Chapter 7: The Demand for Money PDF

Objectives of the Lesson • • 4 theories How do these theories affect the demand for money? Theory of Money Demand • We all have money, held it in terms of cash and current deposit. • We can store our wealthy in terms of house, car, share, or fixed deposit. • So money and wealth is a diffe...

Objectives of the Lesson • • 4 theories How do these theories affect the demand for money? Theory of Money Demand • We all have money, held it in terms of cash and current deposit. • We can store our wealthy in terms of house, car, share, or fixed deposit. • So money and wealth is a different things and that differences may causes the concept of Demand for Money. Loading… • The theory is a theory of how nominal value of aggregate income is determined. • Explain on how much money is held for a given income. • Interest rate has no effect on the demand for money. • So, this issue has attracted in-depth research from some economists like Fisher (1910), Keynes (1920-1930), and Friedman (1950). • In this chapter, we want to know, why people demand for money. What is the history behind that. • Also, we want to know about:- 1. How quantity money demand is affected by changes in interest rate; 2. How money affect the aggregate economy. • Interest rate -> demand for money -> aggregate economy. • First - Classical theory for money demand, Cambridge and Keynes. Then, there is Friedman theory which has introduced the modern theory. Loading… Classical theory of Money Demand • Irving Fisher’s Quantity Theory of Money Demand • Velocity of money & equation of exchange • • Quantity Theory Quantity Demand Theory of Money • Cambridge’s Demand Theory of Money • Keynes’s Liquidity Preference Theory • These theories explaining on how much the money are required to be paid for all the transactions at all income levels. a. Velocity of money & Equation of exchange • • • Basic formula MV=PY (eq. of exchange) • When all the Ringgit is spend, MV, it must be equal to the total g&S produced by firms (total revenue), PY. • It means that, total expenses by consumers must equal to total output sales. RM20 for a book that customer pay = to RM20 that seller receive (RM20x1 unit) M : Qty of Money V : Velocity P : Price level Y : Real Income level/ aggregate output • V – link between the total quantity of money (M/ Money supply) and the total amount of spending on final g&s produced in the economy (PxY). • V is the rate of turnover of money, that is the average number of times per year that a Ringgit is spent in buying the total amount of g&S produced in the economy. • V = total spending, PY, divided by the quantity of money, M. (V=PY/M) Factors that influence V: • Fisher said that velocity is determined by the institutions in an economy that affect the way individuals conduct transactions. • Fisher took the view that the institutional and technological features of the economy would affect velocity only slowly over time, so velocity would normally be constant in the short run. • If we prefer more using in credit card, so money usage is less, and it was easy to change from 1 to another person. So V becomes more highly circulated in the market. Otherwise, if public prefer more using in cash and cheque, so they should hold more money and money circulation becomes less volatile because of there is much money on their hand. • b. Quantity Theory • Fisher’s view that velocity is fairly constant in the s/run. • It transforms the equation of exchange into the quantity theory of money, which states that nominal income is determined solely by movements in the quantity of money. Y is also constant in the s/run because Y is not easy to fluctuate in s/run. Loading… • When the quantity of money M doubles; M x V doubles; and so must P x Y. • If M doubled, P must also be doubled in short run because V and Y are constant. • For the Classical Economist, the quantity theory of money provided an explanation of movements in the price level: movement in the price level result solely from changes in the quantity of money. C. Quantity Theory of Money Demand • The quantity theory of money tells us how much money is held for a given amount of aggregate income, hence it is in fact a theory of a demand for money. • From M‘V’ = PY, we know that public hold money for the transaction proposes. • It can be rewritten as M = (1/V) PY. So here, we know that the amount of M affected by PY is equal to the value of 1/V. • When the money market is in equilibrium, the quantity of money (M) that people hold equals to the quantity of money demanded (Md), so we can replace M with Md using k to represent 1/V. • • So, Md = k x PY. • Also, because k is constant, the level of transactions generated by a fixed level of nominal income (PY) determines the quantity of money (Md) that people demand. k, V and Y are constant, so increase in M will result in increase in P. • It mention that, people were holding money when their real income is PY. • Increasing in income is lead to an increasing in Md as k or 1/V times. • Another factor like an interest rates is not affect on Md. • Conclusion: people hold money only to conduct transactions. • The demand for money is determined by: 1. the level of transactions generated by the level of nominal income, PY. 2. the institutions in the economy that effect the way people conduct transactions (that determine velocity and hence k). Cambridge’s Theory of Demand Money • Cambridge asked how much individuals would want to hold money. • Individual holding money because of this both function of money. • 1. Medium of exchange - holding money for transaction purposes. Similar to the Fisher. • 2. Store of value – bond and real asset brings benefit to their holders. So to hold the money, individual will choose either one that bring more benefit to them, bond or money. • • • • • • So, based on Cambridge, Md maybe influenced by interest rate and profit from capital. Money is a part of individual wealth. So holding of money is depends on the wealthy. W ↑ , holding of money ↑ Cambridge Md is function of wealth (Md = aW), wealth is a proportional to national income. So, Md is a proportional to national income, the Cambridge expressed the Md function as: Md = k x PY Where k = interest rate • Although the equation is identical to Fisher, Cambridge disagreed with Fisher on the role of interest rates on the Md. • Cambridge:- k could fluctuate in the short run. It is because the decisions about using money as a store wealth would depend on the yields and expected return on other assets. Where, these are the function to the stores of wealth. If this characteristics of other assets change, k might change too. Keynes’s Liquidity Preference Theory • KEYNES’ demand for money includes demand for idle cash (currency and demand deposits). • 3 motives of holding money: • • • Transactionary motive Precautionary motive Speculative motive Transactionary Motive (DMt) • Very importance motive for consumer expenditures and business transaction • Household demand for purchase g&S Firms demand for purchase pf that supply by Household • Demand for this motive depends on income level • As income increase, DMt also increase (+ve relationship) Precautionary Motive (DMp) • DD for money also used for saving or for unpredictable problems in the future. • Money may used to pay for hospital bill if accident or use when individual resign from their work. • • DD for this motive also depends on Yd As income increase, DMp also increase (+ve relationship) Speculative Motive (DMs) • Individual DD for money for the purpose of speculation. • • They buy share and bond to get the profit. • People will buy bond when they expect interest rate will decrease and price increase in the future. Speculative motive exist when people choose either want to hold money without any interest rate or invest it and get more income. • • Otherwise, people will sell bond when they expect interest rate will increase and price decrease in the future. So, DMs is depends on interest rate. When interest rate is high, DMs will be lower (-ve/inverse relationship) Putting the 3 motives together • Based on the 3 motive, so Keynes combine together all of the 3 motives. • • Md= DMt + DMp + DMs So the liquidity preference function is : Md/ P = f (i, Y) where is, i is –ve, and Y is +ve. • If Md/P is positive to Y, it means, when real income ↑, transaction and precaution motives also ↑. • • • • If Md/P is negative to r, it means, when i ↑, Demand for money ↓. The lower the i, the increase the demand for money. Public sell or buy bond, to obtain the money as an alternative asset. As the interest rates goes up, (S↑,I↓), so the quantity of money declines (refer to ms/md curve), and therefore velocity rises. A rise in interest rate encourages people to hold lower real money balances for a given level of income, therefore the rate of turnover of money (velocity) must be higher. Velocity • Velocity is not constant, it fluctuates with movements in the interest rate. • Unstable movement in interest rate can lead to instability of velocity. • • When recession, velocity falls. Velocity and interest rate are positively related. Friedman’s Modern Quantity Theory of Money • Milton Friedman developed a model for money demand based on the general theory of asset demand. • Money demand, like the demand for any other asset, should be a function of wealth and the returns of other assets relative to the expected return on money. • Like Keynes, Friedman recognized that people want to hold a certain amount of real money balances (the certain amount of income that have not been used). • where Md/P = Demand for real money • Yp = Friedman’s measure of wealth:permanent income (the expected long-run average of current and future income) • rb = the expected return on bonds • rm = the expected return on money • re = the expected return on stocks • pi(e) = the expected inflation rate (the expected return on goods, since inflation is the increasing in the price of goods). The people that hold the goods such as sellers/suppliers. • Md have –ve r/ship with the relative asset rate of return. Increase or decrease the money demand rate depending on other assets return. • Permanent income have positive relationship with Md which is its more stable rather than current income (price fluctuate). Therefore it will not being as source of fluctuation in Md. • Friedman focus on the Md fluctuation in long run, which is he stated that demand for money will not fluctuate much with business cycle movements. • Therefore, permanent income fluctuate either in s/r or l/r. less • Return on money can be seen trough the services provided by bank. If more money was lending, Md will rise in circulation. • When expected return higher in bond, less demand for money. • When expected return higher share/equity, less demand for money. Loading… expected inflation higher, in • When more expected return in goods as its prices rise, thus less demand for money. • rm is influenced by 2 factors: • • Services provided by the bank Interest payment on money balances. Distinguish between the Friedman and Keynesian theories Friedman vs. Keynes • When comparing the money demand frameworks of Friedman and Keynes, several differences arise. • Friedman considers multiple rates of return and considers the RELATIVE returns to be important. • Friedman viewed money and goods are substitutes. • Friedman viewed permanent income as more important than current income in determining money demand. • Friedman's money demand function is much more stable than Keynes'. Why? Consider the terms in Friedman's money demand function: • • permanent income is very stable, and • If the terms affecting money demand are stable, then money demand itself will be stable. Also, velocity will be fairly predictable. the spread between returns will also be stable since returns would tend to rise or fall all at once, causing the spreads to stay the same. So in Friedman's model changes in interest rates have little or no impact on money demand. This is not true in Keynes' model. •TQ