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Chapter 22. Demand For Money

This document summarizes theories of demand for money including the quantity theory of money, Keynes' liquidity preference theory, and Friedman's modern quantity theory. It discusses the relationship between money supply, price level, output and interest rates. It also analyzes empirical evidence regarding whether money demand is sensitive to interest rates and how stable the relationship is over time.

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34 views26 pages

Chapter 22. Demand For Money

This document summarizes theories of demand for money including the quantity theory of money, Keynes' liquidity preference theory, and Friedman's modern quantity theory. It discusses the relationship between money supply, price level, output and interest rates. It also analyzes empirical evidence regarding whether money demand is sensitive to interest rates and how stable the relationship is over time.

Uploaded by

bongolu
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd
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Chapter 22.

Demand for Money

Quantity Theory of Money Keynes & Liquidity Preference Friedmans Modern Quantity Theory Friedman vs. Keynes Empirical Evidence

Monetary Theory

link between MS and other economic


variables price level output

I. Quantity Theory of Money

classical economists
Irving Fisher relates quantity of money to nominal income

equation of exchange

MV = PY where
M = quantity of money P = price level Y = real output = real income V = velocity = # times money used to purchase output

2 assumptions

V is constant in short-run
depends on institutions, technology that change slowly Y is at full employment level also constant in short-run

MV = PY

if V, Y constant then
A change in M must cause an equal % change in P Quantity Theory of Money

money demand

MV = PY M = (1/V)PY M = kPY let (1/V) = k Md = M in equilibrium


Md = kPY Md is depends on income NOT interest rates

Is V constant?

NO.

II. Liquidity Preference

Keynes 1936 3 motives to holding money


transactions motive precautionary motive speculative motive

transactions motive

people hold money to buy stuff


as income rises, Md rises

precautionary motive

people hold money for emergencies


car breakdown job loss Md rises with income

speculative motive

suppose store wealth as money or


bonds high interest rates bonds more attractive, hold less money Md negatively related to interest rate

real quantity of money

M/P if prices rise, must hold more money


to buy same amount of stuff

money demand (M/P)

depends on
income interest rates M/P = f(i,Y)

Keynes & velocity

MV = PY
M/P = Y/V M/P = f(i,Y) Y/V = f(i,Y) V = Y/f(i,Y) velocity fluctuates with the interest rate -- both are procyclical

Tobin & money demand

further extended Keynes approach


transaction demand negatively related to the interest rate people hold money even when is has a lower return, b/c it is less risky

III. Friedmans modern quantity theory

Milton Friedman
Md as asset demand -- wealth -- return relative to other assets

Yp = permanent income rb = expected bond return rm = expected money return re = expected equity return pe = expected inflation

rb - rm = relative return on bonds pe = expected return on goods

increase in Yp will increase Md increase in relative returns of bonds,


equity or money decrease Md

Friedman vs. Keynes

Friedman:
multiple rates of return relative returns money & goods are substitutes Yp more important than current income

stability of Md

Friedmans Md function is more


stable Yp more stable than current income spread between returns is more stable than returns -- interest rates have little impact on Md

IV. empirical evidence

which Md function is right?


Keynes or Friedman test how does Md respond to i? how stable is Md?

Md is sensitive to interest rates

a lot of research reaches same


conclusion sensitivity does not change over time

stability of Md

what does that mean?


relationship between Md, income, interest rates does not change over time does Md function of 1930s still predict Md in 1950s?

up until mid 1970s, Md very stable after 1974, Md becomes less stable
(M1) old relationships overpredicting Md financial innovations changed behaviors Md stability for M2 breaks down in 1990s

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