Chapter Three

The demand for Money and other assets

3. 1. What is money demand?
– It is the demand for liquid asset.
– It is the stock of money that the public is willing
to hold at a particular time.
– The decision about money demand is part of a
broader portfolio decision.
– Because money is one from a wide range of
assets.
• How do people allocate their wealth among
various assets?
3/5/2024 Namo,Lecturer, DaDu 1
Determinants of the demand for asset
– The portfolio allocation decision depends on:
1. Wealth
– the total assets owned by the individual
– the quantity demanded of an asset is positively
related to wealth, ceteris paribus.
2. Expected return
– the return on asset expected over the next period
– Example: interest, dividend, capital gain.
– The quantity demanded of an asset is positively
related to its expected return relative to alternative
assets, ceteris paribus.

3/5/2024 Namo,Lecturer, DaDu 2

3. Risk:
– uncertainty associated with the return on one asset.
– The demand for an asset is negatively related to the risk of
its returns relative to alternative assets, ceteris paribus.
4. Liquidity:
– Ease & speed with which an asset can be turned into cash
– The quantity demanded of an asset is positively related to
its liquidity relative to alternative assets, ceteris paribus.
– Assets like automobiles (it take a long time & costs to
trade them).
• Asset demands
– Trade-off among expected return, risk and liquidity
– Assets with low risk and high liquidity, like checking
accounts, have low expected returns.
3/5/2024 Namo,Lecturer, DaDu 3
 The Demand for Money
– Refers to the quantity of monetary assets people want
to hold in their portfolios.
Determinants of Money demand
– Wealth, Expected return, Risk
– Liquidity, Payment technologies, etc
1. Wealth
– A rise in wealth increase money demand, but not by
much
– Part of increase in wealth is hold in the form of money.
2. Expected return
– Money pays a low return
– People's money-holding decisions depend on how
much they value liquidity against the low return on
money
3/5/2024 Namo,Lecturer, DaDu 4
3. Risk
– Increased riskiness in the economy may increase money
demand.
– Money demand rises when risk of alternative asset
increases.
– However, inflation increases risk to money & reduces its
demand
4. Liquidity
– Increase in Liquidity of alternative assets due to
deregulation, competition & innovation reduces the
demand for money.
5. Payment technologies
– Credit cards, ATMs and other financial innovations
reduce money demand.
3/5/2024 Namo,Lecturer, DaDu 5
Macroeconomic variables that affect money demand
– Price level, expected inflation
– Real income, Interest rates
1. Price level
– The higher the price level, the more money you need for
transactions.
– Nominal money demand is proportional to the price level
– A doubling the price doubles a dollars for a transaction.
2. A higher expected inflation
– a higher expected return on alternative assets.
– Makes assets like house more attractive (capital gain)
3. Real income
– Real income determines transaction demand.
– So money demand rises as real income rises.
3/5/2024 Namo,Lecturer, DaDu 6
• But, the rise in money demand is not proportional to real
income.
• Why?
– Higher-income individuals use money efficiently
– A country's financial sophistication grows as its income
rises (use of credit assets)
4. Interest rates
– An increase in the interest rate or return on non
monetary assets decreases the demand for money.
– There are non monetary assets with different interest
rates.
– They often move together & we assume one nominal
interest rate, i.
– The real interest rate, which affects saving and
investment decisions, is r = i – πe
– An increase in the interest rate on money increases
money demand. The nominal interest paid on money
is im
3/5/2024 Namo,Lecturer, DaDu 7
3.2. Rational for studying Demand for Money
– The demand for money can not be studied with the
framework of the general theory of demand.
– The general approach derives market demand for
goods and services from utility.
• Money does not fit very well into this framework.
– Money is not physically consumed
– It does not yield a flow of services that give satisfaction.
• It does not keep food fresh as a refrigerator does
• It does not provide entertainment as a television does
• It does not satisfy your thirsty as water does
• It does not earn interest as a bond does

3/5/2024 Namo,Lecturer, DaDu 8

• Utility theory cannot explain why money is held
– The demand for money is treated as a special case.
• Two peculiar and interrelated characteristics of money
are usually emphasized.
1. money is acceptable as a medium of exchange
2. market value of money, if not always stable, at least
highly predictable in the short run.
– This are the main reason why it is demanded.
• Money on hand is needed to undertake
transactions

3/5/2024 Namo,Lecturer, DaDu 9

• An individual may
– Buy income-earning asset when payment is received
– Sell it when payment is required
– Thus, never hold money.
• However,
– purchases &sales of assets take time, trouble &costly.
– income-earning asset may not be sold at any particular
moment at the price for which it was bought.
– There is an element of uncertainty involved and
possibility of capital losses.
– Such Costs and losses can be avoided by bridging the
gap between receipt of payments and making of
expenditure by holding money as a buffer stock.
3/5/2024 Namo,Lecturer, DaDu 10
Individual’s demand to hold money as a buffer stock
1. Money is readily acceptable in any transaction and its
value in terms of other goods is more predictable.
2. costs are involved in buying and selling income-
earning assets
3. the prices of income-earning assets can be uncertain
4. the timing of some market transactions is also
uncertain
5. economic agents are not quit certain that their current
receipts will match their current planned expenditure
due to unforeseen contingencies

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• Why we study money demand?
– To know the determinants of money demand
– To know the effect of change in money demand on
economy
• The accurate forecast of money demands helps in
determining the optimum growth rate of money supply.
• Essential for policy makers
• Deciding whether to target interest rate or money
to control inflation

3/5/2024 Namo,Lecturer, DaDu 12

3.3. Theories of demand for money
• Theories of demand for money are concerned with:
1. Why people hold money when they could instead be
holding stocks and bonds that yield a return?
2. What are the determinants of demand for money?
• Several explanations are offered to the questions.
– Quantity theory of money, liquidity preference,
– post Keynesians, Friedman’s theory of money
3.3. 1. Quantity theory of money(QTM)
• States that price level varies with the quantity of money
– directly and proportionately
• Two approaches to the quantity theory of money
1. The American version or cash transaction approach
2. The Cambridge version or cash balance approach
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• Fisher (1911):The Purchasing Power of Money

– the price level increases in direct proportion

– the value of money decreases and vice versa.
• Fisher’s equation of exchange
VM = PY --------------------------------------- (3.1)
Money spent=money received(value of goods sold)
M=Money, P=price, Y=output, V=velocity of money.
��
v = - - - - - - - - - - - - - - - - - - - - - - - - -(3.2)
�
• velocity: average number of times a dollar is exchanged
b/n a buyer and a seller .
• Example: If nominal GDP= PY =$5, M= $1,

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• Aggregate output (Y) is at full-employment level
• Velocity fairly constant in short run
ü Changes in M affect only the price level
• Velocity is determined by institutions that affect the way
individuals conduct transactions.
• If people use credit cards to conduct transactions,
– less money is required and velocity increase.
• If purchase with cash is more convenient,
– more money is used and velocity will fall.
• Institutions changes slowly overtime
– so velocity is .

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• Example: Given: Y=5trillion,V=5,M=$1 trillion, P= $1
a. What happens to price level when M becomes $2 trillion ?

Answer:P must double & become $2 for equation to hold

2 x $5 trillion = nominal income of $10 trillion
• Transforming equation of exchange into QTM
--------------------------------------- (3.3)
• At equilibrium, money (M) that people hold equals money
demand( �� ), so we can replace M by �� .
------------------------------------------ (3.4)
1
Where, k=
�
– The demand for money is purely a function of income
– Interest rate has no effect on the demand for money
– The institutions that affect
3/5/2024
the way people conduct is constant
Namo,Lecturer, DaDu 16
2. The Cambridge Approach
• economists in Cambridge University
– developed equation identical to Fisher's money
demand but their approach differs.
• Fisher studied money demand
– looking at the level of transaction
– institutions that affects the way people
conduct transactions,

3/5/2024 Namo,Lecturer, DaDu 17

 The Cambridge economists asked
• How much money individuals want to hold ?
1. It depends on the level of transactions
ütransaction is proportional to nominal income.
ühence money demand depends on income
2. It depends on the level of their wealth
– As wealth grows, asset holding (including money) grows.
– wealth component of �� is proportional to nominal income.
• Conclusion: �� is proportional to nominal income
�� = kPY --------------------------------------(3.5)
– K = is the fraction of money income held in cash.
– The demand for money implies a demand for cash balance.
– Cash balance is that proportion of the real income which the
people to hold in the form of money.
3/5/2024 Namo,Lecturer, DaDu 18
Theory of interest rate
• Interest rate can be defined as the "rental" price of money.
– It is earning for savers and cost for borrowers.
Classical theory of Interest
– Interest is the marginal productivity of physical capital.
– it is the reward paid to capital because it is productive
– Interest rate is determined by the supply and demand of capital.
Neo Classical theory of Interest
– Interest rate is the price of credit which is determined by the demand
and supply for loanable funds.
Keynes’s Liquidity Preference Theory of Interest
– Interest rate is the Price which equilibrates
.
– equilibrium rate of interest is determined by the interaction between
the liquidity preference function and the supply of money.
3/5/2024 Namo,Lecturer, DaDu 19
• Term Structure of Interest Rates
– ralates interest rates or cost of borrowing with the maturity of
the debt instruments.
– higher rates on longer-term bonds.
• Yield Curve
– depicts how interest rates for similar quality bonds change in
response to different maturity dates.
– plots interest rates on the y-axis and increasing time durations on
the x-axis.

3/5/2024 Namo,Lecturer, DaDu 20

• Explains why interest rate for different matirity move together.
Assumption: Bonds of different maturities are perfect substitutes
Implication: Re on bonds of different maturities are equal
• Consider two alternative investment strategies for a two-year time
horizon.
1. Invest in a two-year bond and hold it to maturity
• i2t is interest rate on 2 year bond bought today, t.
yields (1+i2t)(1+i2t) two years later.
2. Invest in two one-year bonds, one today& one when the first matures
• One-year bond today has interest it
• One year bond purchased in year 2 has interest i e t+1 , where e is
expected.
• One dollar invested today returns (1+it)(1+ iet+1)
3/5/2024 Namo,Lecturer, DaDu 21
Expected return from strategy 1
(� + ��� )(� + ��� )−� = � + �(��� ) + (��� )� − �
Since (i2t)2 is extremely small, expected return is: 2(i2t)
Expected return from strategy 2
• (� + �� )(� + �� �+� )−� = � + �� + �� �+� + �� (�� �+� ) − �
• Since �� (�� �+� ) is very small, expected return is: �� + �� �+�
• Expected returns of two strategies are equal
• Therefore: �(��� ) = �� + �� �+�
�� +�� �+�
Solving for i2t, ��� =
�
For n-period bond,
�� + �� �+� + �� �+� + … + �� � + (� − �)
��� =
�
Interest
3/5/2024 rate on a long-term bond is the
Namo,Lecturer, average of short term rates22
DaDu
• Example: Suppose One-year interest rate over the next
five years are expected to be 5%, 6%, 7%, 8%, and 9%
a. Compute Interest rate on two-year bond today:
(5% + 6%)/2 = 5.5%
b. Compute Interest rate for five-year bond today:
(5% + 6% + 7% + 8% + 9%)/5 = 7%
• Interest rate for one- to five-year bonds today:
5%, 5.5%, 6%, 6.5% and 7%
• Short and long rates move together
• If it, iet+1, iet+2 etc.  int 
• When short rates are low, they are expected to rise to
normal level
• When short rates are high, they are expected to fall in
future
3/5/2024 Namo,Lecturer, DaDu 23
Forecasting Interest Rates with the Term Structure
Pure Expectations Theory:
Invest in 1-period bonds or in a two-period bond 

• Solve for forward rate,

• Numerical example: it = 5%, i2t = 5.5%

3/5/2024 Namo,Lecturer, DaDu 24

 Forecasting Interest Rates with the Term
Structure
• Compare 3-year bond versus 3 one-year bonds

• Using derived in (4), solve for

Generalize to:

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3.3.2. Liquidity Preference Theory
– Developed by Keynes, who was at Cambridge.
– He postulated 3 motives behind demand for money:
1. Transaction motive: to make day-to-day transactions
– directly depends on the level of income
2. Precautionary motive : to meet unforeseen contingency
– holding money more than what is needed for planned
expense
– Example: making purchase at favorable price
– It is proportional to the level of income.
3. Speculative motive: liquidity preference demands.

3/5/2024 Namo,Lecturer, DaDu 26

• Money balance desired for transaction &
precautionary motives is a constant proportion (k)
of income.
�� = kPY --------------------------------- (3.6)
Where,
P= price, Y= output, k = factor of proportionality.
• In real terms, the demand for real balance:
��
= kY -------------------------------------- (3.7)
�
• Cash holdings are directly related to income.

3/5/2024 Namo,Lecturer, DaDu 27

• Speculative demand for money
– money is a store of wealth and this motive for
holding money is the speculative motive.
– Holding money to avoiding expected capital
losses.
– What influence the decisions of holding money?
• interest rates have an important role to play.
– For Keynes , assets to store wealth : Money
&Bond.
– Thus, there is an asset demand for money or
speculative demand or liquidity preference.

3/5/2024 Namo,Lecturer, DaDu 28

• Why individuals hold money rather than bonds?
– Hold money if the
– Keynes assumed that the return on money was zero
– checkable deposits did not have interest payment
• Why individuals hold bonds rather than money?
– Bond pays its owner a certain income per annum
– For bonds, there are two components of return:
• the interest payment & the expected capital gains

3/5/2024 Namo,Lecturer, DaDu 29

• The price of bond, depends on the rate of interest
– bond purchasers or holders wish to earn at least the
going rate of interest on their wealth in the form of bonds.
– Example: if the rate of interest is 5% an individual may
be willing to pay up to, no more than $100 for a bond that
offers an income of $5 per annum in perpetuity.
– However, if people expect the rate to increase to 10%,
no one is willing to pay more than $50 for the same bond.
• When interest rates rise, the price of a bond falls.
– newly issued bonds offer higher yields,
– existing bonds becomes less attractive (lower yield)
– this decreases the price of the existing bonds.
– capital losses for bond holders.
3/5/2024 Namo,Lecturer, DaDu 30
1. Bonds will be
– attractive when the rate of interest is expected to fall.
• the bondholders will benefit capital gain
– Unattractive when the rate of interest is expected to rise
• the bondholders will suffer capital losses.
2. Demand for money (transaction &Precautionary) will be
– low when the rate of interest is expected to fall.
• People hold bonds in anticipation of capital gain
– high when the rate of interest is expected to rise
• people seek to avoid capital losses on holding bonds.
• Keynes assumed that,
– individuals believe that there is a range of values
for interest rate that is regarded as normal towards
3/5/2024 which interest rates gravitate.
Namo,Lecturer, DaDu 31
• When current interest rate is below the normal range,
– People expect rise in interest rate on bonds
– expect to suffer capital loss on bond.
– Thus, individuals will hold money than bonds
• When interest rates are above the normal,
– people expect interest rates to fall, bond prices to rise
– Expect capital gains to be realized.
– demand for bonds will be more than demand for money
• As interest rate rise,
– opportunity cost of holding money increases
– relative expected return of money falls, demand for money
falls
• Therefore, money demand is inversely related to
the level of interest rate.
3/5/2024 Namo,Lecturer, DaDu 32
The speculative component of demand for money:
��
= �(r ) ---------------------------------- (3.8)
�
– Putting the three motives together, liquidity
preference:
��
= �(�) + �(r) -------------------------- (3.9)
�
– Disaggregation is not popular in academic literature.
– Keynes’s money demand function usually takes the
form.
��
= �(�, �)---------------------------------(3.10)
�

• The demand for real money balance is,

– negatively related to the interest rate
– positively related to real income.
3/5/2024 Namo,Lecturer, DaDu 33
• What is liquidity trap?

liquidity trap
• Situation in which at some low level of the rate of interest
– everyone expect the rate to rise and unwilling to hold bonds.
– the demand for money becomes perfectly elastic with the rate
of interest.
– The interest rate can fall no further
3/5/2024 Namo,Lecturer, DaDu 34
• At liquidity trap,
– Any increases in money will simply be absorbed
without any fall in interest rate.
– Keynes argued that the interest elasticity of the
demand for money at low level of the rate of interest
(below r*) could take the value infinity.
– This hypothesis implies when such circumstances
arise monetary policy is quit without effect and
fiscal policy being the only means of economic
control.

3/5/2024 Namo,Lecturer, DaDu 35

• Is velocity constant?
– velocity is not constant
– it fluctuates with interest rates
• The liquidity preference function can be written as
� 1
= ... ... ... .... ... ... ... ... ... ... . . (3.11)
�� �(�,�)
• Multiplying both sides by Y and recognizing that
�� =M, solve for velocity as:
�� �
�= = ... ... ... ... .... ... ... ... ... ... ... . . (3.12)
� �(�,�)
– when r goes up, f(Y, r) declines and velocity rises.
– A rise in interest rates encourages people to hold fewer
real balances for a given level of income; therefore
3/5/2024 the rate of turnoverNamo,Lecturer,
of money DaDu (velocity) must be higher.
36
Criticism against Keynes theory of money demand
1. Focuses only the choice between money & bond
2. Emphasized the difference between the current
and expected interest rate as the basis for
capital gain and losses on bond holding.
– He overlooked the possibility of net loss and net gain.
– though interest rate is expected to rise, there will be
• net loss if capital loss > the interest earnings
• net gain if capital loss < the interest earnings
• neither net loss nor net gain if capital loss is =
the interest earnings (income).
3. Why the c hoic e i s e i t h e r m o n e y o r b o n d s n o t t h e
composition of money Namo,Lecturer,
3/5/2024 and bond DaDu is not mentioned. 37
3.2.3.Post Keynesian Developments
• Neoclassical believes that Keynesian model lacks the
micro foundation: optimizing behavior of economic
agents.
• Baumol (1952) and Tobin (1956)
– Developed an inventory-theoretic model to show how
tra nsa ction deman d is influenced by interest ra te.
– Balances set aside for transactions purposes are held
temporarily in the form of securities, which may be
converted into money when needed to pu rchase
goods and services.

3/5/2024 Namo,Lecturer, DaDu 38

• Assumptions and notations:
– an individual receives a income(Y) once a period and
spends it over the course of this period.
– All purchases are evenly spread over the period &
paid in cash
– Income is earned at the start of each period
– Deposits in saving account earns interest (r).
– number of trips to the bank to withdraw money
from savings account (N)
– cost of a trip to the bank (C)
– The number of times you go bank determines the
amount of money you hold
3/5/2024 Namo,Lecturer, DaDu 39
• Note: If a person earn Y at the beginning of each
month and make withdrawal on the first day ofthe
�
month, his average money holding is: �� =
�
• Money =Y on the first day of the month
• Money= 0 on the last day of each month
3/5/2024 Namo,Lecturer, DaDu 40
• Note: If a person earn Y at the beginning of each month and make
withdrawal two times: On the 1 st day of the 1 st week and On the 1 st
day of the 3 rd week
�
• Money = On the 1st day of the 1st week
2
• Money= 0 On the last day of the 2nd week
�
• Money = On the 1st day of the 3rd week
2
• Money= 0 on the last day of the 4th Week
�
• �� =
�
3/5/2024 Namo,Lecturer, DaDu 41
• Note: If a person earn Y at the beginning of each
month and make withdrawal three times:
�
– On the 1stday, Money = ,On the end of 10th day, Y=0
�
– On the 11 th day, Money =0,On the end of 20th day, Y=0
�
– On 21 th day, Money = ,On the end of 30th day, Y=0
�
�
�� =
�
3/5/2024 Namo,Lecturer, DaDu 42
• In general, households' average money holdings
= Y/2N
�
Mb = ... ... ... ...... ........ . . (3. 13)
2�
�
– cost associated with holding cash balance
��
is given by: Foregone interest = r(Y/2N)
– Transaction costof making frequent visits
to the bank for cash withdrawals or buying
&selling of bonds
– Cost of N trips to bank = cN
�
• Total cost: ��= r +�� ... .... ... . (3. 14)
3/5/2024 ��
Namo,Lecturer, DaDu 43
• A rational household choose N that minimizes the cost
given Y,r, and c
• Take the derivative of total cost with respect to N, set it
equal to zero:
�
−� +� = 0
2�2
• Solve for the cost-minimizing N*
��
N*= ............................ ......... ..... (3.15)
2�
• Plug N* into the expression for average money holdings:
��
• Average Money Holding =M= .......................(3.16)
2�
• Money demand depends positively on Y and c, and
negatively on r.
3/5/2024 Namo,Lecturer, DaDu 44
• This is known as Baumols’ square root rule
– transactions money demand depends directly on Y and
inversely on r
• Implication of Baumol-Tobin analysis to velocity
– let us assume the individual repeatedly receives $1000
payment per month which he put into cash
– This process repeats monthly and his average money balance
during the course of the year is $500.
– Since his yearly nominal income is $12,000 and his holding
of money averages out to $500,
– velocity of money (V= PY/M) is $12,000/$500) is equal to 24.
– If cash withdrawal is made twice and four times per period,
velocity will be 48 and 96 respectively.
• As interest rate increase, the cash held for transaction
purpose will decline and
3/5/2024 velocity
Namo,Lecturer, DaDu will increase. 45
3.2. 4. Friedman 's Theory of Money Demand:
– Is the general Theory of Money Demand
– In 1956, Milton Friedman developed a general
theory of money demand.
– Friedman stated that the demand for money must be
influenced by some factors that influence the demand
for any asset.
– Friedman thus applied the theory of asset demand to
money.
– The theory of asset demand indicates that the demand
for money should be a function of the
– Resources availableto the individual(wealth)
– the expected returns on the other assets relative
to the expected return on money .
3/5/2024 Namo,Lecturer, DaDu 46
• Friedman demand for money is given as
follows:
�� �� �� − �� �� − �� �� − ��
=� , , ,
� + − − −
��
Where, = demand for real money balances
�
�� = permanent income (measure of wealth)
�� = expected return on money
�� = expected return on bonds
�� = expected return on equities
�� = expected inflation rate
• The signs underneath indicate whether the
demand for money is positively related or
negatively related to t h e term s that are
immediately above them.
3/5/2024 Namo,Lecturer, DaDu 47
• Money demand is positively related to wealth
– The last three terms in the money demand function.
• Indicates the expected return from assets relative to money
• as each term rises, the demand for money will fall.
• As the expected return on bonds and equity relative
to money rise, the demand for money falls.
• As expected return on goods relative to money
(� � − � � )rises, the demand for money falls.
• Expected return on money (�� ) is influenced by:
1. Services provided by banks on deposits included
in the money supply
– When services are increased, the �� rises.
2. The interest payments on money balances.
– As interest payments rise, the �� rises.
3/5/2024 Namo,Lecturer, DaDu 48
Friedman and Keynesian theories
1. By inc luding m any assets as alternative to m on e y,
Friedman recognized that more than one interest rate is
important to the operation of aggregate economy. Keynes
lumped financial assets other than money into bonds
2. In contrast to Keynes, Friedman viewed money & goods as
substitutes; people choose between them when deciding how much
money to hold.
3. Friedman did not take the expected return on money to be constant,
as did Keynes.
• Friedman
– Interest rates have little effect on the demand for money
– Permanent income is the primary determinant of money demand
– Velocity of money is predictable since relationship between Y
and Yp is predictable
V = Y/ f( Yp)
3/5/2024 Namo,Lecturer, DaDu 49
3.3. Empirical evidence on Demand for Money
– Money demand is one of the mostly researched topics in
economics.
• 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
stability of the money demand function
– Since 1973, instability of the money demand
function has caused velocity to be harder to
predict
• Implications for how monetary policy should be
conducted
3/5/2024 Namo,Lecturer, DaDu 50
• Empirical results for developing countries:
– although the sign of r is negative, it is not significant
because people are not sensitive to interest rate.
• Currency substitution (holding money in
foreign currency) is more significant
– When people expect domestic currency to depreciate,
they prefer to hold their money in foreign currency
– decrease in interest rate
– Capital outflow
– Depreciation of domestic currency
– Currency substitution rather than increase in
demand for bond !
3/5/2024 Namo,Lecturer, DaDu 51
 End of The Chapter!

3/5/2024 Namo,Lecturer, DaDu 52