Lecture 4 The Demand For Money

Question 1

What is the equation of exchange?

Answer 1

M x V = P x Y

Question 2

What is M?

Answer 2

M = total quantity of money (money supply)

Question 3

What is V?

Answer 3

– the rate of turnover of money
– average # of times per year that a unit of money (e.g. £) is spent in buying the
total amount of goods/services produced in the economy

Question 4

What is P?

Answer 4

aggregate price level

Question 5

What is Y?

Answer 5

total spending (real) = real aggregate income = real GDP

Question 6

What is the point in the equation of exchange?

Answer 6

To convert it into a theory that will explain how money supply
affects aggregate income we need to understand what
determines velocity!

Question 7

What is Fisher’s claim?

Answer 7

•Velocity is determined by institutional & technological features
that shape how transactions are conducted:
– 1) Example: if it gets more convenient to pay with cash/cheques  more
money is used (currency & cheques are counted as M)  velocity will fall
– 2) Ex: if credit cards are introduced  less money is used  velocity will rise

•Fisher believed these features change slowly over time

Question 8

What is the money demand function?

Answer 8

M^d = 1/V x PY

Question 9

demand for real money balances (i.e. adjusted for P)

Answer 9

M^d/P = 1/V x Y

Question 10

Is Velocity Constant?

Answer 10

• If the previous two figures show that velocity is not constant,
then why was the Quantity Theory of Money proposed?
• Well, classical economists thought velocity was constant,
but didn’t have good data to test their assumption.
• Previous two figures show that, even in the short run, velocity
fluctuates quite a lot.
– More specifically, velocity seems to fall during recessions!
• After the Great Depression, a search began for other factors
that influence demand for money and might explain large
fluctuations in velocity

Question 11

What is Keynes Liquidity Preference Theory?

Answer 11

Keynes: The General Theory of Employment, Interest, and Money
(1936). He proposes 3 motives behind the demand for money: Transaction Motive, Precautionary Motive and Speculative Motive.

Question 12

What is the Transaction Motive?

Answer 12

– Money is a medium of exchange that can be used for everyday
transactions
– Demand for it depends on level of people’s transactions
– Transactions are assumed to be proportional to Aggregate Income

Question 13

What is the Precautionary Motive?

Answer 13

– People hold money as a cushion against unexpected future expenses
• e.g. unexpected bill for car repair or hospitalization
– Quantity of money held for precautionary reasons is assumed to be
proportional to Aggregate Income
• As your income rises, you can afford to hold a bigger cushion against unexpected
future expenses

Question 14

What is the Speculative Motive?

Answer 14

– Money is a store of wealth, but not unique!
– Keynes proposed that wealth could be stored into 2 types of assets:
• (A). Money; (B). Bonds (true in the 1930s, less so nowadays)

Question 15

What are Keynes assumptions?

Answer 15

1. Expected return on money = 0% (nowadays deposits may offer interest)
2. Interest rates fluctuate around some normal level :
   – If i >  interest rates will fall  bond prices will rise  exp. return on bonds > 0%
   – If i <  interest rates will rise  bond prices will fall  exp. return on bonds possibly <0%
   – Therefore, high (low) nominal interest rates are accompanied by low
   (high) money demand.
   Money demand is negatively related to nominal interest rates

Question 16

What is the liquidity Preference Function?

Answer 16

Combining the 3 motives together, and recognizing that people
care about how many goods/services they can buy with a given
amount of money, Keynes ended up with the following:
M^d / P = f(i,Y)