Chapter 19
The Demand
for Money
Velocity of Money
and Equation of Exchange
M = the m oney supply
P = price level
Y = aggregate output (incom e)
P  Y  aggregate nom inal incom e (nom inal G D P)
V = velocity of m oney (average num ber of tim es per year that a dollar is spent)
V 
PY
M
E quation of E xchange
M V  P Y
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19-2
Quantity Theory
• Velocity fairly constant in short run
• Aggregate output at full-employment
level
• Changes in money supply affect only
the price level
• Movement in the price level results
solely from change in the quantity
of money
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19-3
Quantity Theory of Money Demand
D ivid e bo th sid es by V
M =
1
 PY
V
W h en the m o ney m arket is in equ ilibrium
M = M
L et k 
d
1
V
M
d
 k  PY
B ecause k is co nstant, the level of tranactio ns g enerated by a
fixed level of P Y determ in es the quan tity of M
d
T h e dem and for m on ey is no t affected by interest rates
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19-4
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19-5
Keynes’s Liquidity Preference Theory
• Transactions Motive
• Precautionary Motive
• Speculative Motive
• Distinguishes between real and nominal
quantities of money
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19-6
The Three Motives
M
d
 f ( i,Y ) w h ere the dem and fo r real m o n ey b alances is
P
n eg ativ ely related to th e in terest rate i,
an d p o sitiv ely related to real inco m e Y
R ew riting
P
M
d
1

f ( i, Y )
M u ltiply b oth sid es b y Y and replacin g M
V 
PY
M
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
d
w ith M
Y
f ( i,Y )
19-7
The Three Motives (cont’d)
T he procyclical m ovem ent of interest rates should induce
procyclical m ovem ents in velocity
V elocity w ill change as expectations about future norm al
levels of interest rates change
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19-8
• There is an opportunity cost and benefit
to holding money
• The transaction component of the demand for
money is negatively related to the level of
interest rates
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19-9
Precautionary Demand
• Similar to transactions demand
• As interest rates rise, the opportunity
cost of holding precautionary
balances rises
• The precautionary demand for money is
negatively related to interest rates
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19-10
Speculative Demand
• Implication of no diversification
• Only partial explanations
developed further

Risk averse people will diversify

Did not explain why money is held as a
store of wealth
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19-11
Friedman’s
Modern Quantity Theory of Money
d
M
 f (Y p , rb  rm , re  rm ,   rm )
e
P
M
d
= d em an d fo r real m o n ey b alan ces
P
Y p = m eau sre o f w ealth (p erm an en t in co m e)
rm = ex p ected retu rn o n m o n ey
rb = ex p ected retu rn o n b o n d s
re = ex p ected retu rn o n eq u ity

e
= ex p ected in flatio n rate
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19-12
Variables in
the Money Demand Function
• Permanent income (average long-run income) is
stable, the demand for money will not fluctuate much
with business cycle movements
• Wealth can be held in bonds, equity and goods;
incentives for holding these are represented by the
expected return on each of these assets relative to the
expected return on money
• The expected return on money is influenced by:

The services proved by banks on deposits

The interest payment on money balances
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19-13
Differences between Keynes’s and
Friedman’s Model
• Friedman

Includes alternative assets to money

Viewed money and goods as substitutes

The expected return on money is not
constant; however, rb – rm does stay
constant as interest rates rise

Interest rates have little effect on the
demand for money
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19-14
Differences between Keynes’s and
Friedman’s Model (cont’d)
• Friedman (cont’d)


The demand for money is stable 
velocity is predictable
Money is the primary determinant of
aggregate spending
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19-15
Empirical Evidence
• Interest rates and money demand


Consistent evidence of the interest sensitivity of the
demand for money
Little evidence of liquidity trap
• Stability of money demand


Prior to 1970, evidence strongly supported stability
of the money demand function
Since 1973, instability of the money demand
function has caused velocity to be harder to predict
• Implications for how monetary policy should
be conducted
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19-16