Overview of Chapter 19 The Demand for Money We have learned a bit about the money supply, how it is determined, and what role the Federal Reserve (FED) plays in it. Now we are going to learn the role of the money supply in determining the price level and total production of goods and services (aggregate output) in the economy. The study of the effect of money on the economy is called monetary theory.

Overview of Chapter 19 The Demand for Money When economists mention supply, the word demand is sure to follow. The supply of money is an essential building block in understanding how monetary policy affects the economy. Another essential part of monetary theory is the demand for money – the focus of this chapter.

VOCABULARY and NEW TERMS Aggregrate = total Monetary theory = study of effect of money Velocity of Money = the average amount of time the dollar is spent for goods in a year Quantity theory of money Liquidity Preference Theory Transactions Motive Precautionary Motive Speculative Motive

VOCABULARY and NEW TERMS Proportional = a part of, or a percentage of Fluctuate = goes up and down Incentives = a reward Expansionary = growing, expanding Liquidity trap Ultrasensitive = super sensitive

Overview of the Money Supply Process Money supply is influenced by 4 players Federal Reserve Depositors Banks Borrowers

The Key Players in the Money Supply Process Federal Reserve influences the money supply by controlling the required reserve ratio Depositors influence the money supply process through: Decisions about the currency ratio

The Key Players in the Money Supply Process Banks influence the money supply process through: Their decisions about the excess reserve ratio Some of which is affected by their expected deposit outflows Expected deposit outflows is affected also by individuals (depositors)

Interest Rates and the Money Supply Process Market interest rates influence the money supply process through: The excess reserve ratio

MONETARY THEORY Monetary Theory The study of the effect of money on the economy Talking about how the theories of the demand for money have evolved Central question in monetary theory is does it have an effect on interest rates? If it does, then how much of an effect will it have?

Quantity Theory of Money Developed late 19th century early 20th century Quantity Theory of Money is a theory of how the nominal (does not include inflation)value of aggregate (total) income is determined This theory actually suggests that the interest rate has no effect on the demand for money

Velocity of Money American economist Irving Fisher wanted to examine the relationship between money supply (M) and the total amount of spending on goods and services produced in the economy (P x Y) (nominal GDP-which does not include inflation). The concept that provides the link between M and (P x Y) is called velocity of money

Velocity of Money Velocity of Money The average number of times per year (turnover) that a dollar is spent in buying the total amount of goods and services produced in the economy Rate at which money is exchanged from one transaction to another Rate at which money in circulation is used for purchasing goods and services. This helps investors gauge how robust the economy is

Velocity of Money If nominal GDP (P x Y) in a year is $5 trillion and the quantity of money (money supply) is $1 trillion The velocity is 5 – meaning that the average dollar bill is spent five times in purchasing final goods

Equation of Exchange Multiply both sides of the equation by M Now have the equation of exchange Equation of Exchange Relates nominal income (GDP) to the quantity of money and velocity

Equation of Exchange States that the number of times that this money is spent in a given year must equal the total amount spent on goods and services in that year (GDP – output)

Equation of Exchange Fisher took the view that institutional and technological features of the economy would affect the velocity of money But only slowly over time It is reasonable to assume that velocity would be reasonably constant in the short-run

Quantity Theory Fisher’s view that velocity is fairly constant in the short run transforms the equation of exchange into Quantity Theory of Money Quantity Theory of Money Nominal income is determined only by movements in the quantity of money

M changes to $2 trillion – then GDP doubles to $10 trillion Quantity Theory To see how this works, assume the V = 5, GDP = $5 trillion, and M = $1 trillion M changes to $2 trillion – then GDP doubles to $10 trillion

Quantity Theory Back in the old days, it was thought that wages and prices were flexible The believed that the level of aggregate output (Y) (goods and services) produced in the economy during normal times would remain at the full-employment level So Y in the equation of exchange could also remain constant

Quantity Theory Quantity theory of money then implies that if the money supply (M) doubles, P (prices) must also double

Quantity Theory It provides an explanation of movements in the price level: Movements in the price level result solely from changes in the quantity of money

Quantity Theory of Money Demand Because the quantity theory of money tells us how much money is held for a given amount of GDP (aggregate income) It is a theory of the demand for money See this by dividing both sides of the equation by V to solve for M

Quantity Theory of Money Demand When the money market is in equilibrium, the quantity of money M that people hold equals the quantity of money demanded M = Md Remember V is constant, so 1 / V is constant Represented by k

Quantity Theory of Money Demand  

Keynes’s Liquidity Preference Theory John Maynard Keynes realized that velocity was not a constant and developed a theory of money demanded that focuses on the importance of interest rates Theory of demand for money is called liquidity preference theory Asks the question, “why do people hold money?

Keynes’s Liquidity Preference Theory He said there were 3 motives behind the demand for money: Transactions motive Precautionary motive Speculative motive

Transactions Motive Hold money to carry out everyday transactions The amount of transactions we make on a daily basis is determined by our level of income Proportional

Precautionary Motive People hold money as a cushion against an unexpected need Precautionary money balances people want to hold are determined primarily by the level of transactions that they expect to make in the future Those transactions are proportional to income He is assuming that the demand for precautionary money balances is proportional to income

Speculative Motive People also hold money as a store of wealth Called this reason speculative motive Our amount of wealth is closely tied with income, therefore, this component of money demand is also related to income Not just income that affects why hold money as a store of wealth

Speculative Motive Interest rates would also have an affect on the amount of money we hold in wealth Store wealth in assets. Keynes will assume that there are only 2 categories: Money and Bonds Assumes that individuals believe that interest rates will move toward some normal value

Speculative Motive If interest rates are below this normal level, then individuals will expect them to rise As interest rates rise, the price of bonds will decrease and they will suffer a capital loss Individuals are more likely to hold their wealth as money rather than bonds Money demand is negatively related to the level of interest rates

Putting All 3 Together Keynes distinguishes between real quantities and nominal quantities Money is valued in terms of what it can buy For example, all prices in the economy double, the same nominal quantity of money will be able to buy only half as many goods Keynes assumed that people want to hold a certain amount of real money balances Quantity of money in real terms

Putting All 3 Together The demand for real money balances is a function (related to) interest rates and real income

Putting All 3 Together Keynes conclusion that the demand for money is related not only to income but also to interest rates is a major departure from Fisher’s view of money demand, in which interest rates have no effect on the demand for money

Putting All 3 Together Once we take into account all of Keynes’s motives, velocity is not constant, but depends on interest rates and on one’s level of income When interest rates rise, it will encourage people to hold lower real money balances Rate at which money will turn over will rise Velocity will rise As interest rates fluctuate, so will the velocity of money

Putting All 3 Together Interest rates are pro-cyclical, meaning that they rise in expansions and fall during recessions Interest rates rise in expansions, velocity of money rises in expansions Movements in interest rates can cause instability in the velocity of money because higher interest rates also mean capital losses on bonds, more people will want to hold money (speculative motive) Demand for money will increase, and velocity will fall

Friedman’s Modern Quantity Theory of Money Milton Friedman – 1956 Pursued the question of why people chose money Keynes analyzed specific motives, Friedman will simply state that the demand for money must be influenced by the same factors that influence the demand for any asset

Friedman’s Modern Quantity Theory of Money Applies the theory of asset demand to money Theory of asset demand indicates that the demand for money is a function of their wealth and the expected returns on other assets relative to the expected return on money Also recognized that people want to hold real money balances

Friedman’s Modern Quantity Theory of Money = demand for real money balances = measure of wealth (permanent income) = expected return on money = expected return on bonds = expected return on equity (common stocks) = expected inflation rate

Friedman’s Modern Quantity Theory of Money = measure of wealth (permanent income) The demand for any asset is positively related to wealth Wealth and the demand for money have a positive relationship

Friedman’s Modern Quantity Theory of Money Friedman says that an individual can hold wealth in other forms besides money: bonds, equity, and goods Incentives for holding these assets rather than money are represented by the expected return on each relative to the expected return on money

Friedman’s Modern Quantity Theory of Money = expected return on money Influenced by: Services provided by banks – the more services, the expected return increases Interest payments from holding deposits – the more interest is paid, the expected return increases

Friedman’s Modern Quantity Theory of Money =expected return on bonds = expected return on equity (common stocks) Represent the expected return on bonds and equity relative to money – as they rise the expected return for money falls, demand for money falls

Friedman’s Modern Quantity Theory of Money = expected inflation rate That represents the expected return on goods relative to money If expected inflation is 10%, that means the price of goods increases by 10% and expected return is 10% When the above part rises, expected return on goods relative to money rises and demand for money falls

Distinguishing b/w Friedman and Keynesian Friedman did not take the expected return on money to be constant It fluctuates with interest rates Interest rates will rise in an expansion During expansionary times, banks are making more loans and they need to attract deposits to support those loans Attract deposits by offering higher interest rates

Distinguishing b/w Friedman and Keynesian The expected return on money held as deposits increases with higher interest rates Higher interest rates on loans will also cause higher interest rates on bonds Therefore, will remain relatively constant

Distinguishing b/w Friedman and Keynesian Friedman’s demand for money is essentially one where wealth is primary determinant of money demand Any rise in the expected return of an asset: bonds, equity, goods would be matched by a rise in the expected return of money For Friedman, velocity is relatively constant Highly predictable

Distinguishing b/w Friedman and Keynesian Since Friedman believes that changes in interest rates have little effect on the expected return on other assets relative to money – The demand for money is insensitive to interest rates Demand for money is relatively stable since it does not shift with interest rates

VELOCITY & QUANTITY OF MONEY Since velocity is relatively predictable and mostly a function of wealth, a change in quantity of money will produce a predictable change in aggregate spending Because the quantity theory of money tells us how much money is held for a given amount of GDP (aggregate income) It is a theory of the demand for money Fisher’s quantity theory of money suggests that the demand for money is purely a function of income

Evidence on the Demand for Money Which theory is an accurate description of the real world? 2 primary issues that distinguish the different theories of money demand: Interest rates Stability

Interest Rates and Money Demand If interest rates do not affect the demand for money, velocity is more likely to be constant (Fisher + Friedman theory) Aggregate spending is determined by the quantity of money is more likely to be true However, (2nd situation) The more sensitive the demand for money is to interest rates, the more unpredictable velocity will be Less clear the link will be between money supply and aggregate spending

Interest Rates and Money Demand The more sensitive demand for money is to interest rates Unpredictable and the link between the two is unclear – a change in money supply has no effect on the change in interest rates If that link is unclear then it is hard to direct and implement monetary policy to achieve a goal Because monetary policy will have no effect on spending, because a change in monetary supply has no change in interest rates

Interest Rates and Money Demand When this happens – the economy will fall into what is called the liquidity trap If demand for money is ultrasensitive to interest rates, then a small change in interest rates will produce a large change in money supply.

Stability of Money Demand If money demand is unstable and undergoes substantial shifts, then velocity will be unstable and unpredictable And the money supply may not be linked to aggregate spending When conducting monetary policy, should the Fed target interest rates or money supply Is money demand stable? It has implications of how monetary policy should be conducted

Summary Chapter 19 Demand for Money 1. Irving Fisher developed a transactions-based theory of the demand for money in which the demand for real balances is proportional (related) to real income and not to interest rate movements. This theory says that velocity, the rate at which money turns over, is constant or remains the same. Aggregate, or total spending is determined by movements in the quantity of money.

Summary Chapter 19 Demand for Money 2. John Maynard Keynes suggested 3 motives for holding money, the transactions motive, the precautionary motive, and the speculative motive. His liquidity preference theory views the transactions and precautionary motives of money demand as proportional to income. However, the speculative motive of money demand is sensitive to interest rates. This theory states that velocity is unstable (goes up and down) and cannot be treated as a constant.

Summary Chapter 19 Demand for Money 3. Milton Friedman’s theory of the demand for money treats money like any other asset. The demand for money is a function of the expected returns on other assets relative to the expected return on money and permanent income. Different from Keynes, Friedman believes the demand for money is stable and does not change because of interest rate movements and money is the primary determinant of aggregate spending

Summary Chapter 19 Demand for Money 4. There are 2 main conclusions from the research on the demand for money. The demand for money IS sensitive to interest rates. Since 1973, money demand has found to be unstable (it is always changing), with the most likely source of the instability being the rapid pace of financial innovation

Chapter 19 Study Questions 1. Suppose the money supply (M) has been growing at 10% per year, and nominal GDP (PY) has been growing at 20% per year. The data is as follows: 2004 2005 2006 M 100 110 121 PY 1,000 1,200 1,440 Calculate the velocity in each year. At what rate is velocity growing? 2. Calculate what happens to nominal GDP if velocity remains constant at 5 and the money supply increases from $200 billion to $300 billion. 3. What happens to nominal GDP if the money supply grows by 20% but velocity declines by 30%

Chapter 19 Study Questions 4. (5.)If velocity and aggregate output are constant what happens to the price level when the money supply increases from $1 trillion to $4 trillion? 5. (6.) If velocity and aggregate output remain constant at 5 and 1,000, what happens to the price level if the money supply declines from $400 billion to $300 billion