Chapter 22. Demand for Money Quantity Theory of Money Keynes & Liquidity Preference Friedman’s Modern Quantity Theory Friedman vs. Keynes Empirical Evidence

Monetary Theory link between MS and other economic variables price level output

I. Quantity Theory of Money classical economists Irving Fisher relates quantity of money to nominal income

equation of exchange MV = PY where M = quantity of money P = price level Y = real output = real income V = velocity = # times money used to purchase output

2 assumptions V is constant in short-run depends on institutions, technology that change slowly Y is at full employment level also constant in short-run

MV = PY if V, Y constant then A change in M must cause an equal % change in P Quantity Theory of Money

money demand MV = PY M = (1/V)PY M = kPY let (1/V) = k Md = M in equilibrium Md = kPY Md is depends on income NOT interest rates

Is V constant? NO.

II. Liquidity Preference Keynes 1936 3 motives to holding money transactions motive precautionary motive speculative motive

transactions motive people hold money to buy stuff as income rises, Md rises

precautionary motive people hold money for emergencies car breakdown job loss Md rises with income

speculative motive suppose store wealth as money or bonds high interest rates bonds more attractive, hold less money Md negatively related to interest rate

real quantity of money M/P if prices rise, must hold more money to buy same amount of stuff

money demand (M/P) depends on income interest rates M/P = f(i,Y)

Keynes & velocity MV = PY M/P = Y/V M/P = f(i,Y) Y/V = f(i,Y) V = Y/f(i,Y) velocity fluctuates with the interest rate -- both are procyclical

Tobin & money demand further extended Keynes approach transaction demand negatively related to the interest rate people hold money even when is has a lower return, b/c it is less risky

III. Friedman’s modern quantity theory Milton Friedman Md as asset demand -- wealth -- return relative to other assets

Yp = permanent income rb = expected bond return rm = expected money return re = expected equity return pe = expected inflation

rb - rm = relative return on bonds pe = expected return on goods

increase in Yp will increase Md increase in relative returns of bonds, equity or money decrease Md

Friedman vs. Keynes Friedman: multiple rates of return relative returns money & goods are substitutes Yp more important than current income

stability of Md Friedman’s Md function is more stable Yp more stable than current income spread between returns is more stable than returns -- interest rates have little impact on Md

IV. empirical evidence which Md function is right? Keynes or Friedman test how does Md respond to i? how stable is Md?

Md is sensitive to interest rates a lot of research reaches same conclusion sensitivity does not change over time

stability of Md what does that mean? relationship between Md, income, interest rates does not change over time does Md function of 1930s still predict Md in 1950s?

up until mid 1970s, Md very stable after 1974, Md becomes less stable (M1) old relationships overpredicting Md financial innovations changed behaviors Md stability for M2 breaks down in 1990s