Download (classical) theory of the demand for money

MONETARY POLICY
Lecture 7
MONETARY THEORY:
DEMAND FOR MONEY
Introduction to Ch. 20 „Quantity Theory, Inflation, and the
Demand for Money” (Mishkin, F.S.):
• „In earlier chapters, we spent a lot of time and effort
learning what the money supply is, how it is determined,
and what role the Federal Reserve System plays in it.
• Now we are ready to explore the role of the money
supply in determining the price level and total production
of goods and services (aggregate output) in the
economy.
• The study of the effect of money on the economy is
called monetary theory.” (Mishkin, F.S.)
• „The supply of money is an essential building block in
understanding how monetary policy affects the economy.
• … Another essential part of monetary theory is the
demand for money.
• … This chapter describes how the theories of the
demand for money have evolved.
• We begin with the classical theories refined at the start
of the twentieth century by economists such as Irving
Fisher and Alfred Marshall … ; then we move on to the
Keynesian theories of the demand for money.
• We end with Milton Friedman’s modern quantity theory.”
(Mishkin, F.S.)
Classical Quantity Theory of Money
• is developed by the classical economists in the
nineteenth and early twentieth centuries.
• 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 also a
(classical) 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.
Irving Fisher (1911):
„ The Purchasing Power of Money”
• Fisher wanted to examine the link between the total
quantity of money M (the money supply) and the total
amount of spending on final goods and services
produced in the economy P∙y
– where P is the price level and y is aggregate real output (real
income)
– Note: Simbol „y” is partly different than in Mishkin’s book.
Mishkin uses „Y” for real income.”
– Note: total spending P∙y = aggregate nominal income for the
economy = nominal GDP
• The concept that provides the link between M and P∙y is
called the velocity of money (the rate of turnover of
money);
• The velocity of money is the average number of times
per year that a dollar is spent in buying the total amount of
goods and services produced in the economy.
• The velocity V is defined more precisely as total spending
P∙y divided by the quantity of money M.
• If, for example, nominal GDP (P∙y ) in a year is $5 trillion
and the quantity of money is $1 trillion, velocity is 5,
meaning that the average dollar bill is spent five times in
purchasing final goods and services in the economy.
By multiplying both sides of
by M, we obtain the equation of exchange, which relates
nominal income to the quantity of money and velocity:
• The equation of exchange thus states that the quantity of
money multiplied by the number of times that this money
is spent in a given year must be equal to nominal income
(the total nominal amount spent on goods and services
in that year).
• Irving Fisher reasoned that velocity is determined by the institutions
and technological features in an economy.
– If, for example, people use credit cards to conduct their transactions
(and consequently use money less often when making purchases), less
money is required to conduct the transactions generated by nominal
income, and velocity will increase.
– Conversely, if it is more convenient for purchases to be paid for with
cash or checks (both of which are money), more money is used to
conduct the transactions generated by the same level of nominal
income, and velocity will fall.
• Fisher took the view that the institutional and technological
features of the economy would affect velocity only slowly over time,
so velocity would normally be reasonably constant in the short
run.
• This view (V = const.) transforms the equation of exchange into the
classical quantity theory of money: When the quantity of money
M doubles, M∙V doubles and so must P∙y (nominal income P∙y will
double).
• Because the classical economists (including Fisher) thought that
wages and prices were completely flexible, they believed that the
level of aggregate output y produced in the economy during normal
times would remain at the full-employment level, so y in the
equation of exchange could also be treated as reasonably
constant in the short run.
If V = constant, and y = constant:
The classical quantity theory of money then implies
that if M doubles, P must also double in the short
run, because V and y are constant.
According to the classical quantity theory of money:
changes in the quantity of money lead to
proportional changes of the price level.
A critical thinking about the classical quantity
theory of money and questions for students
• If velocity and aggregate
output are reasonably
constant (as the classical
economists believed),
what happens to the price
level when the money
supply increases from $1
trillion to $4 trillion?
• If velocity and aggregate
output remain constant at
5 and 1,000, respectively,
what happens to the price
level if the money supply
declines from $400 billion
to $300 billion?
Transformation of the quantity theory of money
into the (classical) theory of inflation
• Do you remember the mathematical rules that the percentage
change (%∆) of a product of two variables is approximately equal to
the sum of the percentage changes of each of these variables?
• Using this mathematical fact, we can rewrite the equation of
exchange as follows:
• Inflation rate is the growth rate of the price level, that is
•
In this case:
• Since classical theory assume that velocity of money is constant (its
growth rate is zero), the classical quantity theory of money is also a
(classical) theory of inflation:
• The classical quantity theory of inflation indicates that the inflation rate
equals the growth rate of the money supply minus the growth rate
of aggregate output .
TODAY VIEW ON THE CLASICAL QUANTITY THEORY OF INFLATION:
• It is a good theory of inflation in the long run, but not in the short
run.
Classical Quantity Theory of Money Demand
• When the money market is in equilibrium, the quantity of
money M that people hold equals the quantity of money
demanded Md, so we can replace M in the equation by Md.
Money supply = Demand for money; Ms = Md
• Because the quantity theory of money tells us how much
money is held for a given amount of aggregate income, it
is in fact a (classical) theory of the demand for money.
• The equation of exchange can be rewriting as:
• According to further contributions in development of the quantity
theory of money demand (eg. in the works of Alfred Marshall), we
can use the Marshall’s coefficient k to represent the quantity 1/V and
rewrite the equation as:
or
, where Y is nominal income.
CONCLUSION: Fisher’s quantity theory of money suggests that the demand
for money is purely a function of nominal income, while interest rates
have no effect on the demand for money.
The demand for money is determined:
1. by the level of transactions generated by the level of nominal income P∙y
2. and by the institutions in the economy that affect the way people conduct
transactions and thus determine velocity V and hence coefficient k.
A critical thinking about the classical quantity
theory of money and questions for students
• What happens to nominal GDP if the money
supply grows by 20% but velocity declines by
30%?
• Is the classical view that velocity can be treated
as a constant supported by the data?
• How would you expect velocity to typically
behave over the business cycle?
Is Velocity a Constant?
What we see in Figure is that even in the short run, velocity fluctuates too
much to be viewed as a constant.
Velocity actually falls (or at least its rate of growth declines) in years when
recessions are taking place. After 1950, velocity appears to have more
moderate fluctuations.
• Unrelated to the theory, what we now about the
relationship between nominal money demand
and price level?
• If price increases by 10%, people will hold more
of money to buy the same bundle of goods.
• For example, if you spent $20 to buy a cup of
tea and a toast before, now you need to hold $2
more to buy the same bundle.
• The quantity of nominal money demanded is
proportional to the price level.
And about the relationship between nominal
money demand and real GDP ????
• Money holdings depend upon planned spending.
• The quantity of money demanded in the
economy as a whole depends on real GDP.
•
• Higher income leads to higher expenditure.
People hold more money to finance the
higher volume of expenditure.
• 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:
1. the transactions motive,
2. the precautionary motive,
3. and the speculative motive.
1. The transactions motive
• individuals hold money because it is a medium of
exchange
• this component of the demand for money is determined
primarily by the level of people’s transactions
• like the classical economists, Keynes took the
transactions component of the demand for money to be
proportional to income.
2. The precautionary motive
• (in addition to holding money to carry out current
transactions), people hold money as a cushion against
an unexpected need
• the demand for precautionary money balances is
proportional to income
3. The speculative motive
• Keynes took the view that money is a store of wealth and
called this reason for holding money the speculative motive.
• The speculative component of money demand would be related to income
but more to interest rates as the factor that influence the holding of money
as a store of wealth.
– Keynes divided the assets that can be used to store wealth into two categories: money
and bonds. He then asked the following question: Why would individuals decide to hold
their wealth in the form of money rather than bonds?
– If interest rates are below normal value, individuals expect the interest rate on bonds to
rise in the future and so expect to suffer capital losses on them. (Note: when interest
rates rise, the price of a bond falls). As a result, individuals will be more likely to hold
their wealth as money rather than bonds, and the demand for money will be high.
• From Keynes’s reasoning, as interest rates rise, the demand
for money falls, and therefore money demand is negatively
related to the level of interest rates.
• Keynes reasoned that people want to hold a certain amount of real
money balances (the quantity of money in real terms)
• an amount that his three motives indicated would be related to real
income y and to (nominal) interest rates i.
• Keynes wrote down the following demand for money equation, known
as the liquidity preference function, which says that the demand
for real money balances Md/P is a function of (related to) i and y.
• the demand for real money balances is negatively related to the
interest rate
• demand for real money balances and real income are positively
related
• The liquidity preference equation can be rewritten as:
• According to this, the velocity can be rewritten as:
• Keynes’s theory of the demand for money implies that velocity is not
constant, but instead fluctuates with movements in interest rates.
• interest rates are procyclical, rising in expansions and falling in
recessions
• The procyclical movements of interest rates should induce
procyclical movements in velocity
• a rise in interest rates will cause velocity to rise also
• William Baumol and James Tobin independently
developed similar demand for money models, which
demonstrated that even money balances held for
transactions purposes are sensitive to the level of
interest rates.
• the transactions component of the demand for money is
the function of income and is negatively related to the
level of interest rates.
• the precautionary demand for money is is the function of
income and is negatively related to interest rates
Unrelated to the theory, what we now about the relationship
between nominal money demand and interest rates ?
• The opportunity cost of holding money is
the interest a person could earn on assets
they could hold instead of money (time
deposits, bonds ….).
• Higher interest rate (higher opportunity
cost) causes lower money demand.
• Note: Money = currency + deposit money
• In 1956, Milton Friedman developed the modern
quantity theory of the demand for money in a famous
article, “The Quantity Theory of Money: A Restatement.”
• Although Friedman frquently refers to Irving Fisher 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 simply stated that the demand for money must
be influenced by the same factors that influence the
demand for any asset.
• Friedman then 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 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 a
certain amount 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:
• Unlike Keynes’s theory, which indicates that interest rates are an
important determinant of the demand for money, Friedman’s theory
suggests that changes in interest rates should have little effect
on the demand for money.
• Therefore, Friedman’s money demand function is essentially one in
which permanent income is the primary determinant of money
demand, and his money demand equation can be approximated by:
The second issue Friedman
stressed is the stability of the
demand for money function, while
the relationship between Y and Yp
is usually quit predictable. .
• When combined with his view that the demand for money is
insensitive to changes in interest rates, this means that velocity is
highly predictable.