Transcript Money and the Economy

Money and the
Economy
The Demand
for Money
Copyright © 2002 Pearson Education, Inc.
Slide 23-1
Transactions Motives



Early theories: people demand money just for
transactions.
Real money balances = M/P : balances people hold
to make transactions.
Velocity of money is the number of times a dollar
is spent each year on final purchases

V = $Spending/M = $GDP/M = PY/M
Copyright © 2002 Pearson Education, Inc.
Slide 23-2
Fisher Equation of Exchange

Equation of exchange: MV = PY.

When V is constant, the equation of exchange
becomes a money demand function
Demand for Real Balances ={M/P}demand = (1/V) x Y = kY

But is V constant?

Hardly
Copyright © 2002 Pearson Education, Inc.
Slide 23-3
Changes in Velocity of
M1 and M2 in the United States
Copyright © 2002 Pearson Education, Inc.
Slide 23-4
Money Demand in the Baumol-Tobin
Model: Money as Inventory
Copyright © 2002 Pearson Education, Inc.
Slide 23-5
Portfolio Allocation Motives for
Holding Money


People compare advantages of holding money relative to
holding other assets
The Usual Suspects





Expected Return
Risk
Liquidity
Information benefits
Money as a buffer stock: Economic order quantity square
root rule

The demand for real balances increases less than proportionately
with real income.
Copyright © 2002 Pearson Education, Inc.
Slide 23-6
Keynes’s Liquidity Preference Theory

John Maynard Keynes emphasized the sensitivity
of money demand to changes in interest rates.





Speculative Motive as well as
Transactions Motive
and Precautionary Motive
Keynes’s money demand model:
M/P = L(Y,i)
When i is “high”, the price of bonds is “low”

Speculate! (Try to) hold bonds rather than money
Copyright © 2002 Pearson Education, Inc.
Slide 23-7
Friedman’s Model of Money Demand
Milton Friedman: money holdings depend on
 An individual’s permanent income, Y *
 The return on “bonds” (i) relative to the return on money
(iM).
 The return on real assets (p e ) relative to the return on
money (iM).
 Friedman’s money demand model:
{M/P}demand = L (Y *, i - iM, p e - iM).
The availability of money substitutes also affects
{M/P}demand
Copyright © 2002 Pearson Education, Inc.
Slide 23-8
Determinants of Money Demand
Copyright © 2002 Pearson Education, Inc.
Slide 23-9