mishkin ch 19

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Chapter 19

The Demand

for Money

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Copyright 2007 Pearson Addison-Wesley. All rights reserved. 19-2

M= the money supply

P =price level

Y = aggregate output (income)P Y aggregate nominal income (nominal GDP)

V = velocity of money (average number of times per year that a dollar is spent)

V P Y

MEquation of Exchange

M V P Y

Velocity of Money

and Equation of Exchange

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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 resultssolely from change in the quantityof money

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Divide both sides byV

M =1

VPY

When the money market is in equilibrium

M = Md

Let k 1

V

Md k PY

Because kis constant, the level of tranactions generated by a

fixed level ofPYdetermines the quantity ofMd

The demand for money is not affected by interest rates

Quantity Theory of Money Demand

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Keyness Liquidity Preference Theory

Transactions Motive

Precautionary Motive

Speculative Motive

Distinguishes between real and nominal

quantities of money

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Md

P f(i,Y) where the demand for real money balances is

negatively related to the interest rate i,

and positively related to real income Y

Rewriting

P

Md

1

f(i,Y)

Multiply both sides by Yand replacingMdwithM

V PY

M

Y

f(i,Y)

The Three Motives

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The procyclical movement of interest rates should induce

procyclical movements in velocity

Velocity will change as expectations about future normallevels of interest rates change

The Three Motives (contd)

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There is an opportunity cost and benefitto holding money

The transaction component of the demand formoney is negatively related to the level ofinterest rates

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Precautionary Demand

Similar to transactions demand

As interest rates rise, the opportunity

cost of holding precautionarybalances rises

The precautionary demand for money is

negatively related to interest rates

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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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( , , , )

=demand for real money balances

= meausre of wealth (permanent income)

= expected return on money

= expected return on bonds= expected return on equity

= expected

de

p b m e m m

d

p

m

b

e

e

Mf Y r r r r r

P

M

P

Y

r

rr

inflation rate

Friedmans

Modern Quantity Theory of Money

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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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Differences between Keyness and

Friedmans Model

Friedman

Includes alternative assets to money

Viewed money and goods as substitutes

The expected return on money is not

constant; however, rbr

mdoes stay

constant as interest rates rise Interest rates have little effect on the

demand for money

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Differences between Keyness and

Friedmans Model (contd)

Friedman (contd)

The demand for money is stable

velocity is predictable Money is the primary determinant of

aggregate spending

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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 stabilityof the money demand function

Since 1973, instability of the money demandfunction has caused velocity to be harder to predict

Implications for how monetary policy shouldbe conducted

mishkin ch 19

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