Carnegie-Rochester Conference Series on Pub/k Policy 29 (1988) 137- 168

North-Holland

I-l-ED
STATES: TITATIVEREVIE

ROBERT E. LUCAS, JR.*

The University of Chicago

eltzer*s research career has been so productive and so varied

that it would be an act of folly, not friendship, to attempt to review it
in a single paper. Yet I do want to talk about his research on this
occasion, for research is what Allan's career is mainly about, and I want
to do SO in detail, because details are the way scholarship is carried
out. Accordingly, I will focus my attention mainly on a single paper, one
that has influenced my own thinking on monetary economics a great deal,
Meltzer's "The Demand for oney: The Evidence from Time Series," published
in the Journal of Political Economy in 1963.
Meltzer's "Demand for ?4oney" was one in a series of his empirical
studies in monetary economics, hich involved joint research with
Karl Drunner. It followed earlier work by Latane and others, especially
Friedman, and helped to stimulate closely related later contributions by
Laidler and others.' The shared objective of this research program was, in
Friedman's (1956) terms, to demonstrate that the demand for money is a
"highly stable function" of a limited number of variables, to discover the
most useful, operational measures of money and these other variables, and
(again citing Friedman) to work "toward isolating the numericdl 'constants'
of monetary behavior." eltzer's paper was the first to estimate an income

4
This paper was prepared for the November ,+ 1987 Carnegie-Rochester Conference. I would
like to thank John Cochrane, Thomas Cooley, Milton Friedman, Lars Peter iiansen, Robert king,
Leonardo Leiderman, Bennett McCallum, Sherwin Rosen, Thomas Sargent and Lawrence Summers for
helpful discussions and/or comments on an earlier draft. I also benefitted from a stimulating
discussion at the Conference. P.S. Eswar-Prasad provided excellent research 8ssisfam?.

‘Two important sequels to this paper are Brunner and M?lfzer (1963) and Laidler (1966).
Of course, this and other work on money demand was closely related to rther cOnteW.)QrarY
research, especially the earlier contributions of Friedman (1956) and his students,. and
Friedman (1959). See Laidler (1977) and, more recently, IvDcCallum and Coocfriend (1987) for
some of the relevant background.

0 167 - 2231/88/$3.50 @ 1988 Elsevier Science Publishers B.V. (North-Holland)

(or wealth) elasticity and an interest elasticity SimultaneoUSly f’rom time

series data from a single country (the U.S.). The objective of the present
paper will be to review and replicate these results, to reconsider how they
might be interpreted theoretically, and to see how well they stand up to
the 25 years of new data that have become available since eltzer wrote-
An estimated money demand function provides answers to two important
questions of economic policy. The income elasticity, in a setting in which
long run real output growth is both fairly predictable and insensitive to
changes in monetary policy, provides the answer to the question: What rate
of growth of money is consistent with long run price stability? The
interest elasticity is the key parameter needed to answer the question:
What are the welfare costs to society of deviations from long run price
stability? Purely qualitative answers to these questions, along the lines
of "Inflation rates are significantly related to money growth rates" or
"Inflation reduces welfare" are interesting and useful, perhaps, but surely
propositions such as "An Ml growth rate of 3 percent per year will bring
about price stability" or "A ten percent annual inflation rate has a social
cost equivalent to a 0.5 percent decline in real income" are more
interesting and, if accurate, much more useful.
Though the objective of an economics that provides quantitative
answers to important questions of economic policy is now very widely
subscribed to, it is remarkable how little attention is paid in many of our
discussions to the substance of parameter estimation, and how little honor
is paid to those few economists who do it well. All of us have sat through
many discussions of econometric work in which the theoretical underpinnings
of the relationships estimated and tested and the econometric methods used
are subjected to intense scrutiny and yet no one seems to care what the
numerical results were! Even in Laidler's (1977) survey of the evidence on
money demand, or in McCallum and Goodfriend's (1987) more recent summary,
it is difficult to find clear statements of what the money demand function
is. As quantitative economists we often seem to be, in Samuelson's (1947)
phrase, "like highly trained athletes who never run a race, and in
consequence grow stale,"
eltzer ran this particular race, in 1963, and turned in his two
numbers. uch has happened since to monetary theory and to the development
of econometric methods, and almost three decades of new data have since
ailable. In Section II I arize the evidence on the income
ealth) and interest elasticities of money demand fro 1900-58 data,
essential1 identical to those eltzer used. Section III introduces a

138
utility-theoretic framework for thinking about money demand, from which I
will conclude that there is some reason to vie 0 parameters as
structural, Section IV reviews U.S. time series evidence from the 1958-85
period, a period during which nominal interest rates reached levels about
twice the highest levels attained in the U.S. in the earlier years of the
century. Remarkably, in view of the stringent nature of the experiment,
these new data precisely confirm the estimates Meltzer obtained in 1963.

IL REVIEWOF THE EVIDENCEFROH 1900-1958

The hypothetical household decision problem underlying the results

reported in Meltzer (1963) is that of allocating a given stock of wealth
across different assets, given a vector of asset returns. I will come back
to this problem in more detail in Section III, but I have said enough to
rationalize a demand function for money of the form

M
- = f(r,w) .
P

Throughout his paper, Meltzer used the log-linear form:

an(mt) = a - bpn(rt) + can(wt) + ut , (1)

where mt is the stock of real balances at t, wt is real wealth or real

income, rt an interest rate, ut is an error term, and a, b and c are
parameters. Meltzer used a long term interest rate to measure rt, treated
as a stand-in for the entire vector of returns on alternative assets. He
experimented with a very wide variety of income and wealth variables as
measures of real wealth, and with both Ml and M2 as measures of the money
stock. The sample period was 1900-1958, with results also reported for the
two subperiods 1900-1929 and 1930-1958.
lne experimental approach Meltzer used for measuring money and
is obviously suitable: we do not have theories that single out particular
measures as clearly superior to others. One could indeed criticize the
paper for reporting too few results, since the single interest rate he used
to represent asset returns was arbitrarily chosen. But much of this Weri-
mentation indicated that the choice of money aggregates
criticaaly important. This finding has been co S uent
research, as described in Laidler (1977). I report and

139
replicate only a small subset of i'& results reported by Meltzer (1963).
Table 1 transcribes results ii3Meltzer (1963). Line 1 is equation (3)
on p. 225, with R2 reported instead of R and "standard errorP instead of
"t-statistics."2 Lines 2,3,5,6,7 and 3 are from Table 2, p. 232- Line 4 is
from Table 1, p. 229. Of course, all regressions reported in this and all
other tables in this paper were estimated with constant terms. Since the
units of the dependent variable I used are not meaningful, I will not
report these constants.
The ce,Aral findings in lines l-3 of Table 1 (these and all subsequent
references are to tables in this paper), confirmed by other results in the
original paper, are the wealth or income elasticities of about unity and
the strong, negative effect of interest rates on real balances demanded.
Notice that neither finding shows up very clearly when the period is
divided in two, as reported in lines 4-8 of Table 1. For the early period,
the income and wealth elasticities diverge, in different directions, from
unity and the interest elasticities are much reduced. Meltzer does not
report the results with wealth only for 1930-1958. From what is reported,
however, it appears that the results for the full period were mainly
dictated by events in the latter half.
Table 2 contains my replications of the results in Table 1.3 I dropped

*The residuals from my replications of Mel tzer’s equations show very severe
autocorrelation, and it is clear from the Durbin-Watson statistics reported in Meltrer (1964)
that this is also true of his original regiessions. As a result, I do not know how to
interpret the “standard errors” reported in these tables. I experimented with a variety of
methods for correcting for serial correlation, but obtained only wildly erratic elasticity
estimates.

3For money, I used Ml throughout the paper. For 1900-14, this series is taken from
Historical Statistics (1960), series X267. From 1914-47, it is from Friedman and Schwartz
(1970), pp. 704-718, column 7. For 1948-85, it is the “IMF series 3” from the International
Monetary Fund’s “International Financial Statistics” tape. (The primary source for these IMF
data is the Federal Reserve Bulletin.)
For 1900-49, real wealth is from Goldsmith (1956), Table W-3, column 1 (“total national
wealth at 1929 prices”). For 1950-57, this series is from Historical Statistics (1960),
series F446.
For 1884-1975, real income is real net nationai product from Friedman and Schwartz
(1982), Table 4.8. For 1976-85, it is taken from various July issues of the Survey of Current
Easiness. The price level (used to deflate Ml) is the imp1 icit NNP deflator from the same
sources. Permanent income is the geometrically weighted sum of current and Past real NNP’s
used in Friedman (1957). The weight on current income is .J3.
The long term interest rate (used only for 1900-57) is the “basic yield on 20 year
corporate bonds” in Historical Statistics (1960). series X346. The short term rate for 1900-
75 ;S the “6 month commercial paper” rate from Friedman and Schwartz (1982), Table 4.8, column
6. For 1976-85 I used Table 8-68 in the Economic Report of the President (1987).

140
 TABLE 1

Meltrer (1963) Results

Dependent variable: hlM,/P)

-
Coefficients on:
(standard errors)

Line Years &n(r) n (W/PI n(Y/P) R2

1 1900-58 -.949 1.11 .984

t.0441 t.026)
2 1900-58 -.79 1.05 .960
f.083) t.0411
3 1900-58 -.92 .97 .13 .980
t.0531 (.103) t.0931
4 1900-29 -.32 1.84 . 960
1.107) t.1141
5 1900-29 - .05 .70 .960
(.094) (.45)
6 1900-29 -.22 .48 .3l ,960
l.122) ( ,240) t.1941
7 1930-58 -.69 .94 .902
t.160) t.0941
8 1930-58 -1.15 1.35 -.lO .980
t.0971 t.1551 t.125)

1958 from the sample because I could not find w for that year. Otherwise,
1 attempted to follow the sources and procedures described in Meltzer
(1963). One can see that lines 1 and 2 from Tables 1 and 2 are very close,
though closer for the income regression than the ealth regression- When
both variables are included (line 3) I obtained very different results from
his, for reasons I cannot explaltl. Notice, however, that eltzer's and my
eMmates of the sum of these c&ficients are very close: I suspect this
is all either of us is estimatir-ic,
with much precision. The other striking
difference is in line 4 of Tables 1 and 2: my ealth elasticity for t
subperiod is well below one; eltzer's is 1.8,
I wanted to use a graphical clevice to help me see ho
theory one obtains ith different
question is not very well posed, b
exhibits three series, all for the f
l/P; the "predicted" l/P from line
from line 2 of Table 2. One c
trend from 1930 on than in the
regressions track this well (of course, with the interest rate alSO

included as a regressor). Real balances did not decrease nearly as much as

did NNP in the 193Os, but they increased much more than income in the
1940s. I conclude (though this is the sort of issue reasonable people can
disagree on) that current income induces fltoomuch" cyclical responsiveness
in predicted money demand, relative to wealth, and that wealth or some
other Woothed" income measure is preferred as the regressor- This is also
the conclusion reached by Laidler (1977).
In Table 3, I report the consequences of some variations on Meltzer's
results. The objective of this experimentation is to locate a version of
Meltzer's model that is reasonably faithful, conceptually and quanti-
tatively, to the original and is at the same time inexpensive to test on
more recent data.4
Line 1 in Table 3 uses permanent income (defined by Friedman's dis-
tributed lag on current and past real NNP's) in place of wealth. This
change does an excellent job of reproducing line 1 of either Table 1 or 2.
From a comparison of Figure 1 with Figure 2, one can see that permanent
income behaves more like wealth than like current NNP in the 1930s.
Lines 2 and 3 report two variations on line 1. In line 2, the long
interest rate used by Meltzer is replaced by a short rate. I will explain
my strong preference for the latter in Section III. The short rate (over
this period) varies sympathetically with the long, but with more amplitude:
hence its smaller coefficient. Otherwise, this variation doesn't matter
much. In line 3, 1 use an unlogged short rate. The issue between the
different functional forms in lines 2 and 3 is mainly aesthetic: the semi-
elasticity at the sample mean value of r (3.26 for 1900-57) is, from the
estimate of the elasticity in line 2, (.18)/(3.26) = ,055. From line 3,
this same semi-elasticity is estimated at .07. (In this, as in all other
economic applications with hich I am familiar, the choice of functional
form is of little substantive consequence.) Thus I will take Table 3 as
justifying my referring to the model reported in line 3 as Weltzer's
theoryn.

4The variations reported in Table 3 are very close to results in Laidler (1966). Laidle’
used U.S. annual series from 1892-1960, and deflated real balances and permanent income oh
population. In his counterpart to line 1 of Table 3 (his Table 2, A, p.548) he obtained
Permanent income and interest elasticities respectively of 1.51 and .25. His counterpart of my
I ine 2 (also Table 2, A in his paper) are 1.39 and . 16. He did not try unlogged intecest
rates.

142
 TABLE 2

fi2pl icat ions

Dependent wwiable: Rn(M,/P)

Coefficients on:
(standard errors)

Line Years h(r) In W/P) en (Y/p) R2

1900-57 -1 .PJ_ 1.32 .957

t.9 1) t.056)
1900-57 ,457 1.04 .971
a .d77) t.0361
1900-57 .90 .49 .68 .978
( .089) (.I221 (: .095)
1900-29 -.21 .86 .957
( .099) l.051)
1900-29 - .07 .73 .932
(.119) (.057)
1900-29 -.20 .65 .I9 .960
t.098) f.149) t.132)
1930-57 -1.72 1.53 -901
(.139) 4.163)
1930 -57 -.55 l93 .937
(.141) t.0751
1930-57 -.78 .34 .75 .939
,264 .332 .19t

Let me conclude this section with a somewhat less formal summary of

the information on income and interest elasticities contained in this 1900-
57 sample. Over this period, real Ml balances grew at the annua7 rate of
.03X6 and real permanent income at the rate .03126. Short term iKerest
rates fluctuated between .69 (during World War II) and 7.4 (in 1920) but
with a negligible trend. Hence the ratio of the money growth rate to the
income growth rate, 1.07, is a good estimate of the income elasticity. This
is about the number obtained, under various assumptions, in Table 3. Over

long periods, it must always be the case that the trend in the dependent
variable must be 'explained" by that subset of the regressors that have
trends, is application, real income does and interest rates do not.
Now imposing an income elasticity of unity, the semi-elasticity Of
money demand ith respect to the interest rate is just the ~10
Of ln(M1/Pyp) against rs. This plot is displayed in Fig
"estimation metho fl - get the into
trends and then get the interest elastici
 L .
1930 1940 1950 1960

Year

Actual Ml/P

--_-- Predicted Ml/P using current income (line 2, Table 1).

. . . . . Predicted Ml/P using wealth (line 1, Table 1).

144
 Figure 2
I

100

Year

Actual Ml/P

----- Predicted Ml/P using current income (line 2, Table 1).

. . . . . Predicted Ml/P using permanent income (line 1, Table 3).

145
 TABLE 3

Variations on Table 2 for 1900-1957

Dependent variable: ~n(Ml/P)

Coefficients on:
(standard errors)

Line an(r) Wrs) r an (y,) R*

S

1 -.77 1.03 ,939

t.0441 f.021)

2 -.18
f.025)

3 -.07 1.06 .963

f.0111 t.042)

- does not depend very critically on our ability to characterize the

residuals accurately, or even on the residuals having a common structure
over the entire period. Since we have much more %eason, to which I will
turn in the next section, for believing these elasticities to be stable
e have reason to believe anything in particular about the residuals,
this seems to me a desirable feature.'
Of course, no estimation method is satisfactory under all assumptions
about the errors, and the critical assumption here is that the errors are
trend-free. If there were important technical changes, not occurring in
terest rate movements, permitting agents to economize on
balances my method (and eltzer's too) has understated the
I do not see ho one can learn more about this
by examining the series at hand.

‘These informal remarks are not intended as a substitute for econometric theory. One
would certain Iy have a better understanding of the estimates reported here and below i f one
could write down a bel ievable stochastic model and use it to derive the properties of these
estimates explicitly. But I have not done this and so am obliged to follow a second best route
and explain why I proceeded as I did in a looser (and hence less informative) way.

146
 Figure 3 : 1900-57
1.9 t? 1

1.0
6s
*
1.7
+
u 0
*
1.8
5
e 1.5
z
5
1.4

1.3

1.2

1.1
2 3 4 5 6 7 0

Short-term Interest Rate

147
 III, A THEORETICALFRAME

As an aid in interpreting the results reported in the last section and

the additional results to be reported in Section IV, I ill introduce a
simple theoretical framework based on the model analyzed in Lucas and
Stokey (1987). The framework has the advantage (relative to the framework
eltzer used) of being explicit about the connection between the portfolio
and transactions demands for money, and the disadvantage of being
unrealistically stylized about the way trading occurs. It will take some

care to exploit the explicitness of this model without being led too far
astray by its unrealistic features.
We consider an economy in which the representative agent has the
ultimate objective of maximizing the discounted expected utility from
consumption of goods,

B t
E{ c t3 U(ct)} l

t=o

This agent lives in a Markovian world, the state of which at t is

arized by a vector St. The distribution of st+l, given St, is given by
a fixed transition function

F(s,A) = Pr(st+I E A(s = s} .

In this setting, all equilibrium date-t prices and quantities will be fixed
(no time subscript) functions of the current state, s+_.
Agents are assumed to alternate between securities trading and goods
trading in lockstep fashion. At the beginning of each period, all agents
trade in securities, including money, in a single centralized market, all
ith full knowledge of the current realization of St. hen securities
trading is concluded, all agents disperse either to produce or to purchase
consumption goods. Some of these goods can only be purchased with money
acquire4 during the course of securities trading: This transactions
requirement is the sole reason for including cash in a portfolio, in
Preference to interest bearing claims to future cash.
Consider first the decision problem facing an agent who is engaged in
securities trading at a time in hich the state of the economy is s and his
. (In a ten lized securities market
is asset
ote the value of this agent's expected,

148
discounted utility if he proceeds optimally from this point on.
At this point, the agent is faced by a vector Q(s) of securities
prices (in dollars, so the price of money is unity). He must choose money
holdings and a vector of securities holdings z, subject to a portfolio
constraint:

+ Q(s) l z I: (2)

Let be the indirect utility function he uses to make this

choice. (Clearly G will depend on s, since the current state variable
includes all the information he has about the returns from these
securities.) Then v(s,W) must satisfy:

v(s,W = max G(M,z,s) subject to (2). (3)

M,z

I call (3) the agent's portfolio problem.

Now where does this indirect utility function G come from? Having
completed securities trading, the agent is about to engage in purchasing a
vector c of consumption goods. He will also receive an endowment y(s)
of goods, but this he must sell for cash or future cash: He cannot consume
his own endowment. The rules of trading in this goods market are summarized
by a vector of constants a, where ai E [OJ] is the fraction of purchases
of good i that must be covered by money. It will be an expositional
simplification in what follows to postulate a technology together with a
choice of units for measuring goods such that all goods sell for the same
nominal price P(s)- In this case, the agent's Clower- or cash-in-advance
constraint is:

P(s)a l c 5 (4)

The outcome (M,z) of the portfolio decision plus the outcome (&Y(S))
of his goods trades plus a given vector D(s') of nominal returns

(dividends, interest, principal) on securities ill determine this agent's

nominal wealth position 1 as of tomorroti, conditional o

state s'. He begins next period with his dollar holdings as
plus the dividends and resale value of his securities,
plus the dollar value of his endo
of his goods purchasesI P(s)S c . That is:

149
 W’ zz + [Q(s')+D(s')]*Z + f'(S)~i[YiO-ciI l
(5)

These considerations determine what I call the transactions problem:

= max U(c) + B/ w(s', ')F(s,ds') subject to (4) , (6)

C

where I is defined in (5).

Eliminating the function G between (3) and (6) defines a functional

equation in the value function v. See Lucas and Stokey (1987) for an
analysis of this equation and its use in constructing an equilibrium for
this economy. My purpose here is not so much analysis as it is clarifying
what we mean by a "demand function for money," and hence in understanding
what an empirical money demand function might mean. Let me begin with what
eTtzer (1963) and certainly Hamburger (1977) meant by a "demand
function for money."
From the portfolio problem (3) one obtains the first order conditions:

GM(M,z,s) = u , (7)

G,_JJI~z,s) = Qju , j = l,...,m , (8)

3

here v is the multiplier associated with the wealth constraint (2) and
here j indexes the m available securities. These m+l equations
ith (2) can be solved to obtain the demand functions for the
hich have as arguments the prices Q and wealth W. Singling
out the demand function (in this sense) for money:

(9)

Note that the entire vector Q of securities prices enters Jn the

right of (9). In practice, as in any empirical application of demand
uld focus on the prices of securities thought to have strong
substitution or complementary relationships with money. In this spirit,
eltzer used a long term bond yield in his econometric work. In the same
experimented ith equities yields and other

a respectable basis for an empirical study,

150
consistent with what e knew then about monetary theory and, I would say,
consistent ith what we know now. Yet it does not seem to me t
would have any confidence that the demand function (9), based on portfolio
considerations only as in my derivation, ould remain stable over time.
Included as suppressed arguments in this functions f are all variables s
characterizing the current state of the system, including all the
information used by agents in forecasting future returns on all securities.
oreover, if the stochastic environment in hich agents operate (the
"regime," as it is often called) should change from time to time, these
changes too will induce shifts in f. Surely shifts in the realizations of
informational variables and/or in the processes assumed to generate these
realizations must have been substantial over so long a period as 1900-1958.
To decide whether the fact that the functions f are not likely to be
structural is an important objection to the empirical application of (9),
consi4ri- the fact that by exactly the above argument on money demand, we
could derive a demand function of the same form as (9) for any portfolio
item. Would one, for example, attempt to estimate a demand function for
Brazilian government securities, including as arguments only their own
current yield and another interest rate standing in for the composite
security consisting of all other portfolio items, and expect this
relationship to be stable over a 60 year period? I think there is more to
Meltzer's money demand theory than portfolio considerations alone.
To see what this is, turn to the transactions problem (6), which also
defines the indirect utility function 6. The first order conditions for
the n consumption goods in this problem are:

uitc) = B/ vw(s‘,W')P(s)F(s,ds') + uP(s)ai 9 i=l,...,n, (10)

where u is the multiplier associated ith the cash-in-advance constraint

(4). One can also calculate the derivatives of the function G from [6):

G AS) = lJ (s',W')F(s,ds') 9 (11)

‘)IQj(S’)+Oj(S’)IF(S,dS’), j=l,...a (12)

That is, the value (in utils) of a dolla

goods trading
The value of any other security is the value of the increment it provides

151
to future wealth. Equations (11) and (12) thus reduce the values of
securities, money included, to the values of their associated

"fundamentals."
Now suppose that among the m available securities is a (nominal) risk
free, dollar denominated, one period bond. For this security, Qj(S') = 0
1 so r(s) is the one
and Oj(S') = 1. Let its current price be p
l+r(s) ’
period nominal interest rate. Then combining (7) and (8) from the
portfolio problem and (11) and (12) from the transactions problem (where
both (8) and (12) are specialized to this one period bond) and inserting
into the first order conditions (10) we obtain:

uitc) = P(S)u[ai + 4r(s) 9 i = 19...,n. (13)

That is to say, the relative "prices" of these consumption goods, as seen

by consumers (normalized so that the prices of each received by sellers are
all equal to P(s)) depend on the cash holdings required tc purchase them
together with the opportunity cost of holding cash, as me.isured by the
nominal interest rate.
In the environment I have been describing, in which no new information
reaches agents after they have switched from securities trading to goods
trading, agents will plan money holdings so that the cash-in-advance
constraint (4) holds with equality: In the theory, as in fact, cash is
dominated by nominal bonds as a store of value. In this case (13) and (4)
(with equality) form a system of ~1 equations in the consumption vector
c and the multiplier v. It is not quite a demand system (since the
"prices" in (13) are not the same as the ").rices" in (4)) but it can be
treated just as if it were and solved f~:+?~~~ consumption vector c as a
function of /P(s) and r(s), say: -/'*" ”

c = (14)

from transactions considerations, an exact relation-

desired consumption mix, their demand for real
the nominal interest rate. Notice that no other securities
rices or returns enter into this relationship, nor dc,lrsthe state s

152
(except through the two prices P(s) and r(s)). C&z;~s in information
or in the information structure of the system ill noi. shift these curves.
They will be stable over time provided only that preferences are and that
the trading technology as su arized in the coefficients al,...,a, is
stable.
It seems to me a violation of common usage to call the relationship

(14) a "demand function for money." It is a relationship among comple-

mentary choice vay*iables that the demand functions must satisfy. hatever
one Calls it, however, it is a relationship that must obtain in equilibrium
and it seems more likely to be an empirically stable one than does the
"true" demand function (9). Why not provide an operational specification
Of these coefficients ai and try to estimate it econometrically? This is
the approach taken in a recent paper by Mankiw and Su ers (1986), with
vc!fy interesting results that I will come back to in the next section,
First, however, it will be useful to go into more detail about the con-
nections between (9) and (14).
Meltzer's estimated income and wealth elasticities are around unity,
suggesting (under the utility-theoretic framework I am using here) that the
current period utility function U takes the form of a constant relative
risk aversion function of a homogeneous of degree one function of con-
sumption. Let us impose this on the model above. Then equations (13) can be
solved for the ratios ci/c of consumption of each good to total con-
sumption C = CiCi: Ci = gi(r)C , say. Substituting into the cash
constraint gives:

M
F = Xiaigi(r) C = h[rjc , (15)

where the second equality defines the function h. This is just a

consolidated special case of (14), still not a demand function for money.
Under these same assumptions, the Yrue'1 demand function for total

%-his rationale for (14) is essentially the same as that used for a simi la! purpose by
McCallum and Goodfriend (1987). See Ando, Modigl iani and She11 (1975) for the earliest
derivation of (14) along these I ines that I have found. These writers draw the same
conclusion I have in the text: that only the short rate ought to appear on the right side of a
money demand function. Hamburger (1977) views (14) as a “Keynesian” formulation, exPlicitlY
contrasting it to the “monetarist” emphasis on portfolio considerations. If he is right, then
my use of (14) to derive Meltzer’s equation (18) is a ver\. “un-monetar i si’” digul?ierIt. But one
of the purposes of this section is exactly to argue that portfolio and transactions
considerations are complementary in thinking about money demand.

153
consumption c takes the form:

Then combining (15) and (16), we have shown that, under this homotheticity
assumption, the true demand function for money (9) takes the form:

P = h(r)k(Q,s) (17)

Now there is no ---

theoretical reason to expect (17) to be more stable
empirically than (9): They are the same relationship! But empirically,

total consumption has been found to be a fairly stable function of

permanent income, suggesting that k(Q,s)/r is nearly constant over a wide
range of circumstances. If so, then:

M
P = WY,
r
) (18)

where e'(r) < 0 should serve as a stable relationship over the same range
of circumstances.
I am going to interpret (18) as the relationship Meltzer estimated.
This involves using a short term interest rate for r, in contrast to the
long term rate It also precludes adding other yields to the
right side of (18), as Hamburger did, unless these other variables can also
be shown to affect the propensity to consume out of permanent income. This
tighter theoretical rationale ill, I hope, give some added insight into
eltzer's empirical work was so successful.7
In the model I have sketched in this section, it is the explicit

71t is a perennial subject of debate among monetary economists whether there are
advantages to being as explicit about the nature of transactions demand as I have been here,
as opposed simply to including real balances as a “good” in agents’ utility functions. I do
not wish to be doctrinaire about this issue, but surely it cannot be wrong for monetary
theorists to think about what people do with the money they hold. Economists who study the
demand for coffee do not hesitate to use common knowledge about what people do with Coffee,
and this knowledge leads them to empirically useful ideas about what goods are likely to be
close substitutes or complements for coffee, and hence what prices are likely to be useful in
coffee demand functions. Why should those who study money demand not do the same thing?
I found Tables 1 and 2 in Mankiw and Summers (1986) of great interest, and of evident use
in guiding these authors’ thinking about money demand. Researchers confined to thinking Of
money simply as something people like to hold, without asking why they like lT(3 hold it, would
never have been led to seek out, display and utilize these data.

154
characterization of transactions demand that lea lationship be-
iween real balances, short term interest rates an pernianent income or
wealth that one might ant to view as structural, racterizatjon
made tractable by the assumption that everyone engages in securities trade
at the same time, all ith the same fixed period. That this assumption is
unrealistic is obvious, That it is unrealistic in a way that is critical to
the theory of money demand was shown by Grossman an eiss (1983) and
Rotemberg (1984), who examined theoretical settings in h only a subset
of agents is engaged in securities trading at any time- This modification
alters the way the system responds to open marke4 operations, because when
the central bank issues money for bonds, interest rates must move so that
the subset of private agents on the other side of this exchange is willing
to acquire a disproportionate share of the economy's new money swpgly, This
alteration introduces a Keynesian "liquidity preference" element in%o money
demand that is entirely absent from the formulation I have sketched.
Cochrane (1988) appears to have identified these liquidity effects, for
periods up to a year, in post-1979 U.S. weekly series on Treasury bill
rates and money growth rates. (I say “appears" because the connections be-
tween theoretical models of the Grossman-Weiss-Rotemberg type and the edi-
mation methods used by Cochrane have not been worked out in any detail.)
By using annual data, it seemed possible that eltzer's results and
mine might avoid contamination from these "liquidity preference" effects.
We will see in the next section, however, that this hope is not confirmed,
at least for post-1958 data. The trick will thus be to get as much as we
can out of a money demand theory that is not adequate to account for some
short run events.

IVI

Econometric research on money demand has undergone considerable

development since the early 1960s. In the main, this ith %he notable

excrption of Friedman and Schwartz's (1963) and (1982) studies o

and U.K. time series) has focused on evidence from r U-S. quarter1
series. eltzer's work is not cited in Judd and SC 2 (1982) revie
article (though they do make repeated use of Laidler (I977),
turn heavily influence
cited in this surve

155
 The pioneering paper in this "modern" era of money demand studies is
Goldfeld (1973), which introduced distributed lag methods that seem to be
needed to obtain close fits to quarterly data. Subsequent work has, in
large part, been devoted to the refinement of Goldfeld's studies and to
dealing with the fact (stressed most forcefully by Goldfeld (1976)) that
his equations deteriorated in fit on data outside the original sample
period.
There is no doubt that recent work is based on a much more sophisti-
cated awareness of econometric issues specific to time series analysis than
was the research of the 1950s and 60s. At the same time, the substantive
results have been disappointing. Judd and Scadding refer to "the observed
instability in the demand for money after 1973," and endorse the conclusion
reached earlier by Cooley and LeRoy (1981) "that the negative interest
elasticity of money demand reported in the literature represents prior
beliefs much more than sample information." The unit income (or wealth)
PTasticity is no longer regarded as we1 T-established, and most recent work
has focused on find- 7 "scale variables" that sharpen short-term forecast
errors rather than on estimates of the income elasticity that stand up well
over different data sets. In short, one gains the impression that subse-
quent research has generally failed to support Meltzer's findings, that the
income and interest elasticities he estimated are inconsistent with more
recent evidence and were even, perhaps, as much the product of his "prior"
as they were inferences drawn from the time series he studied.
I think all of these conclusions, or impressions, are incorrect. Tn
this section I will argue that Meltzer's 1963 results are not only quali-
tatively but quantitatively consistent with observations since 1955: that
even if one takes the income and interest elasticities estimated, by his
methods, from pre-1958 data alone one obtains a more useful account of
money demand in the 25 year period since than is obtained from more recent
distributed lag formulations. Moreover, ill exhibit the information on
the interest elasticity of money demand contained in 1900-1985 data in such
a way as to concentrate even Cooley and LeRoy's posterior distribution on
eltzer's 1963 co* .dsion.
At the sm.. time, this application of Meltzer's equation to more
recent data will also reveal repeated, systematic patterns in the residu-
ah. These are patterns that are not consistent with the t eoretical model
reviewed in Section II (and hence not co
have interpreted it). I thin
d others to resort to dist

156
will argue that these methods have &ved to obscure rather than reveal
both the sense in which this theory helps to understand recent events and
the sense in which it falls short.
Table 4 provides results for the entire 1900-85 period and for the
recent subperiod 1958-85. Line 1 is exactly the same regression as line 3,
Table 3 for the full period. Line 3 of Table 4 is the same regression for
the period 1958- 5 only. One can see that simply adding the later years to
the full sample results in virtually no change in the estimated elastici-
ties. However, the results for the later years taken by themselves show a
drastic deterioration in fit and large changes in estimated coefficients as
compared to the 1900-57 period. In lines 2 and 4 of Table 4, the income
elasticity is constrained to be unity (so no "standard error" is reported).
Line 2 is, not surprisingly, the same as line 1, but so too is line 4.
Examining trends over the later period (as I did in Section II for the
earlier years) helps in interpreting Table 4. In the 27 year period 1958-
85, real money balances grew at an annual rate of ,004 while real income
grew at a rate of .03. Short term interest rates increased (though not at
all smoothly) from around 3 percent to around 9 percent, or at a rate of
about .22 percentage points per year, To fit these trends, the interest
semi-elasticity nr and the income elasticity qy have to lie on the
line: or = -.02 + (.14)qy. With an income elasticity of unity, this implies
an interest semi-elasticity of .12. This pair of estimates is roughly

TABLE 4

Results from 1900-85

Dependent variable: h(Ml/P)

Coefficients on:
(standard errors)

Line Years r Qn(yp) R2

S

1 1900-85 -.07 .97 .967

( .044) (.019)
2 1906-85 -.09 1 .o -_-
(.cm) ---
3 1958-85 -.Ol .21 .328
(.005) f.059)
4 1958-85 ---
-.07 1 .O
(.808) ---

--

157
consistent with the estimates 1.06 and .07 reported in line 3 of Table
3. Tt is also consistent with the estimates .97 and .07 in line 1 of Table
4, and with the constrained estimates in lines 2 and 4 of Table 4, Mimi-
larly, the unconstrained estimates 21 and -J91 on line 3 of Table 4 lie
roughly on this line. One can account for the divergent trends in income
and real balances over the 1958-85 period either with the 1900-57 estimated
income and interest elasticities -
or with much lower income and interest
8
elasticities.
Figure 4 illustrates, in part, why I prefer ts;z constrained estimates
reported on lines 2 and 4 of Table 4 to the unconstrained estimates on line
3. This figure plots the log of f'!/Pyp against the short term interest
rate for the entire 1900-85 period, with the post 1957 observations indi-
cated by different symbols from the 1980-57 observations. One can see that

-if one constrains the income elasticity for the entire period to be unity,
one gets in return a single interest semi-elasticity for the entire period.
The most recent points lie exactly or the line defined by the earlier ones
and, since interest rates behaved so differently in the recent period, the
estimate is greatly sharpened by the new observations.
Let me try to summarize the sense in which Figure 4 confirms both
Meltzer's hypothesis that real money demand is a stable function of perma-
nent income (or wealth ) and interest rates and the nunicrical estimates hn
obtained. Meltzer estimated these two parameters by least squares. As
Figure 2 shows, the estimated income elasticity is mainly dictated by the
on trend of real balances and income. At this estimated value of unity,
Figure 3 shows that the interest elasticity is determined by a reasonably
tight scatter of an(M1/Pyp) against rs. If one imposes the same income
elasticity of unity on the 1958-85 period, this same scatter, reproduced as
Figure 4, confirms the original interest elastic%y estimate, and since
interest rates were so much higher in the later period, the new experiment
is a very good one. Notice that there is nothing arbitrary or experimental
about Figure 4: It is precisely the scatter one would want to look at in

of the estimates eltzer obtained using pre-1958 data only.

as line 3 of Table 4 shows, these two elasticity estimates
cannot be recovered from the 1958-85 data using least squares (as eltzer

a
Poole (1?70) argued much eariier that c,x needs to constrain the incof:re elasticity in
order to obtain an interest elasticity from post-World War I I data that is consistent .fith
we-war evidence.

158
 Figure 4 : 1900-85
2

1.0

1.6

1.4

1.2

0
0

0.8 0
0
0
0
0
0 0

0.6
0 2 4 6 0 10 12 14 16

Short-Term Interest Rate

* - denotes observations from 1900 to 1957.

0 - denotes observations from 1958 to 1355.

159
recovered them from the earlier data). There is a reason why these esti-
mates came out as they did, as Figure 5 shows. Interest rates were not only
increasing dramatically over the 1958-85 period but were also highly er-
ratic. The relatively high interest semi-elasticity on line 3 reconciles
the trends with a high income elasticity, but the cost of this reconcili-
ation is that the "predicted" path of real balances from the constrained
estimates is much too interest-sensitive to fit observed, year-to-year
movements. Actual real balances move in the predicted direction in response
to interest rate changes, but by much less than is predicted. These lead to
large residuals, which are also strongly correlated with interest rates.
This is why the order revealed in Figure 4 cannot be discovered using
unconstrained least squares.
ankiw and Su ers (1986) recover exactly an income elasticity of
unity and an interest semi-elasticity of .05 from least squares applied to
1960-84 U.S. quarterly series. They do so using consumption in place of
Permanent income (justified in part by the kind of argument I used in
Section III) and by using Almon lags to average the independent variables
over time. One can conjecture from Figure 5 that averaging interest rates
will "work," and Mankiw and Summers's results confirm this. (I suspect that
long interest rates worked as well as they did in Meltzer's study for much
the same reason: Long rates are a kind of average of short rates.)

This paper has had three main objectives. As reported in Section II, I
first replicated some of the results in Meltzer (1963), using his 1900-1957
sample period, and showed that two variations of interest to me are empiri-
cally indistinguishable from the model he used. Second, in Section IIT, T
ed a theoretical model of money demand in which the two parameters
eltzer estimated could be expected to be "structural." Thirc:, in Sectjon
TV, 1 compared the predictions of eltzer's model, ith his original
Paramete- estimates, to post-1958 data, and concluded that 'this comparison
yields additional confirmation of the theory and of these two estimates.
eltzer (1963) as criticized (for example, by Courchene and Shapiro
(1964)) for9 among other things, his failure to correct his estimates for
serially correlate esiduals and his failure, despite great
ney demand function, to ap standard
eter estimates across different

160
 Figure 5
1100

1050

1000

930

900

850

800

750

700

650
1960 1965 1980 1985

Year

Actual Ml/P.

----- Predicted Ml/P from line 4, Table 4.

161
sample periods. These two criticisms can certainly be applied as well to
the present paper, for I share Meltzer's emphasis on the "stability" of the
money demand function.
But I agree with that these econometric criticisms are
very badly off the economic point. e begin with a simple economic model

that suggests a two-parameter description of money demand. ldhenwe hypothe-

size that this relationship is %table," we mean that we expect these two
parameters to reflect relatively stable features of consumer preferences
and the way in which business is carried out, and we expect them not to
shift around as monetary or other policies are altered over time. This
theory does not suggest that the residuals can be characterized in a
simple, elegant fashion over a given time period, or even that the stochas-
tic structure of the residuals should be stable over time. Accordingly,
there is little point in testing the theory by maintaining an extreme
hypothesis on the residuals that is not implied by any theoretical
considerations and then performing a Chi-square test for the equality of
coefficients over subperiods. One needs a maintained hypothesis in which
one has more, not less, confidence than one has in the hypothesis being
tested.
eltzer argued, and I agree, that we can only test the theory by
comparing its numerical predictions to as wide a variety of data as we can
find. In carrying out such tests, it is of no interest whatever to let the
o crucial elasticities isolated by the theory change arbitrarily from one
data set to the next. The theory is of no interest or use unless these two
parameters are stable under a wide range of circumstances.
Over the time period Meltzer studied, in which income has a strong
trend and interest rates had none, the method of least squares isolates an
income elasticity of unity, just as does a comparison of income and real
balance trends. ith this income elasticity, one can see from Figure 3 that
there is enough interest variability to trace out a fairly clear demand
curve. Over the more recent period, interest rates have a very strong
as does income, so that there are many combinations of
elasticities that are consistent ith trends in the holding of real
balances. Least squares picks out a combination of elasticities that is
very different from the pair that is consistent with earlier evidence. Yet
imposing the same elasticities in +,he later period is also consistent ith
long term trends and, as Figure s9 traces out a demand function that
e earlier data, and clearer than

162
with those data alone.9 This picture did not
The evidence from the post-1960 years also reveals strong patterns in
the residuals from this estimated demand function that did not appear in
the earlier years of the century. It is clear that, as investigators since
Goldfeld have concluded, the portfolio adjustment process is subject to
lags in a way that neither the theory eltzer had in mind nor the cash-in-
advance model I sketched in Section III helps to understtind. This fact is
hardly surprising: One is, if anything, surprised that this simple model
captures as much as it does.
In these circumstances, it seems to me that it is the econometrician's
job to display as clearly as he can the respects in which the model he has
is a good approximation to reality and the sense in which it is not. This
is what Meltzer did in his 1963 paper, and it is what I have tried to do in
this one. I hope Figure 4 convinces anyone who sees it that the interest
semi-elasticity of money demand has remained stable at something between
-05 and .lO for nearly a century in the U.S. I hope Figure 5 helps to
stimulate someone, perhaps along the lines suggested by Grossman, eiss and
Rotemberg, to discover the short run dynamics that can reconcile this fact
with year-to-year or even quarter-to-quarter movements in observed money
holdings.

‘An income elasttcity of unity is also consistent with the cross-section evidence
reported in Meltzer (1963b). The interest semi-elasticities estimated from U.S. time series
are also consistent with the range of estimates Cagan (1956) found in his study Of

hyperinflations.

163