LECTURE TWO:

DEMAND FOR MONEY

BY
MR. B. M. SIMAUNDU
LECTURE OUTLINE

After studying this unit you should be able to;

 Describe how the demand for money is determined
 Define the theories of the demand for money (classical and Keynesian
theories and Milton Friedman's reformulation of the quantity theory of
money)
 Present empirical evidence on how the demand for money is affected by
changes in interest rates and the level of income
INTRODUCTION
 The study of the effect of money on the economy is called monetary theory, and
we examine this branch of economics in the next chapters.
 When economists mention supply, the word demand is sure to follow, and the
discussion of money is no exception.
 The supply of money is an essential building block in understanding how
monetary policy affects the economy, because it suggests the factors that
influence the quantity of money in the economy.
 Not surprisingly, another essential part of monetary theory is the demand for
money.
CENTRAL QUESTION IN MONETARY THEORY!

 A central question in monetary theory is whether or to what

extent the quantity of money demanded is affected by changes
in interest rates.
 Because this issue is crucial to how we view money's effects on
aggregate economic activity, we focus on the role of interest
rates in the demand for money.
CONT’D

 The demand for money comes from the public (excluding the producers of money).
 The supply of money is made by its producers, i.e., the government and the banking
system.
 The money market comprise of those who demand and supply money.
 The study of the nature and determinants of demand and supply functions is
necessary because of the fact that changes in demand and supply of money tend to
influence greatly the price level, the interest rate and the real income.
 The present unit makes a general survey of the various developments in theories of
demand for money.
CLASSICAL THEORY OF DEMAND FOR MONEY

 The classical theory of demand for money is presented

in the classical quantity theory of money and has two
approaches: the
 Fisherian approach and the
 Cambridge approach.
WHAT IS THE DEMAND FOR MONEY?

 • How much money would you like to have?

 • One billion?
 • Two? That can’t be it.
 • Instead ‘How much money (currency and bank deposits) do you wish to
hold, given your total wealth.’
 In monetary economics, the demand for money is the desired holding of financial
assets in the form of money: that is, cash or bank deposits rather than
investments. It can refer to the demand for money narrowly defined as M1
(directly spendable holdings).
QUANTITY THEORY OF MONEY

 Developed by the classical economists in the nineteenth and early twentieth

centuries, the quantity theory of money is a theory of how the nominal value of
aggregate income is determined.
 Because it also tells us how much money is held for a given amount of aggregate
income, it is a theory of the demand for money.
 The most important feature of this theory is that it suggests that interest rates have
no effect on the demand for money.
FISHERIAN APPROACH/ FISHERS QUANTITY THEORY OF
MONEY

 To the classical economists, the demand for money is transactions demand

for money.
 Money is demanded by the people not for its own sake, but as a medium of
exchange.
 Thus, the demand for money is essentially to spend or for carrying on
transactions and thus is determined by the total quantity of goods and
services to be transacted during a given period.
 Further, the demand for money also depends upon velocity of circulation of
money
FISHER’S TRANSACTIONS MODEL (EQUATION OF
EXCHANGE (1))

 The theory: for a given level

of output, the price level is
proportional to the quantity
of money.
 This theory is made explicit
in the equation of exchange.
VELOCITY OF CIRCULATION

 As noted earlier on in the introduction topic, the velocity of money is the

average number of times per period (year) a unit of currency (dollar) is
used in making a transaction.
 The velocity of money is governed by the nature and sophistication of the
payments system in the society, and therefore changes slowly over time.
 The velocity of money is not related to any of the other variables in the
model, so can be considered exogenous or fixed with respect to these
equations
EQUATION OF EXCHANGE (2)
VELOCITY OF MONEY
 The income velocity of money is the average number of times per period
(year) a unit of currency (dollar) is spent in producing GDP (total economic
activity).
As with the transactions velocity of money:
 The income velocity of money is governed by the nature and sophistication of
the payments system in the society, and therefore changes slowly over time.
 The income velocity of money is not related to any of the other variables in
the model, so can be considered exogenous or fixed with respect to these
equations.
CAMBRIDGE APPROACH
 While Fisher was developing his quantity theory approach to the demand for money, a group
of classical economists in Cambridge, England led by Alfred Marshall and A. C. Pigou, came to
similar conclusions, although with slightly different reasoning.
 They derived Equation 3 by recognizing that two properties of money motivate people to
hold it: its utility as a medium of exchange and as a store of wealth.
 While Fisher's transactions approach emphasized the medium of exchange function of
money, the Cambridge cash-balance approach is based on the store of value function of
money.
 According to the Cambridge economists, the demand for money comes from those who
want to hold it for various motives and not from those who want to exchange it for goods
and services.
CAMBRIDGE “CASH-BALANCES” MODEL (EQUATION OF
EXCHANGE (3))
CONT’D

 The Cambridge model is closer

 If M = kPY, and k and Y are determined
to a modern theory of money separately from money (M) and prices
demand. (P), then M↑⇒ P↑.
 Implies that people hold money  All else equal, inflation (rising prices)
even if they only have a are caused by increasing the money
transactions motive. supply.
 The price level is proportional to the
 Challenged by John Maynard money supply.
Keynes.
KEYNES'S LIQUIDITY PREFERENCE THEORY

 In his famous 1936 book The General Theory of Employment, Interest, and
Money, John Maynard Keynes abandoned the classical view that velocity
was a constant and developed a theory of money demand that
emphasized the importance of interest rates.
 His theory of the demand for money, which he called the liquidity
preference theory, asked the question:
 Why do individuals hold money? He postulated that there are three
motives behind the demand for money: the transactions motive, the
precautionary motive, and the speculative motive.
PUZZLE

 Why hold any money at all?

 It pays no interest.
 It loses purchasing power to inflation.
MOTIVES FOR HOLDING MONEY

 1.To settle transactions. What does it cost to hold money?

 Money is the medium of exchange.  The interest you could have earned!
 That is the opportunity cost.
 2. As a precautionary store of
liquidity. Money is the most liquid of  At today’s T bill yield, what does it cost you
to hold an extra K10,000?
all assets.
 The optimal amount of money to hold is
 3. For Speculative motive. To the amount that balances the benefits of
reduce the riskiness of your portfolio. holding money against the opportunity
Money is the least risky of all assets. cost.
MODERN QUANTITY THEORY

 Friedman’s Modern Quantity Theory of Money

 In 1956, Milton Friedman developed a theory of the demand for
money in a famous article, “The quantity Theory of Money: A
restatement” Although Friedman’s frequently refers to Irving
Fishers and the quantity theory, his analysis of the demand for
money is actually closer to that of Keynes than it is to Fisher’s.
FRIEDMAN’S MODERN QUANTITY THEORY OF
MONEY

 The theory of assets demand indicates that demand for money should be
a function of the resources available to individuals (their wealth) and the
expected returns on other assets relative to the expected return on
money.
 Like Keynes, Friedman recognized that people want to hold certain
amounts of real money balances (the quantity of money in real terms).
 From this reasoning, Friedman expressed his formulation of the demand
for money as follows:
CONT’D

 Where;
 Md/P =Demand for real money balances
Yp= Friedman’s measure of wealth, known as
permanent income (technically , the present
discounted value of all expected future
income, but more easily described as
expected future income, but more easily
described as expected average long run
income).
CONT’D

 Because the demand for an asset is positively related to the wealth, money demand is
positively related to Friedman’s wealth concept, permanent income (indicated by the
plus sign).
 Unlike our usual concept of income, permanent income (which can be thought of as
expected average long run income) has much smaller short run fluctuations, because
many movements of income are transitory (short lived).
 For example, in a business cycle expansion, income increases rapidly, but because
some of the increase is temporary, average long run income does not change very
much.
 Hence in a boom, permanent income rises much less than income.
CONT’D

 During a recession, much of the income decline is transitory,

and average long run income (hence permanent income) falls
less than income.
 One implication of Friedman’s use of the concept of permanent
income as a determinant of the demand for money is that the
demand for money will not fluctuate much with business cycle
movements.
THREE TYPES OF ASSETS AS CATEGORIZED BY FRIEDMAN

 An individual can hold wealth in several forms besides money; Friedman categorized
them into three types of
 assets: bonds, equity (common stock) and goods.
 The incentives for holding these assets rather than money are represented by the
expected return on each of these assets relative to the expected return on money,
the last three terms in the money demand function.
 The minus sign beneath each indicates that as each term rises, demand for money
will fall.
FACTORS AFFECTING EXPECTED RETURN
 The expected return on money rm, which appears in all three terms, is
influenced by two factors:
 i. The service provided by banks on deposits included in the money supply,
such as provision of receipts in the form of cancelled checks or the automatic
paying bills.
 When these services are increased, the expected return from holding money
rises.
 ii. The interest payments on money balances. Now accounts and other
deposits that are included in the money supply currently pay interest.
CONT’D

 As these interest payments rise, the expected return on money

rises.
 The term rb-rm and re-rm represent the expected return on bonds
and equity relative to money; as they rise, the relative expected
return on money falls, and the demand for money falls.
 The final term represents the expected return on goods relative to
money.
EMPIRICAL EVIDENCE ON THE DEMAND FOR MONEY

 As we have seen, the alternative theories of the demand for money can have very
different implications for our view of the role of money in the economy.
 Which of these theories is an accurate description of the real world is an important
question, and it is the reason why evidence on the demand for money has been at
the center of many debates on the effects of monetary policy on aggregate economic
activity.
INTEREST RATES AND MONEY DEMAND

 Earlier in the chapter, we saw that if interest rates do not affect the demand for
money, velocity is more likely to be constant or at least predictable.
 However, the more sensitive the demand for money is to interest rates, the more
unpredictable velocity will be, and the less clear the link between the money supply
and aggregate spending will be.
 Indeed, there is an extreme case of ultra sensitivity of the demand for money to
interest rates, called the liquidity trap, in which monetary policy has no direct effect
on aggregate spending, because a change in the money supply has no effect on
interest rates.
DISCUSSION POINT

 Here we examine the empirical evidence on the two primary issues

that distinguish the different theories of money demand and affect
their conclusions about whether the quantity of money is the
primary determinant of aggregate spending:
 Is the demand for money sensitive to changes in interest rates, and
 is the demand for money function stable over time?
 What is the difference between monetarists and Keynesians?
THE END QUESTIONS???