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Overview of Chapter 19 The Demand
for Money
• We have learned a bit about the money
supply, how it is determined, and what
role the Federal Reserve (FED) plays in it.
• Now we are going to learn 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.
Overview of Chapter 19 The Demand
for Money
• When economists mention supply, the
word demand is sure to follow.
• 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 – the
focus of this chapter.
VOCABULARY and NEW TERMS
• Aggregrate = total
• Monetary theory = study of effect of money
• Velocity of Money = the average amount of
time the dollar is spent for goods in a year
• Quantity theory of money
• Liquidity Preference Theory
• Transactions Motive
• Precautionary Motive
• Speculative Motive
VOCABULARY and NEW TERMS
•
•
•
•
•
•
Proportional = a part of, or a percentage of
Fluctuate = goes up and down
Incentives = a reward
Expansionary = growing, expanding
Liquidity trap
Ultrasensitive = super sensitive
Overview of the Money Supply Process
• Money supply is influenced by 4
players
–Federal Reserve
–Depositors
–Banks
–Borrowers
The Key Players in the Money
Supply Process
• Federal Reserve influences the money
supply by controlling the required
reserve ratio
• Depositors influence the money supply
process through:
–Decisions about the currency ratio
The Key Players in the Money
Supply Process
• Banks influence the money supply process
through:
– Their decisions about the excess reserve
ratio
• Some of which is affected by their
expected deposit outflows
• Expected deposit outflows is affected
also by individuals (depositors)
Interest Rates and the Money
Supply Process
•Market interest rates
influence the money
supply process through:
–The excess reserve
ratio
MONETARY THEORY
• Monetary Theory
– The study of the effect of money on the economy
• Talking about how the theories of the demand
for money have evolved
• Central question in monetary theory is does it
have an effect on interest rates?
If it does, then how much of an effect will it have?
Quantity Theory of Money
• Developed late 19th century early 20th century
• Quantity Theory of Money is a theory of how
the nominal (does not include inflation)value
of aggregate (total) income is determined
• This theory actually suggests that the interest
rate has no effect on the demand for money
Velocity of Money
• American economist Irving Fisher wanted to
examine the relationship between money
supply (M) and the total amount of spending
on goods and services produced in the
economy (P x Y) (nominal GDP-which does not
include inflation).
• The concept that provides the link between M
and (P x Y) is called velocity of money
Velocity of Money
• Velocity of Money
– The average number of times per year
(turnover) that a dollar is spent in buying
the total amount of goods and services
produced in the economy
• Rate at which money is exchanged from one
transaction to another
• Rate at which money in circulation is used for
purchasing goods and services.
– This helps investors gauge how robust the
economy is
Velocity of Money
• If nominal GDP (P x Y) in a year is $5 trillion
and the quantity of money (money supply) is
$1 trillion
– The velocity is 5 – meaning that the average dollar
bill is spent five times in purchasing final goods
PxY
V
M
Equation of Exchange
• Multiply both sides of the equation by M
– Now have the equation of exchange
• Equation of Exchange
– Relates nominal income (GDP) to the quantity of
money and velocity
MxV  PxY
Equation of Exchange
• States that the number of times
that this money is spent in a
given year must equal the total
amount spent on goods and
services in that year (GDP –
output)
Equation of Exchange
• Fisher took the view that institutional
and technological features of the
economy would affect the velocity of
money
–But only slowly over time
• It is reasonable to assume that velocity
would be reasonably constant in the
short-run
Quantity Theory
• Fisher’s view that velocity is fairly
constant in the short run transforms the
equation of exchange into Quantity
Theory of Money
• Quantity Theory of Money
–Nominal income is determined only by
movements in the quantity of money
Quantity Theory
• To see how this works,
assume the V = 5, GDP = $5
trillion, and M = $1 trillion
• M changes to $2 trillion –
then GDP doubles to $10
trillion
Quantity Theory
• Back in the old days, it was thought that
wages and prices were flexible
–The believed that the level of
aggregate output (Y) (goods and
services) produced in the economy
during normal times would remain at
the full-employment level
• So Y in the equation of exchange could
also remain constant
Quantity Theory
•Quantity theory of
money then implies that
if the money supply (M)
doubles, P (prices) must
also double
Quantity Theory
• It provides an explanation of
movements in the price level:
• Movements in the price level
result solely from changes in the
quantity of money
Quantity Theory of Money Demand
• Because the quantity theory of money tells us
how much money is held for a given amount
of GDP (aggregate income)
– It is a theory of the demand for money
• See this by dividing both sides of the equation
by V to solve for M
1
M   PY
V
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
–M = Md
• Remember V is constant, so 1 / V is
constant
–Represented by k
Quantity Theory of Money Demand
M  k  PY
d
Keynes’s Liquidity Preference Theory
• John Maynard Keynes realized that velocity
was not a constant and developed a theory of
money demanded that focuses on the
importance of interest rates
• Theory of demand for money is called
liquidity preference theory
– Asks the question, “why do people hold money?
Keynes’s Liquidity Preference Theory
• He said there were 3 motives
behind the demand for
money:
–Transactions motive
–Precautionary motive
–Speculative motive
Transactions Motive
• Hold money to carry out everyday
transactions
• The amount of transactions we make
on a daily basis is determined by our
level of income
–Proportional
Precautionary Motive
• People hold money as a cushion against an
unexpected need
• Precautionary money balances people want to
hold are determined primarily by the level of
transactions that they expect to make in the
future
– Those transactions are proportional to
income
• He is assuming that the demand for
precautionary money balances is proportional
to income
Speculative Motive
• People also hold money as a store of
wealth
–Called this reason speculative motive
• Our amount of wealth is closely tied with
income, therefore, this component of
money demand is also related to income
• Not just income that affects why hold
money as a store of wealth
Speculative Motive
• Interest rates would also have an affect on the
amount of money we hold in wealth
• Store wealth in assets. Keynes will assume
that there are only 2 categories:
– Money and Bonds
• Assumes that individuals believe that interest
rates will move toward some normal value
Speculative Motive
• If interest rates are below this normal level,
then individuals will expect them to rise
– As interest rates rise, the price of bonds will
decrease and they will suffer a capital loss
– Individuals are more likely to hold their wealth as
money rather than bonds
• Money demand is negatively related to the
level of interest rates
Putting All 3 Together
• Keynes distinguishes between real quantities
and nominal quantities
– Money is valued in terms of what it can buy
– For example, all prices in the economy double, the
same nominal quantity of money will be able to
buy only half as many goods
• Keynes assumed that people want to hold a
certain amount of real money balances
– Quantity of money in real terms
Putting All 3 Together
• The demand for real money balances is a
function (related to) interest rates and real
income
d
M
 f (i ,Y )
P
 
Putting All 3 Together
• Keynes conclusion that the
demand for money is related not
only to income but also to
interest rates is a major
departure from Fisher’s view of
money demand, in which interest
rates have no effect on the
demand for money
Putting All 3 Together
• Once we take into account all of Keynes’s
motives, velocity is not constant, but depends
on interest rates and on one’s level of income
• When interest rates rise, it will encourage
people to hold lower real money balances
– Rate at which money will turn over will rise
– Velocity will rise
– As interest rates fluctuate, so will the velocity of
money
Putting All 3 Together
• Interest rates are pro-cyclical, meaning that they rise
in expansions and fall during recessions
– Interest rates rise in expansions, velocity of money rises in
expansions
• Movements in interest rates can cause instability in
the velocity of money because higher interest rates
also mean capital losses on bonds, more people will
want to hold money (speculative motive)
– Demand for money will increase, and velocity will fall
Friedman’s Modern Quantity Theory of Money
• Milton Friedman – 1956
• Pursued the question of why people chose
money
• Keynes analyzed specific motives, Friedman
will simply state that the demand for money
must be influenced by the same factors that
influence the demand for any asset
Friedman’s Modern Quantity Theory of
Money
• Applies the theory of asset demand to money
• Theory of asset demand indicates that the
demand for money is a function of their
wealth and the expected returns on other
assets relative to the expected return on
money
• Also recognized that people want to hold real
money balances
Friedman’s Modern Quantity
Theory of Money
M
 f Y , r  r , r  r ,   r 
P
d
e
p
Md
P
b
m
e
m
m
= demand for real money balances
Y p = measure of wealth (permanent income)
rm = expected return on money
rb = expected return on bonds
re = expected return on equity (common stocks)
e
= expected inflation rate
Friedman’s Modern Quantity
Theory of Money
Yp =
measure of wealth (permanent income)
The demand for any asset is positively related to
wealth
Wealth and the demand for money have a
positive relationship
Friedman’s Modern Quantity
Theory of Money
• Friedman says that an individual can
hold wealth in other forms besides
money: bonds, equity, and goods
• Incentives for holding these assets
rather than money are represented
by the expected return on each
relative to the expected return on
money
Friedman’s Modern Quantity
Theory of Money
rm = expected return on money
Influenced by:
• Services provided by banks – the more
services, the expected return increases
• Interest payments from holding deposits – the
more interest is paid, the expected return
increases
Friedman’s Modern Quantity
Theory of Money
rb =expected return on bonds
re = expected return on equity (common stocks)
rb  rm , re  rm
Represent the expected return on bonds and
equity relative to money – as they rise the
expected return for money falls, demand for
money falls
Friedman’s Modern Quantity
Theory of Money
 = expected inflation rate
e
  rm
e
That represents the expected return on goods
relative to money
If expected inflation is 10%, that means the price of goods
increases by 10% and expected return is 10%
When the above part rises, expected return on goods
relative to money rises and demand for money falls
Distinguishing b/w Friedman and Keynesian
• Friedman did not take the expected return on
money to be constant
– It fluctuates with interest rates
• Interest rates will rise in an expansion
– During expansionary times, banks are making
more loans and they need to attract deposits to
support those loans
– Attract deposits by offering higher interest rates
Distinguishing b/w Friedman and Keynesian
• The expected return on money held as
deposits increases with higher interest rates
– Higher interest rates on loans will also cause
higher interest rates on bonds
• Therefore, rb  rm will remain relatively
constant
Distinguishing b/w Friedman and Keynesian
• Friedman’s demand for money is essentially
one where wealth is primary determinant of
money demand
– Any rise in the expected return of an asset: bonds,
equity, goods would be matched by a rise in the
expected return of money
• For Friedman, velocity is relatively constant
– Highly predictable
Distinguishing b/w Friedman and Keynesian
• Since Friedman believes that changes in
interest rates have little effect on the
expected return on other assets relative
to money –
–The demand for money is insensitive to
interest rates
• Demand for money is relatively stable
since it does not shift with interest rates
VELOCITY & QUANTITY OF MONEY
• Since velocity is relatively
predictable and mostly a
function of wealth, a change in
quantity of money will
produce a predictable change
in aggregate spending
Evidence on the Demand for Money
• Which theory is an accurate description of the
real world?
• 2 primary issues that distinguish the different
theories of money demand:
– Interest rates
– Stability
Interest Rates and Money Demand
• If interest rates do not affect the demand for
money, velocity is more likely to be constant
(Fisher + Friedman theory)
– Aggregate spending is determined by the
quantity of money is more likely to be true
• However, (2nd situation) The more sensitive
the demand for money is to interest rates, the
more unpredictable velocity will be
– Less clear the link will be between money
supply and aggregate spending
Interest Rates and Money Demand
• The more sensitive demand for money is to
interest rates
– Unpredictable and the link between the two
is unclear – a change in money supply has
no effect on the change in interest rates
• If that link is unclear then it is hard to direct
and implement monetary policy to achieve a
goal
– Because monetary policy will have no effect
on spending, because a change in monetary
supply has no change in interest rates
Interest Rates and Money Demand
• When this happens – the economy
will fall into what is called the
liquidity trap
• If demand for money is ultrasensitive
to interest rates, then a small change
in interest rates will produce a large
change in money supply.
Stability of Money Demand
• If money demand is unstable and undergoes
substantial shifts, then velocity will be
unstable and unpredictable
– And the money supply may not be linked to
aggregate spending
• When conducting monetary policy, should the
Fed target interest rates or money supply
– Is money demand stable? It has implications of
how monetary policy should be conducted
Summary Chapter 19 Demand for Money
1. Irving Fisher developed a transactions-based
theory of the demand for money in which the
demand for real balances is proportional
(related) to real income and not to interest rate
movements. This theory says that velocity, the
rate at which money turns over, is constant or
remains the same. Aggregate, or total spending
is determined by movements in the quantity of
money.
Summary Chapter 19 Demand for Money
2. John Maynard Keynes suggested 3 motives for
holding money, the transactions motive, the
precautionary motive, and the speculative
motive. His liquidity preference theory views
the transactions and precautionary motives of
money demand as proportional to income.
However, the speculative motive of money
demand is sensitive to interest rates. This theory
states that velocity is unstable (goes up and
down) and cannot be treated as a constant.
Summary Chapter 19 Demand for Money
3. Milton Friedman’s theory of the demand for
money treats money like any other asset. The
demand for money is a function of the expected
returns on other assets relative to the expected
return on money and permanent income.
Different from Keynes, Friedman believes the
demand for money is stable and does not
change because of interest rate movements and
money is the primary determinant of aggregate
spending
Summary Chapter 19 Demand for Money
4. There are 2 main conclusions from the
research on the demand for money. The
demand for money IS sensitive to interest rates.
Since 1973, money demand has found to be
unstable (it is always changing), with the most
likely source of the instability being the rapid
pace of financial innovation
Chapter 19 Study Questions
1. Suppose the money supply (M) has been growing at 10% per
year, and nominal GDP (PY) has been growing at 20% per year.
The data is as follows:
2004
2005
2006
M
100
110
121
PY
1,000
1,200
1,440
Calculate the velocity in each year. At what rate is velocity
growing?
2. Calculate what happens to nominal GDP if velocity remains
constant at 5 and the money supply increases from $200 billion
to $300 billion.
3. What happens to nominal GDP if the money supply grows by
20% but velocity declines by 30%
Chapter 19 Study Questions
4. (5.)If velocity and aggregate output are
constant what happens to the price level when
the money supply increases from $1 trillion to
$4 trillion?
5. (6.) If velocity and aggregate output remain
constant at 5 and 1,000, what happens to the
price level if the money supply declines from
$400 billion to $300 billion