1. ECO 473 - Money & Banking - Dr. D. Foster
The Demand
for Money
ECO Money & Banking - Dr. D. Foster

2. The Demand for Money The motives for holding money
Money demand as a medium of exchange
The Cambridge equation.
The Inventory model.
Friedman approach.
Rothbard approach.
Money demand as a store of value
Keynes’ portfolio demand.

3. The Motives for Holding Money
Transactions motive:
To use as a medium of exchange.
Depends upon income, consumption, wealth.
Not influenced very much by interest rates.
Portfolio motive:
To hold money as part of a wealth building strategy.
Depends on the interest rate.

4. The Cambridge Equation
Money is only used for making purchases.
For some given income, Y, you plan to hold some given fraction, k, to facilitate purchases.
As income rises (falls), the money demanded rises (falls).

5. The 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.

6. Annual Spending Patterns with a Constant Rate of Spending for y = $36,000
$18,000
Average money holdings equals … ?
$9,000
$1,500

7. The Inventory Approach to Money Demand
What is the optimal money balance to hold?
Assumptions:
On-hand money earns no interest.
People earn a fixed amount of real income.
People buy goods and services at a constant rate.
People hold either money or bonds.
Bonds earn an interest return of r.
Converting from bonds to money costs a fee, f.
Conversion made n times/year in constant amounts.

8. The Total Cost of Maintaining a Cash Inventory
How many conversions to make per year?
Whatever minimizes your total cost.
Where the cost to convert = lost interest.
r∙ 1 2 ∙ 𝑦 𝑛 =
md = ∙ 𝑦 𝑛

9. Summarizing factors affecting md - real money balances
Real income:
A rise in y causes an increase in md.
A fall in y causes a decrease in md.
The interest rate:
An increase in r causes a decrease in md.
A decrease in r causes an increase in md.
The cash-conversion fee:
An increase in f causes an increase in md.
A decrease in f causes a decrease in md.

10. Money demand varies with …
Friedman approach
Money demand varies with …
Permanent Income.
+ relationship.
Interest spread between bonds & money.
- relationship.
Interest spread between stocks & money.
Inflationary expectations.

11. Money demand varies with …
Rothbard approach
Money demand varies with …
Frequency of payments.
- relationship.
Sophistication of the clearing system.
Confidence in money (esp. paper).
+ relationship.
Inflationary expectations.
Mises:
Phase I
Phase II
Phase III

12. Rothbard presentation
Money S&D in the context of the ppm:
ppm ms $ md
In Phase I, MS rises but its effects are offset by Md.
ms'
md'
In Phase II, Md falls, incorporating inflationary expectations.
md''
Phase III, further increases in MS are constantly offset by declines in Md as people seek to have zero cash.

13. Keynes & the Portfolio Demand
The speculative demand for money:
Relates to money held as a store of value.
We seek to maximize our wealth over time.
Our wealth is held in the form of bonds.
Holding money allows us to time bond purchases.
At “high” interest rates, we expect them to fall … raising bond prices; strategy - buy bonds now.
At “low” interest rates, we expect them to rise … lowering bond prices; strategy - sell bonds now.

14. Keynesian Money Demand
md(T) r m r m
md(S)
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.

15. The Liquidity Trap
Increasing the MS doesn’t actually lower interest rates!
Or, increasing the MB doesn’t actually increase the MS!

16. The Fed has run out of an interest rate policy!
Is the U.S. in a Liquidity Trap? Fight Recession by  interest rates
The Fed has run out of an interest rate policy!
1982
1991
2001
2009

17. What has the Fed done? The Monetary Base has more than quintupled!
3/2017:
$3,861 b. :
~ $800 b.

18. ECO 473 - Money & Banking - Dr. D. Foster
The Demand
for Money
ECO Money & Banking - Dr. D. Foster