23-10-2023

Errol D’Souza

The Demand for Money

Determinants of real money demand -
Errol D’Souza
Cost of holding money is that an agent opts to forgo
an income from interest earnings

Benefit to the household and firms of holding money,

however, is that it provides liquidity without
which transactions minus the inconvenience
of barter would not be possible

Indian Institute of This tradeoff is given by the budget line

Advanced Study
Rashtrapati Niwas
Shimla
Which point on the budget line would an agent
Turin School
of Development
choose?

Email: errol@iimahd.ernet.in

1 2

Errol D’Souza Errol D’Souza

This depends on the agents’ preferences for cons-

umption and holding money balances. Decision problem -

Utility depends on consumption as in the final  M 

analysis we are interested in the consumption Max U  C1 , 1 
C1 ,( M 1 P1 ),( B1 i1 P1 ) P1 
made possible by income 

Y2 i1 M1 C2
such that Y1 + − = C1 +
Utility depends on money balances as money has (1 + r1 ) (1 + i1 ) P1 (1 + r1 )
value because it is used to exchange goods
and services. As money is a medium of
Individual chooses consumption, nominal money
exchange we should measure money in
balances, and nominal bond holdings, to
units of output, M P
maximize utility subject to the budget
 M constraint.
U = U  C, 
 P Nominal interest rate and price level are
taken as given

3 4

1
 23-10-2023

Errol D’Souza Errol D’Souza

 M
U = U  C ,  = constant
 P
Consumption C Parametric changes and Money Demand
Optimal demand for real
d

Y1 +
Y2
−
C2
A
money balances is M * What happens when the interest rate increases?
(1 + r1 ) (1 + r1 ) P

/
An increase in the interest rate to i makes the
i budget constraint steeper and the increased
Slope =
E 1+ i interest rate will result in the budget constraint
AB/

An increase in the interest rate increases the value

B
M
of the slope given by i (1 + i )
O
Md* P
Real
P (1 + i1 )  Y +
Y2
−
C2 
 Money
i1  1
(1 + r1 ) (1 + r1 ) 
 Balances

Figure 6.2: Equilibrium Money Balances Held

5 6

Errol D’Souza Errol D’Souza

Consumption C Rise in interest rate reduces

the demand for money Rise in interest rate increases the opportunity cost
balances to M
d/
of holding money which is the interest fore-
Y1 +
Y2
−
C2
A
P gone on bonds
(1 + r1 ) (1 + r1 )

Individuals then reallocate their portfolio of finan-

/
cial assets and increase their holding of
i
E
Slope =
1 + i/
bonds whilst reducing their holding of money

B/ B
M
O
/ Md* P
Md Real
P
P (1 + i1/ )  Y1 +
Y2
−
C2 
 Money
i1/  (1 + r1 ) (1 + r1 )  Balances

Figure 6.3: Effect of rise in Interest Rate

7 8

2
 23-10-2023

Errol D’Souza Errol D’Souza

A rise in income to Y1/ increa-

Consumption C
What happens if there is a rise in real income? ses the demand for money
Y2 C2 A/ d/
Y1/ + −
(1 + r1 ) (1 + r1 ) to M
P
A rise in real income shifts the budget line outwards A
—parallel to itself

A rise in real income increases the volume of i

Slope =
planned transactions in the economy E 1+ i
which requires additional money balances.
Real
/ Money
There is an increase in money demand to Md Balances
P B/ M
B
O P
Md* /
Md
P (1 + i1 )  Y / + Y2
−
C2 

P 
i1 
1
(1 + r1 ) (1 + r1 ) 

Figure 6.4: Effect of a Rise in Income

9 10

Errol D’Souza Errol D’Souza

Demand for real money balances is negatively related

Money demand decreases with a rise in the interest
to the nominal rate of interest, i = r + 
rate and increases with a rise in income
Thus a rise in inflation results in a reduction in the
Md
= f( i ,Y ) demand for real money balances
P ( −) ( + )

In the chapter on IS – LM we shall write the linear

form of this function as

Md
= h + nY − ei
P

11 12

3
 23-10-2023

Errol D’Souza Errol D’Souza

Demand for real money balances is negatively related As the demand for money is the demand for a stock
to the nominal rate of interest, i = r +  of an asset there is a period of adjustment
before individual agents can achieve their
Thus a rise in inflation results in a reduction in the
desired stock of real money balances
demand for real money balances
Thus it is usual to have a one-period lag in real
In developing countries with a rise in inflation, a
money stock as an explanatory variable to
substitution is induced not just between
incorporate the partial stock adjustment in
money and other financial assets such as
money balances
bonds, but also between money and real
assets such as gold and real estate
Estimated Money demand function for India -
Expected inflation  is then included as an
e

explanatory variable in the demand for M  M 

log  t  = .48 + .73log  t −1  + .38log Y − .23i − .0043log  e
money function
 Pt   Pt −1 

13 14

Errol D’Souza Errol D’Souza

𝑈𝑀𝑡 Τ𝑃𝑡 1Τ𝑀𝑡 Τ𝑃𝑡 𝐶𝑡

Monetary Policy Slope of Indifference Curve: 𝑈𝐶𝑡
=
1Τ𝐶𝑡
=
𝑀𝑡Τ𝑃𝑡

Suppose the utility function is given by

𝑀𝑡 𝑀𝑡 𝑖𝑡
𝑈 𝐶𝑡 , = 𝑙𝑛𝐶𝑡 + 𝑙𝑛 Slope of Budget Line:
𝑃𝑡 𝑃𝑡 1 + 𝑖𝑡

The marginal utility functions associated with this Hence the period t consumption-money optimality
utility function are: condition is given by
𝐶𝑡 𝑖𝑡
𝑈𝐶𝑡 𝐶𝑡 ,
𝑀𝑡
=
𝜕𝑈
=
1 =
𝑃𝑡 𝜕𝐶𝑡 𝐶𝑡 𝑀𝑡Τ𝑃𝑡 1+𝑖𝑡
From this the money demand function may be
𝑀𝑡 𝜕𝑈 1
𝑈𝑀𝑡Τ𝑃𝑡 𝐶𝑡 , = = written as
𝑃𝑡 𝜕 𝑀𝑡 Τ𝑃𝑡 𝑀𝑡Τ𝑃𝑡
𝑀𝑡𝑑 1+𝑖𝑡
The slope of the indifference curve then is given by = 𝐶𝑡
𝑃𝑡 𝑖𝑡
𝑈𝑀𝑡 Τ𝑃𝑡 1Τ𝑀𝑡 Τ𝑃𝑡 𝐶𝑡
= =
𝑈𝐶𝑡 1Τ𝐶𝑡 𝑀𝑡Τ𝑃𝑡

15 16

4
 23-10-2023

Errol D’Souza Errol D’Souza

𝑀𝑡𝑑 𝑀𝑡𝑆 𝑀𝑡
= =
Short-run: 𝑃𝑡 𝑃𝑡 𝑃𝑡

𝑀𝑡𝑑 1+𝑖𝑡
Consider this as one period of time which we can label However, = 𝐶𝑡
𝑃𝑡 𝑖𝑡
as period t.
Consider a unexpected change in monetary policy by Then,
𝑀𝑡
=
1+𝑖𝑡
𝐶𝑡
the central bank and since the focus is on period 𝑃𝑡 𝑖𝑡
t consider that money markets clear quickly.
We can then state that a nominal money supply
Suppose that money supply in period t, 𝑀𝑡𝑆 , unexpect- shock requires that 𝑃𝑡 adjusts or 𝐶𝑡 adjusts
edly turns out to be larger than markets had or 𝑖𝑡 adjusts, or some combination thereof.
earlier anticipated.
For monetary policy to have an impact in the
Money market equilibrium requires that short-run we require that any increase in
price levels is less than the unanticipated
𝑀𝑡𝑑 𝑀𝑡𝑆 change in money supply. Only then is it
= possible that 𝑀𝑡 Τ𝑃𝑡 increases.
𝑃𝑡 𝑃𝑡

17 18

Errol D’Souza Errol D’Souza

𝑀𝑡 1+𝑖𝑡
= 𝐶𝑡 𝑀𝑡𝑑 𝑀𝑡𝑆 𝑀𝑡
𝑃𝑡 𝑖𝑡 = =
𝑃𝑡 𝑃𝑡 𝑃𝑡
For monetary policy to have an impact in the
𝑀𝑡𝑑 1+𝑖𝑡
short-run we require that any increase in However, = 𝐶𝑡
𝑃𝑡 𝑖𝑡
price levels is less than the unanticipated
change in money supply. Only then is it Then,
𝑀𝑡
=
1+𝑖𝑡
𝐶𝑡
possible that 𝑀𝑡 Τ𝑃𝑡 increases. 𝑃𝑡 𝑖𝑡

It is only when 𝑀𝑡 Τ𝑃𝑡 increases that there is a
decrease in the interest rate which induces
increases in interest sensitive components
of aggregate expenditure such as consump-
tion, 𝐶𝑡 , and investment.
When we think of monetary policy as a change
in interest rate and not money supply it
requires that the interest rate increase is more
than the rate of inflation – Taylor’s Rule.
We can then state that a nominal money supply
shock requires that 𝑃𝑡 adjusts or 𝐶𝑡 adjusts
or 𝑖𝑡 adjusts, or some combination thereof.
Macro theory has two schools of thought about
price adjustment:
Sticky Price View – the New Keynesian View – is
that nominal prices do not adjust in the
short run

19 20

5
 23-10-2023

Macro theory has two schools of thought about

Errol D’Souza Errol D’Souza

price adjustment:
Sticky Price View – the New Keynesian View Long-run:

Flexible Price View – Real Business Cycle case 𝑀𝑡𝑑 1+𝑖𝑡

that nominal prices adjust quickly in the The money demand expression is = 𝐶𝑡
𝑃𝑡 𝑖𝑡
short run
A similar expression holds in period t – 1.
In this view the increase in consumption 𝑑
𝑀𝑡−1 1+𝑖𝑡−1
= 𝐶𝑡−1
as individuals spend their increased 𝑃𝑡−1 𝑖𝑡−1
money balances results in a rise in
prices that neutralizes the increase Dividing the former by the latter,
in consumption demand.
𝑀𝑡𝑑 Τ𝑃𝑡 𝐶𝑡 1 + 𝑖𝑡 𝑖𝑡−1
𝑑 Τ
=
The monetary stimulus thus results 𝑀𝑡−1 𝑃𝑡−1 𝐶𝑡−1 𝑖𝑡 1 + 𝑖𝑡−1
in an increase in inflation such
that there is no impact on real
variables like consumption.

21 22

Errol D’Souza Errol D’Souza

𝑀𝑡𝑑 Τ𝑃𝑡 𝐶𝑡 1 + 𝑖𝑡 𝑖𝑡−1

=
𝑑 Τ
𝑀𝑡−1 𝑃𝑡−1 𝐶𝑡−1 𝑖𝑡 1 + 𝑖𝑡−1 Similarly define the growth rate of nominal money
as
𝑀
Rearranging terms, 𝜇𝑡 = 𝑡 − 1
𝑀𝑡−1

𝑀𝑡 𝑃𝑡−1 𝐶𝑡 1 + 𝑖𝑡 𝑖𝑡−1 𝑀𝑡 𝑃𝑡−1 1 + 𝜇𝑡 𝐶𝑡 1 + 𝑖𝑡 𝑖𝑡−1

= Then, = =
𝑀𝑡−1 𝑃𝑡 𝐶𝑡−1 𝑖𝑡 1 + 𝑖𝑡−1 𝑀𝑡−1 𝑃𝑡 1 + 𝜋𝑡 𝐶𝑡−1 𝑖𝑡 1 + 𝑖𝑡−1
𝑃𝑡 −𝑃𝑡−1
Inflation is defined as 𝜋𝑡 =
𝑃𝑡−1
Now, consider the steady state – a state of the
𝑃𝑡
Or, 𝜋𝑡 = −1 economy where a variable settles down to
𝑃𝑡−1
a constant value over time. Then,
𝑃𝑡
= 1 + 𝜋𝑡
𝑃𝑡−1 𝐶𝑡−1 = 𝐶𝑡 = 𝐶 𝑖𝑡−1 = 𝑖𝑡 = 𝑖 𝜇𝑡−1 = 𝜇𝑡 = 𝜇
𝑃𝑡−1 1 and 𝜋𝑡−1 = 𝜋𝑡 = 𝜋
=
𝑃𝑡 1 + 𝜋𝑡

23 24

6
 23-10-2023

Errol D’Souza Errol D’Souza

1+𝜇𝑡 𝐶𝑡 1+𝑖𝑡 𝑖𝑡−1

In the steady state, = reduces to
1+𝜋𝑡 𝐶𝑡−1 𝑖𝑡 1+𝑖𝑡−1 Hence money is nonneutral in the long run. This
proposition is accepted by all schools of
1+𝜇
=1 macroeconomics – New Keynesian and Real
1+𝜋
Business Cycle. In the long run nominal
Or, prices adjust and the effect of a change in
𝜋=𝜇
money supply is countered by a change in
Thus, in the long-run – the steady-state – the inf- inflation.
lation rate of the economy is governed by
the rate of growth of the money supply.

The higher is the growth rate of money in an

economy – a variable controlled by the central
bank – the higher (in the long-run) is the
economy’s inflation rate.
This is the essence of the Monetarist proposition that
inflation is ultimately a monetary phenomena.

25 26

Errol D’Souza Errol D’Souza

Velocity, Money and Inflation Rewrite the definition of velocity, V = PY/M as the
quantity equation -
Different approach to demand for money is based on MV = PY
concept of velocity – the speed with which money
circulates in transactions involving final goods
and services Irving Fisher used this to argue that there is a link
between money and prices. Suppose velocity
and real output are constant, then,
Nominal GDP PY
Velocity = =
Nominal Money Stock M
MV = PY

Higher is velocity the quicker is a typical rupee An increase in money supply then will get
circulating reflected in a change in prices

27 28

7
 23-10-2023

Errol D’Souza Errol D’Souza

To understand the relationship suppose output is not To understand the relationship suppose output is not
constant - constant -
MV = PY MV = PY

Then, any increase in nominal money over and above Then, any increase in nominal money over and above
the growth of real output would just lead to a the growth of real output would just lead to a
change in prices. change in prices.

By contrast, suppose instead output is constant -

MV = PY

With output constant there is no requirement to

hold any change in nominal money. With
people wanting to hold money for as short
a time as possible velocity will rise.

29 30

Errol D’Souza Errol D’Souza

MV = PY
Over short periods of time inflation can arise due
to factors other than an increase in the
With both money stock and velocity rising the price supply of money such as a bad harvest or
level on the right hand side will also rise. an increase in oil prices.

For long periods of time, however, and especially

Hence, any growth in money that is not absorbed for inflation that is high and persistent,
by a growth in real output will lead to inflation
there is a close relationship between the rate
in the absence of financial innovations or
of inflation and the rate of growth of money
changes in financial intermediation that affect
supply.
money demand and thereby the velocity of
money.

31 32

8
 23-10-2023

Errol D’Souza Errol D’Souza

Figure 6.9 : Inflation and Money Growth

Rapid increase in money growth that accompanies high
140 inflation is usually due to large government
Belarus budget deficits.
120
Bulgaria

100

Central banks usually accommodate deficit spending

80
by the government and monetize the deficit when
Annual Inflation (%)

60
countries are suffering from war or political
Zimbabwe

Turkey instability and the government is unable to

40 Uruguay
Colombia raise revenues in the form of taxes or to borrow
20 India
Kenya Poland
directly from the public.
Nigeria

Brazil Kazakhstan
Ethiopia Argentina
0
0 10 20 30 40 50 60 70 80 90 100
China
South Af rica
-20

Annual money growth (%)

Source: International Financial Statistics, IMF

33 34

Errol D’Souza Errol D’Souza

Phillip Cagan in 1956 studied hyperinflations during

the period 1920 to 1946. A hyperinflation was
Sargent shows how after World War I Austria
defined by Cagan as inflation in excess of 50 per
printed money at extremely high rates to
cent per month for at least a year. Cagan found
finance its government deficit.
that during these hyperinflationary episodes in
countries such as Russia, Germany, Poland,
Austrian notes in circulation increased by
Hungary, and Greece, the actual rate of
over 70 per cent from July to August
monetary growth was excessive
1922.

The rapid increase in money creation led to

annual inflation rates that approached
10,000 per cent per year.

35 36

9
 23-10-2023

Errol D’Souza

Between 1947 and 1984 there were no hyperinflations

in the world economy.

Since 1984 there have been at least seven countries

that witnessed hyperinflation episodes

The Nicaraguan hyperinflation that occurred

over a period of 58 months between June 1986
and March 1991 was the worst amongst these
seven with a cumulative inflation of 11,895
billion

37 38

10