Demand for Money

WHAT IS DEMAND FOR MONEY? 

The demand for money is the relationship between the quantity of money people want to hold and the factors that determine that quantity

FACTORS WHICH INCREASES THE DEMAND FOR MONEY 

A reduction in the interest rate.

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A rise in the demand for consumer spending

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A rise in uncertainty about the future and future opportunities A rise in the demand for a currency by central banks (both domestic and foreign)

Overview    

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Fisher’s Quantity Theory of money The Cambridge Cash-Balance Theory Keynes’s Liquidity Preference Theory Baumol-Tobin Optimal cash Management Model Friedman’s Approach The Velocity Of Money Liquidity Trap

Notation V   velocity of money P  price level  y   real income/output/GDP Y  nominal income/output/GDP  Py  M  quantity of money (supplied) M  quantity of money demanded d 

Fisher’s Quantity Theory of  Money 

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This theory states that nominal income is determined soley by movements in the quantity of  money. It assumes that velocity is fairly constant. It concludes that movements in the price level result soley from changes in the quantity of  money.

P  y  M V   The equation of

Quantity Theory of Money Demand  

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Equilibrium Condition: Md =M The theory suggests that the 1 demand for money is purely a M   Py  V  function of nominal income, 1 and that interest rates have Let k  and set M  M d  no effect on the demand for V  money. M d   k  Py   People only hold money to conduct transactions.

The Cambridge Cash Balance Theory 

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The Cambridge approach emphasises that there are alternatives to holding money in the shape of  shares and bonds. These assets yield a return which can be viewed as the opportunity cost of holding money. As interest rates rise, agents will economise on money holdings and vice versa.

Cash balance Theory ( cont’d) 

Another factor that will influence money holdings is the expected rate of inflation. If  inflation is expected to be high, then the purchasing power of money will fall. This will prompt agents to buy securities or commodities as a hedge against inflation

Cash balance Theory ( cont’d) 

We can set out the Cambridge cash balance approach as follows

k=Md/k Y

Keynes’s Liquidity Preference Theory 

Proposes that individuals hold money for 3 reasons:   

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Transactions Motive Precautionary Motive Speculative Motive

Concludes that money demand is negatively related to the level of interest rates. Velocity is therefore unstable.

TRANSACTION MOTIVE 

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People need money as consumers as well as producers. As consumers they need money in the form of income to meet their day to day needs, and as producers they need money in the form of capital to make investments Therefore the transaction motive can be classified into ‘Income Motive’ and Business Motive’

PRECAUTIONARY MOTIVE: 

All individuals want to cover unforeseen events such as sickness, accidents and losses, for which they want money as precaution for contingency.

Speculative Motive: 

People need money for making gains from speculation on future value of bonds and securities.

Liquidity Preference Theory (Cont’d) R  nominal interest rate M  real money balances P M d   demand for real money balances P f ( R,Y )  liquidity preference function

M d     f (R , Y ) P M d  e   f      ,Y  P

 _ 

+

Friedman’s Approach 

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Friedman’s restatement of the quantity theory of money simply stated that the demand for money must be influenced by the same factors that influence the demand for any asset.

Friedman applied the theory of asset demand to money.

d 

M  f  RB , RE  ,  , Wh / Wn , y, u  P        R B  nominal return on bonds R E   nominal return on equity   

rate of inflation (measuring the return on money)

W h  human wealth W n  nonhuman wealth u  other omitted factors Friedman argued that when the return on equity or bonds change, the return on money would not necessarily remain constant. A simplified version of Friedman’s view of the demand for money, is to view it as a function of permanent income, y p 

d 

M P

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P

 g( y  )

Friedman’s view 

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Friedman’s theory suggests that changes in interest rates should have little effect on the demand for money. Another conclusion from Friedman’s theory is that velocity is predictable.

Baumol-Tobin Optimal Cash Management Model 

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states that the transactions component of the demand for money is negatively related to the level of interest rates. Assumes individuals choose between two assets: money and bonds. Y Py  d  M   2n 2n where n is the number of transactions per period

In panel (a), the individual is paid $1000 monthly. Therefore the monthly average cash holdings is

$1000  0 M   $500 2 d 

In panel (b), the individual’s biweekly income is $500. Therefore the monthly average cash holdings is

$500  0  $250 M  2 d 

d 

0.5

M  b  0.5 0.5     y  R P  2P  where b is the cost each time a transfer is made in our out of cash

The Velocity of Money 

The velocity of money is the rate of turnover of  money; the average number of times per year that a dollar is spent in buying the total amount of final goods and services produced in the economy.

Nominal Income Py Y  V     Quantity of Money M M

Liquidity Trap 

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This is an extreme case of ultrasensitivity of  the demand for money to interest rates. Under these circumstances, monetary policy has no effect on aggregate spending because changes in the money supply has no effect on interest rates.

Liquidity Trap MS0

MS1

   R

 ,   e    t   a    R    t   s   e   r   e    t   n    I

MS2

Money demand is very elastic so that very large changes in money supply are needed to get minimal change in interest rates.

Md

Quantity of Money

Is Money Demand sensitive to interest rates? 

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If interest rates do not affect the demand for money, velocity is more likely to be constant, or at least predictable. The evidence on interest rate sensitivity of  money demand found by various researchers is remarkably consistent: the demand for money is sensitive to interest rates, however it is not ultra-sensitive (i.e. little evidence that a liquidity trap has ever existed).