ECON 302: ADVANCED

MACROECONOMIC THEORY

TOPIC 2 DEMAND FOR MONEY

The Demand for Money
l Suppose you only have a choice between two assets:
l money and bonds.

l Money are used for transactions, but it pays no interest.

l Two types of money:

§ Currency and checkable deposits.
l Bonds pay a positive interest rate, i (the rate of interest), but
cannot be used for transactions.
l Demand for money refers to how much assets individuals
wish to hold in the form of money.
l It is sometimes referred to as liquidity preference.
l The demand for money is related to income, interest rates and
whether people prefer to hold cash (money) or illiquid assets
like money.
The Demand for Money
l The holding of money and bonds depends on:
l Your level of transactions

l The interest rate on bonds

l You can hold bonds indirectly through money market funds,

or money market mutual funds.
l In the early 1980s, the interest rate on money market funds
reached 14% per year, so people earned more interest by
moving their wealth from checking accounts to these funds.
FOCUS: Semantic Traps: Money, Income, and Wealth

l Money is what can be used to pay for transactions.

l Income is what you earn, and it is a flow.
l Saving is the part of after-tax income that you do not spend, and it is
also a flow.
l Savings is the value of what you have accumulated over time.
l Financial wealth, or wealth, is the value of all your financial assets
minus all your financial liabilities, and it is a stock variable.
l Investment is what economists refer to as the purchase of new
capital goods.
l Financial investment is the purchase of shares or other financial
assets.
Types of demand for money
l Transaction demand – money needed to buy goods and services
in day to day life – this is related to income.
l Precautionary demand – money needed for financial
emergencies.
l Asset motive – people demand money as a way to hold wealth.
This may occur during periods of deflation or periods where
investors expect bonds to fall in value.
l Speculative demand (Keynes): demand for money is a choice between
holding cash and buying bonds.
l Portfolio motive (James Tobin): there is a trade off between asset
growth and risk aversion.
l For example,
§ if an individual is nervous about future economic trends, he will hold
money rather than purchase more risky bonds and shares.
§ if the individual is optimistic, he will take risks and purchase fewer bonds
and shares. 5
Theories of Money Demand
l Different theories of money demand:
l Classical Quantity Theory of Money
l Keynes’ Liquidity Preference Theory

l Friedman’s Modern Quantity Theory of Money

l Main questions:
l How is money demand determined?

l Is it affected by interest rates?

l How does money demand move over time?

6
PART 1: CLASSICAL QUANTITY
THEORY
Due to Irving Fisher (1911)
l Idea: to examine the link between total money supply 𝑀!
and the total amount of spending on final goods and
services produced in a given period (PY).
l Velocity of money: average number of times per year that a
dollar is spent in purchasing goods and services.
"#
𝑉= $!
. (definition)

l The Quantity Theory of Money refers to the idea that the

quantity of money available (money supply) grows at the
same rate as price levels do in the long run.

8
From Exchange Equation to Quantity Theory
l The equation of exchange MV = PY (identity)
l M is the stock of money,

l V is its velocity (how many times a unit of money turns

over during a period of time)
§ Velocity is determined by transaction technology factors (e.g. rise of credit cards);
as people use cash less often, less money is needed to transact, money supply falls,
and velocity rises.
§ Transaction technology changes slowly.

l P is the price level and Y is real income.

l Consequently, PY is nominal income or in other words the
number of transactions carried out in an economy during a
period of time.
l Holding Y and V constant, we can see that increases in the
money supply will cause price levels to increase, thus
causing inflation. 9
Quantity Theory of Money
1. Irving Fisher’s (1911) view: V is fairly constant
2. Equation of exchange no longer identity, but theory
3. Nominal income, PY, determined by M
4. Classicals assume Y fairly constant
5. P determined by M

10
Quantity theory of Money Demand
l The above identity of exchange equation can be remodeled
(assuming 𝑀 ! = 𝑀% ) and given it a behavioral
interpretation as a demand for money as follows:
! " $" &
l 𝑀 =
#
𝑃𝑌 = 𝒌𝑷𝒀 ⟹ %
=
#
[demand for real balance]
§ Money demand is proportional to nominal income (V – constant)
§ Interest rates have no effect on demand for money
§ Hence in this simple formulation demand for money is a function
of prices and income, as long as its velocity is constant.
l Underlying the theory is the belief that people hold money
only for transactions purposes.
l Implication: interest rates not important to Md

11
 Change in Velocity from
Year to Year: US Data, 1915–2002

© 2004 Pearson Addison-Wesley. 5-12

All rights reserved
Criticism
l The theory is accepted by most economists per se.
l However,
l Keynesian economists and economists from the Monetarist
School of Economics have criticized the theory.
l According to them,

l the theory fails in the short run when the prices are sticky.
l Moreover, it has been proved that velocity of money doesn't
remain constant over time.
§ Despite all this, the theory is very well respected and is heavily
used to control inflation in the market.

13
PART 2: KEYNES’ LIQUIDITY
PREFERENCE THEORY
Cambridge Approach and Keynes (1936)
l Cambridge approach: Is velocity constant?
1. Classicals thought V constant because they did not have good
data
2. Great Depression => economists realized velocity was far
from constant
l Keynes: 3 motives to hold money
1. Transactions motive — related to Y
2. Precautionary motive (for unexpected expenses) –
related to Y
3. Speculative motive speculative demand (money as store
of wealth) – holding money as a store of wealth

15
Speculative Demand for Money
l Can hold wealth as money or bonds (a composite of all
other assets that pay interest)
l Expected returns to both affect how much you want to hold
of each
l assume money pays zero interest
l return on bonds consists of interest and expected rate of
capital gain
l if interest rates are low, and you expect them to rise, this
will lead to potential capital loss on bonds – hold more
#'()%
money [𝑃& = ' ]
l if interest rates are high, hold less money
l Money demand is negatively affected by interest rates
16
Liquidity Preference Theory, Formally
l Liquidity preference function
𝑀%
= 𝑓 𝑌, 𝑖
𝑃
+ −

l Relationship between liquidity preference and velocity:

𝑃𝑌 𝑌
𝑉= !=
𝑀 𝑓 𝑌, 𝑖
l Thus, when interest rates go up, velocity goes up (i ­, f(i,Y) ¯,
V ­) – Keynes’s theory predicts fluctuation in velocity
l Change in expectations of future i, change f(i,Y) and V
changes
l Theory can also explain why velocity is somewhat
procyclical.
17
The Demand for Money
l Demand for money (Md) is equal to nominal income $Y (a
measure of level of transactions in the economy) times a
decreasing function of the interest rate i:

𝑀! = $𝑌 𝐿 𝑖 (2.1)
(−)

l An increase in the interest rate decreases the demand for

money, as people put more of their wealth into bonds.
The Demand for Money
l Equation (2.1) means that the demand for money:
l increases in proportion to nominal income, and

l depends negatively on the interest rate.

l The relation between the demand for money and interest rate
for a given level of income $Y is represented by the Md curve.
The Demand for Money
Figure 2.1 The Demand for Money
For a given level of nominal income, a lower interest rate
increases the demand for money.
At a given interest rate, an increase in nominal income shifts the
demand for money to the right.
 Post-Keynesian Theories of Demand for Money

PART 2: 1. PORTFOLIO
THEORIES OF MONEY
DEMAND

James Tobin, “Liquidity Preference as Behavior Toward Risk,’’ Review of Economic

Studies 25 (February 1958): 65–86.
What determines how much money people choose to hold

l Studies of the money demand function rely on

microeconomic models of the money demand decision.
l Money serves three functions:
l unit of account,
l a store of value, and

l a medium of exchange.

l The first function—money as a unit of account—does not

by itself generate any demand for money, because one can
quote prices in dollars without holding any.
l By contrast, money can serve its other two functions only if
people hold it.
l Theories of money demand emphasize the role of money
either as a store of value or as a medium of exchange. 22
Background
l Tobin, in his 1958 article, “Liquidity Preference as Behavior Towards
Risk,” has also reformulated Keynes’s speculative theory of money
demand.
l The main drawback of Keynes’ speculative demand for money is that it
visualizes that people hold their assets in either all money or all bonds
depending upon his estimate of the future rate of interest.
l This seems quite unrealistic as individuals hold their financial wealth in
some combination of both money and bonds.
l According to Tobin, individual’s behaviour shows risk aversion.
l People are uncertain about future rate of interest. If a wealth holder chooses
to hold a greater proportion of risky assets such as bonds in his portfolio, he
will be earning a high average return but will bear a higher degree of risk.
l This gave rise to portfolio approach to demand for money put forward by
Tobin, Baumol and Freidman.
l The portfolio of wealth consists of money, interest-bearing bonds, shares,
physical assets etc.
23
Background (contd.)
l While according to Keynes’ theory, demand for money for
transaction purposes is insensitive to interest rate, the modem
theories of money demand put forward by Baumol and Tobin show
that money held for transaction purposes is interest elastic.
l Further, while Keynes derived an inverse aggregate relationship
between the demand for money and the interest rate from the
assumption of certain expectations that differ among individuals,
Tobin (1958) derived this same demand for money relationship for
an individual from the assumption of uncertain expectations and
risk avoidance.
l He refers to his theory as a theory of liquidity preference,
following Keynes’s terminology.

24
Tobin’s Portfolio Approach to Demand for Money
l Theories of money demand that emphasize the role of money as a
store of value are called portfolio theories.
l an investor is faced with a problem of what proportion of his portfolio of
financial assets he should keep in the form of money (which earns no
interest) and interest-bearing bonds. The portfolio of individuals may also
consist of more risky assets such as shares.
l people hold money as part of their portfolio of assets.
l The key insight is that money offers a different combination of risk and
return than other assets.
l According to Tobin, faced with various safe and risky assets, individuals
diversify their portfolio by holding a balanced combination of safe and
risky assets.
l In particular, money offers a safe (nominal) return, whereas the prices of
stocks and bonds may rise or fall (risk).
l It is important to note that a person will be unwilling to hold
all risky assets such as bonds unless he obtains a higher
average return on them. 25
Tobin’s Portfolio Approach to Demand for Money
l Determinants of demand:
l the risk and return offered by money and by the various assets households can
hold instead of money.
l total wealth, because wealth measures the size of the portfolio to be allocated
among money and the alternative assets.
l we might write the money demand function as
(𝑀/𝑝)# = 𝐿(𝑟$ <−> , 𝑟% <−>, 𝐸& <−>, 𝑊 <+>),
where 𝑟" is the expected real return on stock, 𝑟# is the expected real return on bonds,
𝐸$ is the expected inflation rate, and 𝑊 is real wealth.
l From the standpoint of portfolio theories, we can view our money
demand function, L(i, Y ), as a useful simplification.
l First, it uses real income Y as a proxy for real wealth W.
l Second, the only return variable it includes is the nominal interest rate, which is
the sum of the real return on bonds and expected inflation (that is, 𝑖 = 𝑟# + 𝐸$ ).
l According to portfolio theories, however, the money demand
function should include the expected returns on other assets as well.
26
Tobin’s theory is explained in Fig.
On the vertical axis of the upper
On the horizontal axis we measure
quadrant we measure the expected
the riskiness of the portfolio.
return (interest that can be earned on
bond) to the portfolio
l This depends on two things: (i)
the interest rate and (ii) the
proportion of the portfolio held in
bonds.
l The total risk to which an
individual is exposed depends on
(i) the uncertainty concerning
bond prices — that is, the
uncertainty concerning future
movements in market rate of
interest, and (ii) the proportion of
the portfolio held in bonds.

27
l Let us denote the expected total return by R and the total risk of the
portfolio as a σt.
l If an individual holds all his wealth (W) in money and none in bonds, i.e.,
W = M + 0, both R and σt will be zero.
l With an increase in the proportion of bonds, i.e., W = M + B; as M falls and
B increases, R and σt, will both rise.
l The opportunity line C is a locus of points showing the terms on which the
individual investor can increase R at the cost of increasing σt.
l A movement along C from left to right shows that the investor increases his
bond holding only by reducing his money holding.
l The lower quadrant of Fig. shows alternative portfolio allocations, resulting
in different combinations of R and σt.
l The vertical axis measures bond holding. The amount of bonds (B) held in
W increases as the investor moves down the vertical axis to a maximum of
W.
l The difference between W and B is the asset demand for money (M). The
line OB in the lower part of the diagram shows the relationship between σt,
and B. As the proportion of B in W increases, σt also increases. 28
Preference of the Investor: Risk-Aversion:
l The optimal portfolio allocation depends on the preferences of
the investor.
l We assume here that the investor is risk-averse.
l He wants the best of both the worlds — a high return on the portfolio by
avoiding risk.
l Let us assume that the utility function of the investor is
U = f(R <+>, σt <->)
l The indifference curves are upward sloping because the
investor is risk-averse.
l He will take more risk only if compensated by a higher return.
l Moreover, the curves become steeper as the investor moves to
the right, implying increasing risk aversion.

29
Optimal Portfolio Allocation
l A risk-averse investor will move along the line C ends up choosing that portfolio
which he intends to choose and, thus, maximises his utility.
l At the tangency point E, with R = R* and σt = σ*t, the terms on which the investor
is able to increase expected return on the portfolio by taking more risk, shown by
the slope of the line C, is equated to the terms on which he (she) is willing to make
the trade-off, as is measured by the slope of the indifference curve.
l From the lower part we see that this risk-return combination is achieved by holding
an amount of bonds equal to B*, and by holding the remainder of wealth (W̅ – B* =
M*) in the form of money.
l The demand for money thus shows the investor’s ‘behaviour towards risk’, i.e., the
result of seeking to reduce risk below what it would be if W̅ = B and M = 0. In Fig.
19.4 such an all-bonds-portfolio would be associated with risk of σt and the
expected return of R, as shown by point F in the upper part of the diagram.
l This portfolio yields a lower level of utility, U1, than that represented by bond
holdings of B* and money holdings of M*.
l The reason is that as the investor moves to the right of point E along the line 0C, the
additional return expected from the portfolio by holding more bonds (and less
money) is not adequate to compensate the investor for the additional risk (the slope
of the line 0C is less than that of the indifference curve U2).
30
Interest Rate Changes and the
Speculative Demand for
Money
Fig. 19.5 shows the relationship
between interest rate and asset
demand for money.
l An increase in the rate of interest from r0 to r1 and
then to r2will improve the terms on which the
expected return on the portfolio can be increased
by taking more risk.
l So the line 0C becomes steeper. It rotates anti-
clockwise from C(r0) to C(r1) and then to C(r2).
l The investor responds by taking more risk and
earning higher expected returns by moving from
E to F and then to G.
l In this case his holdings of bonds (risky asset)
increase (from B0 to B1, and then to B2) and
money holdings fall (from M0 to M1, then M2).
l In short, as the interest rate rises, a given increase
in risk, which corresponds to a given increase in
the amount of bonds in the portfolio, will result in
a greater increase in expected return on the
portfolio.
31
Asset Demand For Money
l That is, at a higher rate of
interest, their demand for
holding money (i.e.,
liquidity) will be less and
therefore they will hold more
bonds in their portfolio.
l This means, like the Keynes’s
speculative demand for
money, in Tobin’s portfolio
approach demand function
for money as an asset (i.e. his
liquidity preference function
curve) slopes downwards

32
l Are portfolio theories useful for studying money demand?
l The answer depends on which measure of money we are considering.
l M1, currency and deposits in checking accounts — dominated asset,
forms of money earn zero or very low rates of interest.
l it is not optimal for people to hold money as part of their portfolio,
and portfolio theories cannot explain the demand for these dominated
forms of money.
l There are other assets that dominate currency and checking accounts —
such as savings accounts, Treasury bills, certificates of deposit, and
money market mutual funds — that earn higher rates of interest and
have the same risk characteristics as currency and checking accounts.
l M2, for example, includes savings accounts and money market mutual
funds.
l Hence, although the portfolio approach to money demand may not be
plausible when applied to M1, it may be a good theory to explain the
demand for M2 — a broad measure of money.

33
Evaluation
l Tobin’s approach has done away with the limitation of Keynes’ theory of
liquidity preference for speculative motive, namely, individuals hold their
wealth in either all money or all bonds. Thus, Tobin’s approach, according
to which individuals simultaneously hold both money and bonds but in
different proportion at different rates of interest yields a continuous
liquidity preference curve.
l Further, Tobin’s analysis of simultaneous holding of money and bonds is
not based on the erroneous Keynes’s assumption that interest rate will
move only in one direction but on a simple fact that individuals do not
know with certainty which way the interest rate will change.
l It is worth mentioning that Tobin’s portfolio approach, according to which
liquidity preference (i.e. demand for money) is determined by the
individual’s attitude towards risk, can be extended to the problem of asset
choice when there are several alternative assets, not just two, of money and
bonds.

34
PART 3: 2. TRANSACTIONS
THEORIES OF MONEY
DEMAND
The Baumol–Tobin Model of Cash Management
l These are further developments on the Keynesian theory
l Variations in each type of money demand:
l transactions demand is also affected by interest rates
l so is precautionary demand

l speculative demand is affected not only by interest rates but

also by relative riskiness of available assets
l Bottom line: demand for money is still positively related to
income and interest rates, but through multiple channels.

36
l Baumol asserts that individuals also hold inventory of money because this
facilitates transactions (i.e. purchases) of goods and services.
l Individuals incur cost when they hold inventories of money for transactions
purposes.
l So, individuals have to keep optimum inventory of money for transaction
purposes.
l They incur cost on these inventories as they have to forgone interest which
they could have earned if they had kept their wealth in saving deposits or
fixed deposits or invested in bonds.
l This interest income forgone is the cost of holding money for transactions
purposes.
l In this way Baumol and Tobin emphasized that transaction demand for
money is not independent of the rate of interest.
l It may be noted that by money we mean currency and demand deposits
which are quite safe and riskless but carry no interest. On the other hand,
bonds yield interest or return but are risky and may involve capital loss if
wealth holders invest in them. 37
Baumol’s Analysis of Transactions Demand:
l People hold money for transaction purposes “to bridge the gap between the
receipt of income and its spending.” As interest rate on saving deposits
goes up people will tend to shift a part of their money holdings to the
interest-bearing saving deposits.
l Individual receives income at a specified interval, say every month, and
spends it gradually at a steady rate.

38
Assumptions
l The individual receives a payment, Y, at the beginning of
each month and spends it at an even pace during the month.
l He or she can earn interest at the rate i per month by
holding money in a savings account (equivalently, bonds).
l There is a cost of tc per transaction for moving between
bonds and money.
l We denote by n the number of transactions per month
between bonds and money
l Monthly income is paid into the savings account or paid in
the form of bonds.
l The individual minimizes the cost of money management
during the month.
39
Assumptions
l Total cost = the transactions cost, (𝑛×𝑡𝑐) + the interest
forgone by holding money instead of bonds during the
month, 𝑖×𝑀, where M is the average holdings of money
during the month.
l M, the average holdings of money, depends on n, the
number of transactions.
l Suppose that each time the individual makes a transaction,
she transfers amount Z from bonds into money.18
l If the individual makes n equal-size withdrawals during the
!
# "
month, the size of each transfer is = , since a total of
:; :
Y has to be transferred. Thus,
𝑛𝑍 = 𝑌 (1)
40
§ Now, how is the average cash balance
§ The optimum number of transactions is found
related to n? by minimizing total cost with respect to n.
§ In Figure 1a (n = 1), the average cash That implies
balance held during the month is Y/2 "#
𝑛∗ = . (3)
= Z/2, since the cash balance starts at $%&

Y and runs down in a straight line to where n* is the optimal number of transactions.

zero.19 § As we should expect, the individual makes

more transactions the higher the interest rate,
§ In Figure 1b (n = 2), the average cash the higher the income, and the lower the
balance for the first half of the month transactions cost.
is Y/4 = Z/2, and the average cash
balance for the second half of the
month is also Z/2.
§ Thus, the average cash balance for the
entire month is Y/4 = Z/2.
§ Using equation (A1), it follows that
the average cash balance is Y/2n.
%&
§ 𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 = 𝑛×𝑡𝑐 + (2)
'(

41
Properties of Money Demand
E #
l Average cash balance, 𝑀 = :
= :;

'#
l Plugging the value of 𝑛∗ = into the above equation we
:GH
get
GH×#
𝑀∗ = :'
(4)
l Equation (4) shows:
l The transaction demand for money increases with the brokerage fee, or
the cost of transaction (more trips to bank), and with the level of
income.
l The demand for money decreases with the interest rate
l Conclusion: Higher is i and income gain from holding bonds,
less likely to hold cash: Therefore i ­, Md ¯
42
l Now, which scheme will he decide to adopt?
l It may be noted that investing in saving deposits and then withdrawing cash
from it to meet the transactions demand involves cost also.
l Cost on brokerage fee is incurred when one invests in interest-bearing
bonds and sells them.
l Even in case of saving deposits, the asset which we are taking for
illustration, one has to spend on transportation costs for making extra trips
to the bank for withdrawing money from the Savings Account.
l Besides, one has to spend time in the waiting line in the bank to withdraw
cash each time from the saving deposits.
l Thus, individual faces a trade-off problem-, the greater the amount of pay
cheque he withdraws in cash, less the cost on account of broker’s fee but
the greater the opportunity cost of forgoing interest income.
l The problem is therefore to determine an optimum amount of money to
hold.

43
Precautionary and Speculative Md
Precautionary Demand
Similar trade-off to Baumol-Tobin framework
1. Benefits of precautionary balances
2. Opportunity cost of interest foregone
Conclusion:
d
i ­, opportunity cost ­, hold less precautionary balances, M ¯
Speculative Demand
Problems with Keynes’s framework:
Hold all bonds or all money: no diversification
Tobin (1958) Model
1. People want high Re, but low risk
2. As i ­, hold more bonds and less M, but still diversify and hold M
Problem with Tobin model: No speculative demand because T-bills have
no risk (like money) but have higher return
PART 4: FRIEDMAN’S NEW
QUANTITY THEORY
 Monetarism
Friedman was a Marshallian,
but he was a macroeconomist.

He had his own research

Agenda: Money and Inflation.

And he was out to counter

Keynesian theory and policy.
MILTON FRIEDMAN
Friedman’s Restatement of the Quantity Theory
v Quantity theory of money – a restatement (1956)
v Monetary trends in the United States and United Kingdom
(1982)
v Building on the work of earlier scholars, including Irving Fisher of
Fisher Equation fame, Milton Friedman improved on Keynes’s liquidity
preference theory by treating money like any other asset.
Ø “Money does matter”-------- Friedman

Ø Inflation is always and everywhere a monetary phenomenon!!

Ø Economic agents (individuals, firms, government) want to hold a

certain quantity of real, as opposed to nominal, money balances.
Ø If inflation erodes the purchasing power of the unit of account,
economic agents will want to hold higher nominal balances to
compensate, to keep their real money balances constant.
!
Ø That is, if 𝑃 ↑→ 𝑀 ↑ → "
𝑢𝑛𝑐ℎ𝑎𝑛𝑔𝑒𝑑

47
Major assumptions and beliefs of Friedman
l Quantity theory is a theory of demand for money and not a
theory of output, income or prices.
l Two types of demand for money:
l Money serves as a medium of exchange ⟶ is demanded for
transaction purposes [similar to the old quantity theory].
l Money is demanded because it is considered as an asset or
capital good.
§ It is an asset or a part of wealth.
l Demand for money just like the demand for any durable
consumer good.
l Each form of wealth has its own characteristics and a
different yield or return.

48
Determinants of Demand for Money

§ Friedman argues that the demand for nominal liquid

balances by economic agents depends on:
1. Income and wealth;
§ In practice, estimates of total wealth are seldom available. Instead,
income may serve as an index/ surrogate of wealth.

2. The opportunity cost of holding wealth in liquid form;

§ The price or return from these various assets
3. The purchasing power of money;
4. Expected changes in the value of money arising from
future price level movements; and
5. Tastes & preferences of the asset holders.
49
Forms of Wealth
l Wealth can be held in five forms:
1. Money (M) – currency, demand deposit, and time deposit
2. Bonds (B) – payments that are fixed in nominal units
3. Equities (E) – payments that are fixed in real units
4. Physical non-human goods (G) – inventories of producer and
consumer durables (real asset: housing, cars, etc.)
5. Human capital (H) – skill, training, and productive efficiency of
human being
l The wealth holders distribute their total wealth among these
various forms of it so as to maximise utility from them.

50
Cost of Holding Assets
l The cost of holding various assets except human capital can be measured
by the rate of interest on various assets and the expected change in their
prices.
l Thus Friedman says there are four factors which determine the demand
for money.
l They are: (1) price level, (2) real income, (3) rate of interest and (4) rate of
increase in the price level.
l Relationship between demand for money and
l real income (output of goods and services) is direct.
§ But not proportional as in the case of price [it is more than proportional].
l rate of interest is inverse
§ The rate of interest and the rate of increase in the price level constitute the cost of
holding cash balances. If money is kept in the form of cash, it does not earn any
income. But if the same money is lent out, it could earn some income in the form
of interest to the owner.
l increase in the price level is inverse.
§ When the price level increases at a high rate, the cost of holding money will
increase.
51
Returns from Wealth
l Friedman believes that each form of wealth has its own
characteristics and a different yield or return (assumption 4).
l In a broad sense money includes currency, demand deposits
and time deposits which yield interest.
l Money also yields real return in the form of convenience,
security etc., to the holder which is measured in terms of
price (P).
§ When the price level falls, the rate of return on money is
positive because the value of money increases.
§ When the price level rises, the value of money falls and the
rate of return is negative.
l Thus P is an important variable in the demand function of
Friedman.
52
Returns from Wealth (continued)
l The rate of return on bonds, equities and physical assets
consists of currently paid interest rate and changes in their
prices.
l As far as human wealth is concerned it is very difficult to measure the
conversion of human into non-human wealth due to institutional
constraints.
l But there is some possibility of substituting human wealth for non-
human wealth.

53
Demand for Money
l Premise: demand for money is affected by same factors as demand for any
other asset
l Wealth (permanent income)
l Relative returns on assets (which incorporate risk)
l The level of real balances is a function of permanent income (the present
discounted value of all expected future income), the relative expected return
on bonds and stocks versus money, and expected inflation.
l More formally,
%#
&
= 𝑓(𝑌' <+>, 𝑟( − 𝑟) <−>, 𝑟* − 𝑟) <−>, 𝜋 * − 𝑟) <−>)
l 𝑌$ = permanent income
l 𝑟% − 𝑟& = the expected rate of return on bonds minus the expected return on money
l 𝑟' − 𝑟& = the expected rate of return on stocks minus the expected return on money
l 𝜋 ' − 𝑟& = expected inflation (return on goods) minus the expected return on money
§ expected returns on money, 𝑟! , includes both the interest paid on deposits and the services
banks provide to depositors.
l <+> = increases in and <−> = decreases in

54
Relationships Explained
l This all makes perfectly good sense when you think about it.
l If people suspect they are permanently more wealthy, they
are going to want to hold more money, in real terms, so they
can buy caviar and fancy golf clubs and what not.
l If the return on financial investments decreases vis-à-vis
money, they will want to hold more money because its
opportunity cost is lower.
l If inflation expectations increase, but the return on money
doesn’t, people will want to hold less money, ceteris
paribus, because the relative return on goods (land, gold,
turnips) will increase.
l In other words, expected inflation here proxies the expected
return on nonfinancial goods.
55
Expected Returns on Money
l Expected returns on money is affected not only by interest
paid on deposits...
l ...but also by services provided by a bank for holding your money there
(e.g. electronic bill payment, check(que) processing, etc.)
l If interest rates in the economy increase, banks make more
profit on loans, so – to get more customers – also increase
interest rates on deposits.
l Hence, 𝑟) moves (need not be constant, unlike in Keynes’s approach)
l Even if banks cannot increase interest rates by regulation, can
improve services which may still keep holding money in a
bank relatively attractive.

56
Differences from Keynesian theories
1. The modern quantity theory is generally thought superior to Keynes’s
liquidity preference theory because it is more complex, specifying three
types of assets (bonds, equities, goods) instead of just one (bonds).
2. Goods and money are substitutes (choice) => M has direct effect on
spending
3. It does not assume that the return on money, rm, is zero, or even a
constant.
l However, unlike the liquidity preference theory, Friedman’s modern quantity
theory predicts that interest rate changes should have little effect on money
demand.
l Friedman believed that the return on bonds, stocks, goods, and money would
be positively correlated, leading to little change in rb− rm, re − rm, or πe −
rm because both sides would rise or fall about the same amount.
d
§ That is, rb ­, rm ­, rb – rm unchanged, so M insensitive to interest rates: Δrb have
d
little effect on M since matched by Δrm
l Thus, correlation between interest rates and money demand is weak, since
relative incentive to hold money does not change very much. This is in stark
contrast to Keynes.
4. Md is a stable function
57
Differences from Keynesian theories (contd.)

l Implication of (3) combined with (4):

-3 0
= 𝑓(𝑌/ ) ⟹ 𝑉=
. 1 04
l Since relationship of Y and YP predictable, (4)
implies V is predictable: Get QTM theory view that
change in M leads to predictable changes in nominal
income, PY

58
KEY TAKEAWAYS
l According to Milton Friedman, demand for real money balances
(Md/P) is directly related to permanent income (Yp)—the discounted
present value of expected future income—and indirectly related to
the expected differential returns from bonds, stocks (equities), and
goods vis-à-vis money (rb − rm, rs − rm, πe − rm ), where inflation (π)
proxies the return on goods.
l Because he believed that the return on money would increase
(decrease) as returns on bonds, stocks, and goods increased
(decreased), Friedman did not think that interest rate changes
mattered much.
l Friedman’s modern quantity theory proved itself superior to
Keynes’s liquidity preference theory because it was more complex,
accounting for equities and goods as well as bonds.
l Friedman allowed the return on money to vary and to increase above
zero, making it more realistic than Keynes’s assumption of zero
return. 59
Empirical Evidence on Demand for Money
l Is demand for money sensitive to changes in interest rates?
l If not, velocity is more likely to be a constant, and then
money supply has a tight link to aggregate spending.
l The more sensitive, the more increasingly volatile will be

l Extreme situation: liquidity trap – infinitely elastic money

demand (w.r.t. interest rates)
l Is money demand unstable?
l If yes, velocity would be unpredictable.

l Helps central bank decide whether to target money growth

or inflation.
l In the data, money demand is becoming more unstable with
time (innovation), though it is also hard to measure.
60
Empirical Evidence on Money Demand

Interest Rate Sensitivity of Money Demand

Is sensitive, but no liquidity trap
Stability of Money Demand
1. M1 demand stable till 1973, unstable after
2. Most likely source of instability is financial innovation
3. Cast doubts on money targets
 IS-LM Model:
Effectiveness of
Monetary and
Fiscal Policy

1. M d is unrelated to i Þ i ­, M d = M s at same
Y Þ LM vertical
2. Panel (a): G ­, IS shifts right Þ i ­, Y stays
same (complete crowding out)
3. Panel (b): M s ­, Y­ so M d ­, LM shifts right
Þi¯Y­
Conclusion: Less interest sensitive is M d,
more effective is monetary policy relative to
fiscal policy
5-62
AD-AS Analysis: Monetarist View of AD

P´Y 1 ´ 2000
V= = = 2
M 1000
Modern Quantity Theory of Money (Friedman, 1956)
M´V=P´Y
Implication: M determines P ´ Y if V predictable and unrelated to DM
Deriving AD Curve
P=1, M = 1000, V = 2 Þ P ´ Y = 2000 (Point B below)
Point A: P = 2 Y = 1000 PY = 2 ´ 1000 = 2000
Point B: P = 1 Y = 2000 PY = 1 ´ 2000 = 2000
Point C: P = 0.5 Y = 4000 PY = 0.5 ´ 4000 = 2000
Conclusion: P ¯, Y ­, downward sloping AD
2 Key Differences w.r.t. Keynesians (see also next slide):
l Shift in AD Curve: one primary source, DM (e.g., if M = 2000 above)
M ­ <=> P´Y ­, i.e., AD shifts right (at any given P)
l Crowding out: complete (see next slide)

5-63
AD-AS Analysis: Keynesian View of AD
Yad = C + I + G + NX
Downward Sloping AD
P ¯, M/P ­, i ¯, E ¯ (depreciation, in Mishkin) I ­, NX ­, Yad ­, Y ­
2 Key Differences w.r.t. Monetarists
Shift in AD: many sources
ad
M ­, M/P ­, i ¯, I ­, NX ­, Y ­, Y ­
Þ AD shifts right
C ­ or I ­ or NX ­ or G ­ or T ¯ : Yad ­, Y ­
Þ AD shifts right
Crowding Out: partial (in the short run)
Complete (monetarists): G ­, i ­ Þ C ¯, I ¯, NX ¯ Þ C + I + G + NX = Yad
unchanged
Partial (Keynesians): private spending down, but not fully offsetting G ­

5-64
Money and Inflation: The Evidence

“Inflation is always and everywhere a monetary phenomenon”

(M. Friedman)
Evidence
In every case when p high for sustained period, M growth is high
Examples:
1. Latin American inflations
2. German Hyperinflation, 1921–1923
Controlled experiment, particularly after 1923 French invasion of Ruhr—
government prints money to pay strikers, p > 1 million %
Meaning of “inflation”
Friedman’s statement uses definition of p as continuing, rapidly rising price
level: only then does evidence support it!

5-65
German
Hyperinflation:
1921–1923
Monetarist and Keynesian Views on p

Monetarist View
Only source of AD shifts and p can be Ms growth
Keynesian View
Allows for other sources of AD shifts, but comes to same conclusion that
s
only source of sustained high p is M growth
Lags in Shifting AD
1. Data lag
2. Recognition lag
3. Legislative lag
4. Implementation lag
5. Effectiveness lag
Case for Activist Policy
If self-correcting mechanism is slow (U > Un for long time)
Case for Nonactivist Policy
If self-correcting mechanism is fast
5-67
Lucas (1976) Critique

Lucas challenges usefulness of econometric models for policy evaluation

1. Critique follows from RE implication that change in way variable moves,
changes way expectations are formed
2. Policy change, changes relationship between expectations and past behavior
3. Estimated relationships in econometric model change
4. Therefore, can’t be used to evaluate change in policy
Example: Evaluate effect on long rate from Fed policy raising short-term
i permanently, if in past changes in i quickly reversed (were temporary)
1. Estimated term structure relationship indicates only small change in long rate
2. Once realize short i ­ permanently, average future short rates ­ a lot, long
rate ­ a lot
3. Another implication of Lucas analysis: expectations about policy influence
response to policy
New (Neo)Classical Model
Assumptions:
1. Rational expectations
2. Wages and prices completely flexible with respect to expected
inflation: adjust immediately and fully to changes in the expected
price level
Implications:
1. Policy ineffectiveness proposition: anticipated policy has no effect
on business cycle
2. Effects of (unanticipated) policy are uncertain because they depend
on expectations
3. No beneficial effect from activist policy: supports nonactivism
New Keynesian (or NNS) Model

Assumptions:
1. Rational expectations
2. Wages and prices display rigidity: do not adjust immediately
(and fully) to changes in the expected price level
Implications:
1. Unanticipated policy has larger effect on Y than anticipated
policy
2. But policy ineffectiveness does not hold:
Anticipated policy does affect Y!
3. Does not rule out beneficial effect from activist policy
4. However, effects of policy are affected by expectations:
designing policy is tough
Concluding Wrap-Up

l What have we learnt?

l How alternative theories of money demand differ

l What is the role of money in IS-LM and AD-AS

models
l Why inflation is ultimately a monetary phenomenon

l What are the effects of money and policy on output

l Where we go next: to the formulation and

implementation of monetary policy by central banks