Transcript Chapter 8: What You Will Learn

Chapter 12:
Learning Objectives
 The
Demand for Money: The Micro View
 Cash Management: An Inventory Approach
 Theories of Money Demand:
Quantity Theory
Friedman’s Approach

Velocity of Circulation: The Institutionalist
Approach
The Microfundations of Money
Money (M1) is held for transactions purposes and
incurs an opportunity cost and potentially a loss of
purchasing power (1/P)
 The demand for money is a demand for “real balances”
(M/P)
 A simple model:

mtd = f(ct, Rt)
An Inventory Model of Cash Management:
The Baumol-Tobin Model
 Assume, initially, that income is paid at the
beginning of the period
 Assume, initially, that consumption spending
occurs at a constant rate throughout the period
Figure 12.1 illustrates graphically
 Assume a constant opportunity cost of money
and fixed transactions costs of obtaining money
Optimal Cash Management: Inventory
Approach
(A) Constant Expenditures Through Monthly/bimonthly pay
$2000
Md (income = $2000)
$1000
Md (income = $1000)
$500
1/2
1
1 1/2
Optimal Cash Management: Inventory
Approach
(b) Variable Expenditures through a Monthly pay period
$2000
$1000
$500
1
2
The Mathematics of the Inventory Model
Average Cash Holdings: Md = Y/2n
Opportunity cost of holding cash: R(Y/2n)
Marginal cost of another trip to the bank: b
Optimum money demand is solution to: b =(RY/2n2 )
Optimum money demand is: Md = P (b/2P).5 y.5 R-.5
The Quantity Theory of Money
 Is perhaps one of the oldest economic theories
and links the price level to the quantity of money
in circulation
Ms V = P y
 If velocity of money
(V) and real income (y) are
constant then changes in Ms lead to proportional
changes in P
Friedman’s extension
Money is but one of many assets in a portfolio, including
“human” capital
 Various simplifications lead to a theory, not supported
by empirical results, which links the demand for money
to permanent income

Money Demand in Canada
600
500
Real balances (M2/CPI)
Money Supply (M2) in millions of $
500000
400000
300000
200000
100000
400
300
200
100
0
0
0
200
400
CPI (1949=100)
Full Sample
600
800
0
200
400
600
800
1000 1200
Real GDP (1949 $)
Post World War II
Money Demand in Canada (cont’d)
40
600
Real balances (M2/CPI)
Real balances (M2/CPI)
500
35
30
25
400
300
200
100
20
0.03
0.04
0.05
0.06
Long-term interest rate
Pre World War II
0.07
0
0.00
0.05
0.10
0.15
Long-term interest rate
(10 yrs + Govt. Can. bonds)
Post World War II
0.20
Velocity of Circulation in Canada &
the Institutionalist Hypothesis
2.0
Monetization phase
Financial sophistication
phase
Velocity= Income/M2
1.8
1.6
1.4
1.2
v elocity
"smoothed" v elocity
1.0
0.8
0.6
0.4
1880
1900
1920
1940
Y ear
1960
1980
Summary
The demand for money arises because of transactions
in a monetary economy and is constrained by
opportunity cost and transactions costs considerations
 Money can be viewed as being held in an inventory
 The quantity theory of money expresses the
proportional relationship between the money supply and
the price level
 understanding velocity can help us understand the role
of financial innovations over time
