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

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

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

4. 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

5. 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

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

7. 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

8. Is V constant?
NO.

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

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

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

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

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

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

15. 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

16. 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

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

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

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

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

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

22. 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

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

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

25. 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?

26. 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