Economics 330
Lecture 14
We’ve spent time looking at the Keynesian Model, the ISLM Model, and the AD/AS Model. Before we go on to use the AD/AS Model to consider its implications let’s turn our attention to alternative approaches to the demand for money.
The four approaches to the demand for money that we will consider are
We can think of this as the Classical approach to the theory of money demand.
It is based on the Equation of Exchange
Where M = Money Supply, V = velocity, P = price level, Y = real GDP
If we look more closely at this equation we will see that PY is the price level times the level of real GDP, or in other words, nominal income. This equation suggests that there is a relationship between the level of the money supply and the level of nominal GDP.
But, what about velocity? What is this concept?
Velocity is the rate of turnover of money. It is the average number of times per year that a dollar is spent in buying the total amount of goods and services produced in an economy. What does a relatively low velocity mean? What does a relatively high velocity imply?
So, what determines velocity in the Classical Model?
Fisher thought that velocity was a function of the institutions that affect the way people make transactions.
Furthermore, Fisher believed that institutions changed slowly over time and thus, he concluded that velocity was fairly constant in the short run.
The Equation of Exchange is an IDENTITY: that is, it is a statement that is true by definition.
If we look at the Equation of Exchange we can note a few more things given our understanding of the Classical View of the Economy:
The Classical View holds that the price level changes only with changes in the money supply: a doubling of the money supply will result in a doubling of the price level.
So, how does the Equation of Exchange relate to money demand?
First, we can note that the money supply can be written as
And then, in equilibrium we know that the money supply equals money demand:
So,
Money demand = kPY where k = (1/v)
How do we interpret this?
For Fisher the demand for money is purely a function of income…interest rates have no effect on money demand. We can say that money demand is insensitive to interest rates.
Money Demand is a function then of the institutions in the economy affecting the way people make transactions (v, k), and the level of transactions generated by the level of nominal income (PY).
Marshall and Pigou thought that interest rate affects on the demand for money should not be ruled out.
Question: How much money would people want to hold, given a set of circumstances?
People hold money
· To carry out transactions: money as a medium of exchange
· As a store of wealth
Money demand = k PY where k is a constant of proportionality
These two approaches differ with regard to their initial starting points: the Classical View is a mechanical definition while the Cambridge Approach has a transaction focus. Yet, both approaches yield similar results.
For both of these approaches there’s a problem: velocity fluctuates too much to be considered a constant: so why didn’t the Classical Economists realize this?
Data on GDP and the money supply not readily available when these theories were being developed
Keynes’ Liquidity
Preference Theory
Keynes’ Theory of Demand for Money emphasizes the importance of interest rates
Money Demand is a function of transactions motive, precautionary motive, speculative motive.
· Transactions motive: money as a medium of exchange. This was assumed to be proportional to income
· Precautionary motive: assumed to be proportional to income
· Speculative motive: store of wealth: income and interest rates are important here
Keynes thought of consumers as having two choices:
1. Hold money or
2. Hold Bonds
As we talked about briefly in an earlier lecture, money carries no interest return and thus as interest rates increase the opportunity cost of holding money will increase. This implies that the relationship between interest rates and money demand is an inverse one.
Graph:
So, the demand for real money balances (Money Demand/Price Level) is a function of interest rates, and the level of income (or real GDP) in the economy.
***This is a real departure from Fisher because of the emphasis on the importance of interest rates and their impact on money demand. Keynes is less of a departure from the Cambridge School because they did not explicitly rule out the possibility that interest rates were related to money demand.***
It is interesting to note, however that Keynes’ approach can be mathematically examined to yield the result that velocity does not have to be a constant and instead can be a variable. In addition, this theory is able to explicitly model the idea that money demand is dependent on the level of the interest rate. Let’s look at these relationships in more detail.
Recent Developments in the Keynesian Approach: Keynes illustrated the importance of interest rates and their impact on speculative demand. Is it possible to illustrate the importance of interest rates with regard to transactions demand…after all, transactions demand is the most important of the three motives for holding money.
Let’s look at the Baumol-Tobin Transactions Demand Approach:
Initially:
If interest rates increase, then
When the interest rate increases, the individual reduces his cash holdings and his cash balances in order to earn more interest. Thus, Baumol and Tobin suggest that all three motives—transactions motive, precautionary motives, and speculative motives – are all inversely related to interest rates.
Friedman’s Modern
Quantity Theory of Money
Friedman wanted to apply the theory of asset demand to the demand for money
So, he theorized that money demand was a function of the resources available to individuals—i.e., wealth and expected returns on other assets relative to returns on money.
We can write these ideas as
Thus, Friedman suggests that
Let’s compare the Keynesian to Friedman Theories
|
Keynesian |
Friedman |
|
2 assets: money and bonds Importance of interest rates in determining the demand for money |
Includes many assets Includes many interest rates Money and goods are substitutes rm is not treated as a constant But, rb-rm is relatively constant since competition in the banking industry leads to adjustments in rm when rb changes (so, if rb changes then rm also changes Interest rates (ironically) have little effect on money demand. This is like the Quantity Theory of Money. |
Friedman’s Theory is essentially
· Relative unimportance of interest rates for Friedman
· Friedman views money demand as a stable function: random fluctuations in money demand are small
· Contrast this with Keynesians and their belief that money demand fluctuated a lot
· For Friedman velocity his highly predictable (it does not have to be a constant, but it is predictable)…let’s look at this …
· Friedman, thus, restates the Quantity Theory of Money because the money supply is the primary determinant of nominal income for Friedman’s Theory
To summarize
|
Keynesian |
Friedman/Monetarists |
|
Looks at motives for holding money New emphasis on the importance of interest rates Velocity is not a constant: velocity fluctuates as does the interest rate |
Uses the theory of asset demand Money demand is insensitive to interest rates Money demand function does not shift much and is stable Velocity is predictable Money is the primary determinant of aggregate spending Includes interest rates, but concludes they aren’t important |
Graphically, this means
Keynesians:
· Money demand bounces around a lot
· If the money supply is constant, then interest rates fluctuate a lot and there is instability in the economy
· Implication that the money supply needs to moved around to offset changes in money demand so that the interest rate stays constant
Monetarists:
· Money demand is fairly stable and what growth that occurs in money demand is fairly predictable
· If the money supply changes this will change interest rates and destabilize the economy
· Monetarists call for monetary growth rules so that the money supply and the money demand can grow together
Empirical Evidence on the
Demand for Money:
Two issues:
1. Is the demand for money sensitive to changes in interest rates?
2. Is the money demand function stable over time?
1. Sensitivity of money demand to changes in interest rates
· If money demand is insensitive then
· If money demand is sensitive then
2. Stability of money demand
· If money demand is unstable then