Chapter 13 The Demand for Money

Components of the money stock Currency: coins and notes in circulation; Demand deposits: checking accounts and traveler’s checks; Traveler’s checks by non-bank institutions; Interest-earning checking accounts; M1=CU+the rest; M1 is almost as liquid as currency.

Components of the money stock M2: M1 plus less liquid monetary assets  Savings account: interest bearing, but cannot be freely transferred into the checking account;  Small time deposits: cannot be withdrawn before maturity;  MMMF and MMDF: accounts invested on short- term securities and cannot be freely checked. Stable money demand in the past on M1; Quantity targeting becomes problematic with instability in money demand recently.

The functions of money Medium of exchange:  Eliminates barter and provides convenience. Store of value:  Keeps the nominal value but not interest bearing. The unit of account: non-essential; The standard of deferred payment: non- essential.

The demand for money: theory Household demand real balances instead of nominal quantities; Keynes’s arguments:  The transactions motive;  The precautionary motive;  The speculative motive.

The demand for money: theory Transactions demand:  The trade-offs: Holding more real balances lowers transaction costs; Holding more real balances increases more interest loss.  The Baumol-Tobin model: Income Y in money; Nominal interest rate i; Transaction costs: tc per time; Number of transactions: n.

The demand for money: theory Real balances.

The demand for money: theory Interest costs: iY/2n; Transaction costs: tc  n; The household problem: Optimal solution: Money demand:

The demand for money: theory  Money demand elasticities: Economics in scale in cash management; The demand for money rises slower than income; Average cost per dollar is lower for large transfers.

The demand for money: theory The precautionary motive:  Probability of illiquidity: p(M,  );  Expected cost from illiquidity: p(M,  )q;  Interest loss: iM;  Total expected cost: iM+p(M,  )q.

The demand for money: theory The speculative demand for money:  Money offers lower return but low risk;  Risk-averse households will diversify wealth over different types of assets, including money;  An increase in the expected return of other assets lowers money demand;  An increase in the riskiness of other assets increases money demand.

Empirical evidence An increase in interest rates reduces the demand for money; The demand for money increases with the level of real income; The demand for money is more responsive to the interest rate and income in the long run than in the short run; No money illusion observed.

The income velocity of money and the quantity theory Velocity of money: M  V=P  Y; The quantity theory:  Y and V are both fixed;  Nominal money stock is proportional to the price level: P=M  V/Y. Velocity and policy: all policies will be neutral if velocity is constant;

The income velocity of money and the quantity theory Velocity and the demand for money:  Velocity depends on real income and the interest rate: Velocity increases with real income; Velocity increases with the interest rate.