Copyright © 2002 Pearson Education, Inc. Slide 23-1 Money and the Economy The Demand for Money

Copyright © 2002 Pearson Education, Inc. Slide 23-2 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 23-3 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 23-4 Changes in Velocity of M1 and M2 in the United States

Copyright © 2002 Pearson Education, Inc. Slide 23-5 Money Demand in the Baumol-Tobin Model: Money as Inventory

Copyright © 2002 Pearson Education, Inc. Slide 23-6 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 23-7 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 23-8 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 (i M ).  The return on real assets (  e ) relative to the return on money (i M ). Friedman’s money demand model: {M/P} demand = L (Y *, i - i M,  e - i M ). The availability of money substitutes also affects {M/P} demand

Copyright © 2002 Pearson Education, Inc. Slide 23-9 Determinants of Money Demand