The DemandThe Demand

ECO 473 - Money & Banking - Dr. D. Foster

for Moneyfor Money

The Demand for MoneyThe Demand for Money

• The motivesmotives for holding money

• Money demand as a medium of exchangemedium of exchangeThe Cambridge equation.The Inventory model.Friedman approach.Rothbard approach.

• Money demand as a store of valuestore of valueKeynes’ portfolio demand.

The Motives for Holding MoneyThe Motives for Holding Money

• Transactions motiveTransactions motive: To use as a medium of exchange.Depends upon income, consumption,

wealth.Not influenced very much by interest rates.

• Portfolio motivePortfolio motive: To hold money as part of a wealth building strategy.Depends on the interest rate.

The Cambridge EquationThe Cambridge Equation

Money is only used for making purchases.

For some given income, YY, you plan to hold some given fraction, kk, to facilitate purchases.

As income risesrises (fallsfalls), the money demanded risesrises (fallsfalls).

The Demand for Real Money BalancesThe Demand for Real Money Balances

• Md is a “nominal” value - as prices rise, we want to hold more money, but not in real terms. So, to convert to “real” values . . .

• Y = nominal income = (Prices) x (real income) = P•y

• md eliminates price effects on money demand.

Annual Spending Annual Spending Patterns with aPatterns with a

Constant Rate of Constant Rate of Spending forSpending for

y = $36,000y = $36,000

Average money holdings equals … ?

$18,000$18,000

$9,000$9,000 $1,500$1,500

The Inventory Approach to Money DemandThe Inventory Approach to Money Demand

• What is the optimal money balance to hold?• Assumptions:

On-hand money earns no interest.On-hand money earns no interest.

People earn a fixed amount of real income.People earn a fixed amount of real income.

People buy goods and services at a constant rate.People buy goods and services at a constant rate.

People hold either money or bonds.People hold either money or bonds.

Bonds earn an interest return of Bonds earn an interest return of rr..

Converting from bonds to money costs a fee, Converting from bonds to money costs a fee, ff..

Conversion made Conversion made nn times/year in constant amounts. times/year in constant amounts.

Summarizing factors affecting mSummarizing factors affecting mdd - - real money balancesreal money balances

• Real incomeReal income:A rise in yy causes an increase in mmdd.A fall in yy causes a decrease in mmdd.

• The interest rateThe interest rate:An increase in rr causes a decrease in mmdd.A decrease in rr causes an increase in mmdd.

• The cash-conversion feeThe cash-conversion fee:An increase in ff causes an increase in mmdd.A decrease in ff causes a decrease in mmdd.

Friedman approachFriedman approach

Money demand varies with …Money demand varies with …•Permanent Income.Permanent Income.

+ relationship.+ relationship.

•Interest spread between bonds & money.Interest spread between bonds & money. - relationship.- relationship.

•Interest spread between stocks & money.Interest spread between stocks & money. - relationship.- relationship.

•Inflationary expectations.Inflationary expectations. - relationship.- relationship.

Rothbard approachRothbard approach

Money demand varies with …Money demand varies with …•Frequency of payments.Frequency of payments.

- relationship.- relationship.

•Sophistication of the clearing system.Sophistication of the clearing system. - relationship.- relationship.

•Confidence in money (esp. paper).Confidence in money (esp. paper). + relationship.+ relationship.

•Inflationary expectations.Inflationary expectations. - relationship.- relationship.

Mises:Mises:Phase IPhase IPhase IIPhase IIPhase IIIPhase III

Rothbard presentationRothbard presentation

Money S&D in the context of the ppm:Money S&D in the context of the ppm:

ms'

ppmms

$

md

md''

md'

In Phase I, MS rises but its effects are offset by Md.

In Phase II, Md falls, incorporating inflationary expectations.

Phase III, further increases in MS are constantly offset by declines in Md as people seek to have zero cash.

Keynes & the Portfolio DemandKeynes & the Portfolio Demand

• The speculative demandspeculative demand for money:Relates to money held as a store of valuestore of value.We seek to maximize our wealthmaximize our wealth over time.Our wealth is held in the form of bondsbonds.Holding money allows us to time bond purchasestime bond purchases.

At “highhigh” interest rates, we expect them to fall …raising bond prices; strategy - buy bondsbuy bonds now.

At “lowlow” interest rates, we expect them to rise …lowering bond prices; strategy - sell bondssell bonds now.

Keynesian Money DemandKeynesian Money Demand

r

m

md(S)

md(T)

r

m

Money demanded for transactions purposes in the Cambridge equation isn’t related to the interest rate. [Also, Friedman & Rothbard.]

Keynes’ speculative demand shows money is related to the interest rate.

The Liquidity TrapThe Liquidity Trap

Increasing the MS doesn’t actually lower interest rates!

Or, increasing the MB doesn’t actually increase the MS!Or, increasing the MB doesn’t actually increase the MS!

Is the U.S. in a Liquidity Is the U.S. in a Liquidity Trap?Trap?Fight Recession by Fight Recession by interest rates interest ratesThe Fed has run out of an interest rate policy!

Effective Federal Funds Rate of Interest 1981 to 2011

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

20.00%

Jan-

81

Jan-

83

Jan-

85

Jan-

87

Jan-

89

Jan-

91

Jan-

93

Jan-

95

Jan-

97

Jan-

99

Jan-

01

Jan-

03

Jan-

05

Jan-

07

Jan-

09

Jan-

11

1982

19912001

2009

2004-2008:~ $800 b.

9/2012:$2,652

b.

What has the Fed done?What has the Fed done?

The Monetary Base has more than doubled!

The DemandThe Demand

ECO 473 - Money & Banking - Dr. D. Foster

for Moneyfor Money