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The Demand for Money BSc Economics programme ECN 326: Monetary Economics Module 5 THE DEMAND FOR MONEY In Lecture 3, on the nature of money, we saw why there was a need for money: • to solve the double coincidence of wants problem associated with barter • to obviate the lack of trust between the payer and the payee in a transaction. However, what determines the quantity of money that individuals and economies demand is a separate question. It is the aim of this lecture to explain what determines the quantity of money we demand and also to present a number of models (or theories) of the demand for money. The lecture is majorly split into two main sections. The first part considers the demand for money from individuals or institutions/firms perspective, i.e., the microeconomic determinants of money demand. The second part examines the demand for money at the macroeconomic level, gives a brief history of money demand, focusing on the breakdown of the macroeconomic demand for money function. The ultimate aim of the lecture is to study the money demand as one of the building blocks of the money market equilibrium. The study of the demand for money function has long dominated empirical research in monetary economics. One is therefore tempted o inquire into the nature of this function that qualifies it for a special study. This is of particular importance as traditional microeconomics theory presents us with a generalized framework in which the demand for any good may be analyzed. Traditional theory approaches demand analysis by postulating that an individual derives satisfaction from the consumption of goods and services. Individual market demand for these goods is thus derived from this satisfaction or utility. Money, however, does not seem to fit neatly into this kind of analysis, and the demand for it does not appear to be adequately explained by utility theory. What then are the various factors that distinguish money from other goods and services? As emphasized in earlier lectures, money is a medium of exchange for goods and services. Besides, its market value in general is predictable and stable. These two characteristics combine to give it liquidity. Because money is the most liquid of all assets, individuals hold it for day-to-day events to make transactions. If money is held for the reasons mentioned, why do we study the demand for money? One reason is the peculiar nature of money mentioned above (i.e. its liquidity). The other is the importance of money in economic activity. Specifically, a stable money demand function forms the core in the conduct of monetary policy as a stable money demand function enables a policy-driven change in monetary aggregates to have measurable or indeed predictable influence on output, interest rates and ultimately on the price level. The size of the interest elasticity of the demand for money provides a useful guide to the effectiveness of monetary policy and impact of money on the economy. Because of its importance, a steady stream of theoretical and empirical research has been carried out over several decades. Most of the earlier work concentrated on developed countries. In recent years, however, there have been a lot of analyses as well on developing countries. Page | 1 There are eight broad sections expected to be covered in this lecture on the demand for money. The first section deals with the basic theoretical analysis of the demand for money by the classical economists. Specifically considered are the Fisher's equation of exchange, and the Cambridge version of the quantity theory. The second section deals with the Keynesian theory of the demand for money. In the same section, we explore the demand for money in the Keynesian tradition. These include the regressive expectation model, and liquidity preference as behaviour towards risk. We discuss also the interest elasticity of the demand for cash. The third section deals with the Friedman analysis of the demand for money which is a restatement of the classical theory of the demand for money. The fourth section deals with the specification of the demand for money. Specifically, in this section, we deal with the basic questions about the theoretical and empirical analysis of the demand for money. The fifth section deals with the general issues in the specification as well as the empirical results of studies of the demand for money in developing countries. The sixth section outlines the modern general overview of the demand for money including: the inventory theoretic model of Baumol-Tobin and the portfolio selection model of Tobin; discuss why Tobin's model solves the `plunger' problem of the demand for money model of Keynes; describe the general set-up of macroeconomic money demand equations; discuss empirical evidence on money demand functions, especially on income and interest elasticities; and finally describe what happened and what is meant by `the case of the missing money' and give reasons for the breakdown of the estimated money demand equations. Microeconomic determinants of the demand for money There are essentially four main determinants of money demand at the individual level. These are 1. Interest differentials: the difference between the yield on money, commonly assumed in the literature to be zero,1 and the rate of return on other assets. The greater the rate of return on assets other than money, the greater the opportunity cost of holding money, and so the fewer money balances will be demanded. 2. Cost of transfers: the costs associated with transferring between higher interest earning assets and money, needed to purchase goods and services. If the cost of transfers, known as brokerage fees, are high then it is unlikely that we will put our wealth into the higher interest earning assets as to do so will involve substantial costs. Demand for money will then be a positive function of these transfer costs. 3. Price uncertainty of assets: there is inevitably risk involved in holding assets. Even though there exists a risk in holding money as a store of value, since we do not know for certain how many goods a given quantity of money can buy in the future due to inflation, the risk associated with holding other, interest earning, assets is generally considered to be greater. If the price of assets is likely to vary over time then, by the time we want to sell those assets in order to obtain money to undertake transactions, we may face considerable capital loss. If we are risk-averse then our demand for money will therefore be a positive function of the riskiness or price uncertainty of alternative assets. 4. The expected pattern of expenditures and receipts: if individuals were paid their wages in lump sums weekly then average cash balances would be less than if wages were paid monthly. If the pattern of payments and receipts was uncertain then cash balances would be likely to be higher; it may be Page | 2 unwise to face the brokerage fees and transfer cash to bonds if there is a possibility that you will need to make a large cash payment in the near future. These determinants are also related to Keynes' description of money demand motives. Keynes (1936) broke down the demand for money into three types: transactions, precautionary and speculative motives: The transaction demand for money is essentially that needed to buy goods and services where money is needed as a medium of exchange. Precautionary money balances are simply holdings of money kept in case of emergencies (an unexpectedly large hospital treatment bill or a domestic accident for example). Finally, the speculative demand for money considers money as an alternative to interest earning assets. Due to the capital loss involved with holding bonds when the interest rate increases2 if an individual expects the interest rate to rise, then he will expect to experience a capital loss on his bond holdings. Knowing that the bond price will fall, he will want to hold a larger quantity of money. In fact, Keynes originally assumed that individuals held their expectations of interest rate movements with certainty. When the interest rate was below what they expected in the long run, R* in Figure 3.1, then they would put all of their financial wealth in the form of money to avoid the capital loss associated with holding bonds. When the interest rate was above what was expected, then the expected interest rate fall would be associated with a capital gain from holding bonds. The individual would then hold as little money as possible, only covering the transactions and precautionary motives (T representing minimum cash required to conduct transactions). The individual's demand for money, as a function of the interest rate, would then be a step function, shown in Figure 1 below. Figure 1: Interest rate R* 0 T Quantity of money Page | 3 It has become standard to model each component of the demand for money separately. The transaction demand for money is typically modelled by allowing money to be a function of determinants 1, 2 and 4 above (i.e. ignoring asset price uncertainty). By allowing more flexible assumptions on the expected pattern of expenditures and receipts, similar analysis can incorporate a precautionary motive for money holdings. Analysis of the speculative demand for money, however, concentrates on determinant 3, asset price uncertainty, while dropping one or more of the other factors for tractability. THE THEORETICAL ANALYSIS OF THE DEMAND FOR MONEY This topic examines the demand for money at the macroeconomic level. On a more general level, the following theoretical analyses are considered. 1. The Classical Approach to the demand for money (or the quantity theory of money): Fisher’s Equation of Exchange 2.
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