Chapter 4

The Demand For Money

 Money Demand

• Demand for money: how much individuals wish to hold in

the form of money at any point in time. “Holding money”.

• Individuals keep the wealth in different forms such as

buying a house or securities, holding a checking account
or cash.

• Why would anyone hold part of his wealth as money,

whether cash or checking accounts?

• Why not hold wealth in the form of assets that yield

income?
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 Money Demand

• Cost of holding money:

1. Interest rate or return foregone.

2. Money loses its purchasing power due to inflation.

• Financial innovations also affect the demand for money

over time. For example, individuals who use credit cards to
make a large proportion of their transactions hold less
money on average than do those who deal “solely in cash”.

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 THEORIES OF MONEY DEMAND

• Below are some theories that attempted to answer these

questions.

1. Classical’s Theory, Quantity Theory of Money by Fisher.

2. Keynes’s Theory of Money: Liquidity Preference Theory.

3. Friedman’s Modern Quantity Theory of Money.

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 1. Quantity Theory of Money (QTM)

• Quantity theory of money relates the amount of money (Md) in the

economy to the nominal value of aggregate income (y).

• It tell us how much money is held for a given amount of aggregate

income, it is also a theory of the demand for money.

• This theory states the changes in the quantity of money tend to affect
the purchasing power of money inversely.

• That is, with every increase in the quantity of money, each monetary
unit (such as dinar or dollar) tends to buy a smaller quantity of goods
and services while a decrease in the quantity of money has the
opposite effect.

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 The Quantity Theory of Money
• The theory begins with an identity known as the equation of
exchange:
MxV = PxY
M = the quantity of money (or money supply).
V = velocity of money (average number of times per year that a dollar or
dinar is spent)
P = the price level.
Y = aggregate output (aggregate income).
PY = the total amount of spending on final goods and services produced
in the economy, aggregate nominal income or (nominal GDP).

• The equation of exchange states that the quantity of money

multiplies by number of times this money is spent in a given
year must equal to nominal GDP (PY).

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 Velocity of money (V)
• V = is the average number of times that a monetary unit such as dinar
or dollar is spent (used) in buying the total amount of final goods and
services produced in an economy during a given time period.

Example: Consider 4 college students:

– Ahmad has BD100 in currency;

– Sana has two tickets to the weekend football game, worth BD 50 each;
– Adam has a mobile worth BD 100 ; and
– Noor has a set of 4 books that sell for BD 25 each.

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 Velocity of money (cont..)

• Ahmad with BD100 buys the mobile from Adam.

• Adam now uses the BD100 to buy the football
tickets from Sana.
• Sana now uses the BD100 to buy the 4 Books from Noor.

• so the total value of the transactions is BD 300.

In this 4-person economy, the BD100 was used 3 times

resulting in BD 300 worth of transactions.

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 Velocity and the Equation of Exchange

• By rearranging the equation of exchange (MV = PY) we get the

velocity of money equation.
• V = PY/ M = (Nominal GDP /Quantity of Money).
• The number of times each dollar is used (per unit of time) is called
the velocity of money.

Example:
• If nominal GDP (PY) = $6 Billion and quantity of money (M) = $2
Billion.
• Then, V = 6/2 = 3, which means that the average $ is spent 3 times
in purchasing final goods and services.
• This would mean that each banknote in circulation changed hands
on average 3 times over the course of the time (year).

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 Assumptions of QTM
• Velocity (V) is constant in short run.
• Aggregate output (Y) at full-employment level.

• Putting these two assumptions together lets look again at

the equation of exchange (MV = PY).

• Therefore,Changes in M affect only P. i.e., movement in

the price level results only from change in the quantity of
money.

• The most important feature of this theory is that it suggests

that interest rates have no effect on the demand for money.

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 QTM
• We can further modify this relationship by dividing both
sides by V:
• Since V is constant we can replace 1/V with some constant,
k, so k = 1/V, and when the money market is in equilibrium,

So our equation becomes Md = k x PY

• According to Fisher, Md is determined by:

1. the level of transactions generated by the level of nominal
income (PY).
2. the institutions in the economy that affect the way people
conduct transactions and thus V and k.
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EXERCISE: The impact of ATMs on money demand

During the 1980s, automatic teller

machines became widely available.

How do you think this affected

money demand and V? Explain.

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 2. Keynes’s Theory of Money:
Liquidity Preference Theory

• Keynes’s theory emphasized the importance of interest

rate.
• Keynes rejected the classical view that velocity was a
constant.
• In his theory, Keynes explened Why individuals hold
money, he believed that there are three motives for
individuals to hold money:
1. transaction motive (medium of exchange).
2. precautionary motive (store of wealth).
3. speculative motive (store of wealth).

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 Transaction Motive

• Keynes agreed with the classical theory that:

1. money is used as a medium of exchange. So people’s

demand for money is for the purpose of transactions.

2. as income rises, people have more transactions and

people will hold more money.

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 Precautionary Motive

• People hold money to be used in future for unexpected

needs and emergencies.

• Since this also depends on the amount of transactions

people expect to make, money demand is again expected
to rise with income.

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 Speculative Motive

• Keynes suggested that people also hold money as a store of wealth.

• Because wealth is tied closely to income, the speculative motive for
money demand is related to income. It is also related to the rate of
interest (i).

• Keynes assumed that people stored wealth with either money or

bonds.

• Bonds are more attractive than money when interest rates are high
and less when interest rates are low.

• Thus, under the speculative motive, money demand is negatively

related to the interest rate.

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 Keynes' theory

• Keynes modeled money demand as the demand

for the real quantity of money (real balances) or (M/P).

• In other words, if prices double, you must hold twice the

amount of M to buy the same amount of items, but your
real balances stay the same.

• So people choose a certain amount of real balances

based on the interest rate, and income.

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 Keynes' theory

• Thus, Keynes wrote the demand for money equation ,

Md/p = F (i,Y)
• where:
Md/p is the demand for real money balances.
i is the interest rate, and
Y is the real income

• The importance of interest rates in the Keynesian approach is

the big difference between Keynes and Fisher.

• With this difference also come different implications about the

behavior of velocity.

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 Keynes' theory

• This means that under Keynes' theory, velocity fluctuates

with the interest rate.

• Since interest rates fluctuate, then velocity must too.

• In fact, velocity and interest rates will move in the same

direction.

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 Further Development in the Keynesian Approach
Baumol–Tobin Model

• James Tobin and William Baumol both independently

developed similar money demand model. The basic idea
in their analysis are:
• Deciding how much money to hold depends on the costs
and benefits.
• Benefits: Holding money allows people to make payments.
• The cost is based on opportunity cost. The interest that
people lose in not buying an interest bearing bond is the
opportunity cost of holding money.
• The benefit of holding money is the avoidance of
transaction costs.
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 Transaction Demand

• The higher the nominal interest rate, the higher the

opportunity cost of holding money, the less money
individuals will hold for a given level of transactions, and
the higher the velocity of money.

• As stated earlier, Baumol‐Tobin model revealed that the

transaction demand for money, and not just the
speculative demand, would be sensitive to interest rate.

• The transaction component of Md is negatively

related to the level of i.

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 Precautionary Demand

• As in transaction case, there is an opportunity cost of

holding money for precautionary purposes.

• As i increases the opportunity cost increases so the

holding of money decreases.

• The precautionary demand for money is negatively

related to i.

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 Speculative Demand

• Keynes' speculative demand predicted that people would

hold wealth as either money or bonds, but not both at
once.That is not realistic according to Tobin‐Baumol
models for two reasons:

1. People would hold money and bonds at the same time.

2. People not only do care about the expected return on

asset versus another when they decide what to hold in
their portfolio, but they also care about the riskiness of
the returns from each asset.

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 Speculative Demand
• Tobin assumed that most people are risk averse that
they would be willing to hold on asset with a lower
expected return if it is less risky.

• So even if the expected returns on bonds exceed the

expected return on money, people might still want to
hold money as a store of wealth because it has less risk
than bonds do.

• People can reduce risk by diversifying their portfolio, by

holding both money and bonds simultaneously as stores
of wealth.

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 3: Friedman’s Modern Quantity Theory of Money

• He stated that the Md is influenced by the same factors

that influence the demand for any asset.

• He then applied the theory of asset demand to money.

• The theory of asset demand indicates that the demand

for money should be a function of:

• (1) the resources available to individuals (their wealth).

• (2) the expected returns on other assets relative to the
expected return on money.
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 Friedman’s Theory
1. As wealth rises, the quantity of all these investments,
including money, rises with it.

2. A decline in bond will increase the portfolio demand for

money.

3. When interest rates rise, bond prices drop and bond-

holders suffer a capital loss.

-- If you think interest rates are likely to rise, bonds will become less
attractive than money to you.

4. When interest rates are expected to rise, money demand

goes up.
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 Friedman’s Theory

• Friedman’s demand function for real money balances is

d
M
 F (Yp , rb  rm , re ,  e  rm )
Where: P

Md/p is the demand for real balances,

Yp is permanent income (expected average of long run income)
rm is the expected return on money,
rb is the expected return on bonds,
re is the expected return on equity, and
πe is the expected inflation rate

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 Differences between Keynes’s and
Friedman’s Model

Friedman
• introduces several assets as
alternative to money and
considers multiple relative rates
of return to be important.
Keynes
• Put all financial assets in one
category - bonds- because he felt
that their returns generally move
together.

• Md is relatively stable • Md relatively unstable

》 stable velocity 》great variability in velocity
》 monetary authorities can control 》MS effectively endogenous beyond
MS effectively authorities’ control.
》 Monetary Policy more effective 》Monetary Policy less effective
》advocate superiority of Fiscal
Policy.
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 Recent Empirical Evidence

• Interest rates and money demand

– Consistent evidence of the interest sensitivity of the
demand for money.

• Stability of money demand

– Prior to 1970, evidence strongly supported stability of the
money demand function .

– Since 1973, instability of the money demand function

has caused velocity to be harder to predict

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 CONCLUSION

In conclusion, economists identify three reasons why

people will demand money, or desire to hold a certain
stock of money.

1. Transactions Motive (y+,y+, i-).

2. Precautionary Motive.
3. Speculative Motive.

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