS!
Is the U.S. in a Liquidity Trap?
Fight Recession by  interest rates
The Fed has run out of an interest rate policy!
Effective Federal Funds Rate of Interest 1981 to 2011
20.00%
1982
18.00%
16.00%
14.00%
1991
12.00%
2001
10.00%
2009
8.00%
6.00%
4.00%
Jan-11
Jan-09
Jan-07
Jan-05
Jan-03
Jan-01
Jan-99
Jan-97
Jan-95
Jan-93
Jan-91
Jan-89
Jan-87
Jan-85
Jan-83
0.00%
Jan-81
2.00%
What has the Fed done?
The Monetary Base has more than quintupled!
2004-2008:
~ $800 b.
9/2015:
$4,028 b.
The Demand
for Money
ECO 473 - Money & Banking - Dr. D. Foster