EC 201

Lecture 15: Demand for Money

what is money
monetary aggregates
transactions demand for money
interest responsiveness of transactions demand
precautionary motive
speculative motive
empirical evidence


What is money?


Monetary Aggregates

Click here to view the Federal Reserve's most recent estimates of the monetary aggregates.

M1

M1 = currency + traveler's checks + demand deposits + other checkable deposits

M2

M2 = M1 + overnight RP's + overnight Eurodollars + money market mutual funds + money market deposit accounts + savings deposits + small time deposits

M3

M3 = M2 + large time deposits + term RP's + term Eurodollars + institutional money market mutual funds

Transactions Demand for Money

The transactions demand is for use as a medium of exchange. The demand for money should depend on the value of transactions. As prices rise, you need more money to buy the same quantity of goods and services. So, changes in nominal money holdings are proportional to changes in the price level. So, we focus on the demand for real money balances.

The quantity theory of money argues that the velocity of money (the average number of times a dollar is spent each year to purchase goods and services) is constant. Then, the demand for real money balances is proportional to aggregate output. So, as income rises, the demand for money rises because more transactions are carried out.

the velocity of money depends on

Velocity fluctuates too much even in the short run to be viewed as a constant.


Interest Responsiveness of Transactions Demand

The quantity theory assumes that interest rates do not affect the transactions demand for money.

The funds that people hold for transactions can be held in either cash or savings deposits. There is a tradeoff between the convenience of cash (since you don't have to make a trip to the bank) and the interest you can earn on your savings account. The higher the interest rate, the less cash you will hold and the more transactions balances you place in your savings account.


Precautionary Motive

A second motive for holding money is to avoid being illiquid. Money is the most liquid of all assets. So, you want to hold some money for emergency purposes.


Speculative Motive

The speculative motive looks at the demand for money as an asset. People are viewed as switching their asset holdings back and forth between money and bonds.

The expected return on money is assumed to be zero. The expected return on a bond consists of the interest payment plus expected capital gains. When interest rates rise, bond prices fall. So, bondholders suffer a capital loss. Bondholders receive a capital gain when interest rates fall.

People are assumed to hold in mind some "normal" interest rate. When interest rates are above "normal", they will be expected to fall. Wishing to earn a capital gain, investors will hold all bonds and no money. If interest rates are below "normal", bondholders will suffer a capital loss when interest rates rise to return to "normal", so investors will sell their bonds and hold all their wealth in money. So, the demand for money is negatively related to the interest rate.


Empirical Evidence

Every study has found that the demand for money is sensitive to interest rates.

Until the early 1970's, the demand for money could be quite reliably predicted if one knew only (1) the value of real GNP, (2) the interest rate on Treasury bills, and (3) the interest rate on savings deposits. However, starting in 1974, the conventional money demand function began to seriously overpredict money demand. The money demand curve began shifting around. In other words, money demand is unstable.

possible explanations:

  1. financial innovation
  2. financial deregulation
A truly stable money demand function has not yet been found.



David A. Latzko
318 COB
Department of Business and Economics
Wilkes University
Wilkes-Barre, PA 18766
phone: (717) 408-4718
fax: (717) 408-4917
dlatzko@wilkes.edu
wilkes1.wilkes.edu/~dlatzko