Lecture 4 - The demand for money

Question 1

What is the quantity theory of money?

Answer 1

The theory of how the nominal value of aggregate income is determined. As it tells us how much money is held for a given amount of aggregate income, it is a theory of the demand for money.

Question 2

What is the most important feature of this theory?

Answer 2

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

Question 3

What did Fisher want to examine?

Answer 3

The link between money supply (M) and aggregate nominal income (P x Y).

Question 4

What is the velocity of money?

Answer 4

The concept that provides the link between M and P x Y. V is defined as total spending (P x Y) divided by the quantity of money M. The average number of times per year that a unit of money is spent in buying the total amount of goods/services produced in the economy.

Question 5

What is the equation of exchange?

Answer 5

It relates nominal income to the quantity of money and velocity. It states that the quantity of money multiplied by the number of times that this money is spent in a given year must equal nominal income (the total nominal amount spent on goods and services in that year). (M x V = P x Y)

Question 6

What determines velocity?

Answer 6

The institutions in an economy that affect the way individuals conduct transactions.

Question 7

If people use credit cards to conduct their transactions, and consequently use money less often when making purchases, less money is required to conduct the transactions generated by nominal income, and velocity will…

Answer 7

Increase.

Question 8

If it is more convenient for purchases to be paid for with cash or cheque, more money is used to conduct the transactions generated by the same level of nominal income, and velocity will…

Answer 8

Fall.

Question 9

Why did Fisher view that velocity would normally be reasonably constant in the short run?

Answer 9

Institutional and technological features of the economy would affect velocity only slowly over time.

Question 10

What does Fisher’s view that velocity is fairly constant in the short run do?

Answer 10

It transforms the equation of exchange into the quantity theory of money.

Question 11

What does the quantity theory of money state?

Answer 11

It states that nominal income is determined solely by movements in the quantity of money. When the quantity of money doubles (M), M x V doubles and so must P x Y the value of nominal income.

Question 12

What did classical economists including Fisher think?

Answer 12

They thought that wages and prices were completely flexible, they believed that the level of aggregate output Y produced in the economy during normal times would remain at the full employment level, so Y could be treated as reasonably constant in the short run. The quantity theory of money then implies if M doubles, P must also double in the short run, because V and Y are constant. Movements in the price level result solely from changes in the quantity of money.

Question 13

Until the Great Depression, economists did not recognise that velocity declines sharply during severe economic recessions. Why was this?

Answer 13

Accurate data on GDP and money supply did not exist before WW2. Lack of data availability until after the war.

Question 14

What is the liquidity preference theory?

Answer 14

Keynes abandoned the classical view that velocity was a constant and developed a theory of money demand that emphasised the importance of interest rates. His theory asked, why do individuals hold money?

Question 15

What is the transactions motive?

Answer 15

Individuals are assumed to hold money because it is a medium of exchange that can be used to carry out everyday transactions. This component of the demand for money is determined primarily by the level of people’s transactions. These transactions are believed to be proportional to income.

Question 16

What is the precautionary motive?

Answer 16

Keynes recognised that in addition to holding money to carry out current transactions, people hold money as a cushion against an unexpected need. Precautionary money balances are useful if you are hit with an unexpected bill for a car repair or private health care. Keynes believed that the precautionary money balances people want to hold are determined primarily by the level of transactions that they expect to make in the future and that these transactions are proportional to income. The demand for precautionary money balances is proportional to income.

Question 17

What is the speculative motive?

Answer 17

Keynes took the view that people also hold money as a store of wealth. He believed that wealth is tied closely to income and divided the assets that can be used to store wealth into two categories; money and bonds.

Question 18

What can be concluded from Keynes’ reasoning?

Answer 18

As interest rates rise, the demand for money falls and therefore money demand is negatively related to the level of interest rates.

Question 19

What are real money balances?

Answer 19

The quantity of money in real terms.

Question 20

Demand for real money balances depends on…

Answer 20

Interest rates and real aggregate income.

Question 21

Explain Keynes’ three motives for holding money.

Answer 21

Although Keynes took the transactions and precautionary components of the demand for money to be proportional to income, he reasoned that the speculative motive would be negatively related to the level of interest rates.

Question 22

What does Keynes’ model of the demand for money imply?

Answer 22

Velocity is not constant but instead is positively related to interest rates, which fluctuate substantially.

Question 23

Why does Keynes believe velocity is not constant?

Answer 23

Changes in people’s expectations about the normal level of interest rates would cause shifts in the demand for money that would cause velocity to shift as well.

Question 24

What did Friedman state that the demand for money must be influenced by?

Answer 24

The same factors that influence the demand for any asset. Friedman then applied the theory of asset demand to money.

Question 25

What is the theory of asset demand?

Answer 25

Indicates that the demand for money should be a function of the resources available to individuals (their wealth) and the expected returns on other assets relative to the expected return on money.

Question 26

What is the expected return on money rm influenced by?

Answer 26

• The services provided by banks on deposits included in the money supply, such as provision of receipts in the form of cancelled cheques or the automatic paying of bills. When these services are increased, the expected return from holding money rises.
• The interest payments on money balances. Now accounts and other deposits that are included in the money supply currently pay interest. As these interest payments rise, the expected return on money rises.

Question 27

Differences between the Friedman and Keynesian theories.

Answer 27

• Friedman included many assets (stored as wealth) as alternatives to money, whereas, Keynes lumped financial assets other than money into one big category because he felt their returns generally move together.
• Friedman viewed money and goods as substitutes; people choosing between them when deciding how much money to hold. Hence why he included the expected return on goods relative to money as a term in his money demand function. This assumption indicates that changes in the quantity of money may have a direct effect on aggregate spending.
• Friedman did not take the expected return on money to be constant, as Keynes did. He argued that a rise in market interest rates will raise the expected return on money sufficiently so that rb - rm will remain relatively constant.
• Unlike Keynes’ theory, which indicates that interest rates are an important determinant of the demand for money, Friedman’s theory suggests that changes in interest rates should have little effect on the demand for money. In Friedman’s view, the demand for money was insensitive to interest rates. Friedman’s money demand function was essentially one in which permanent income is the primary determinant of money demand. The spread (rb-rm) is fairly constant over time.
• Friedman suggested that random fluctuations in the demand for money are small and that the demand for money can be predicted accurately by the money demand function. When combined with his view that the demand for money is insensitive to changes in the interest rates, this means that velocity is highly predictable.

Question 28

What does Friedman’s theory say about velocity being procyclical?

Answer 28

Indicates that the demand for money rises only a small amount relative to the rise in measured income and velocity rises. Similarly, in a recession, the demand for money falls less than measured income, because the decline in permanent income is small relative to measured income, and velocity falls. We have the procyclical movement in velocity.

Question 29

What are the two major differences in Friedman and Keynes’ theories?

Answer 29

Friedman believed that changes in interest rates have little effect on the expected returns on other assets relative to money. Thus, in contrast to Keynes, he viewed the demand for money as insensitive to interest rates. In addition, he differed from Keynes in stressing that the money demand function does not undergo substantial shifts and is therefore stable. These two differences also indicate that velocity is predictable, yielding a quantity theory conclusion that money is the primary determinant of aggregate spending. The view that the money supply is the primary source of movements in the price level and aggregate output.

Question 30

The more sensitive the demand for money is to interest rates the…

Answer 30

More unpredictable velocity will be and the less clear the link between money supply and aggregate spending will be. For this reason, velocity is not constant.

Question 31

What is the stability of the money demand function crucial for?

Answer 31

Whether the central bank should target interest rates or the money supply.

Question 32

If the money demand function is unstable and undergoes substantial unpredictable shifts, as Keynes thought, then velocity is unpredictable, and the quantity of money may…

Answer 32

Not be tightly linked to aggregate spending, as it is in the modern quantity theory.

Question 33

In the early 1970s, evidence strongly supported the stability of the money demand function. What happened after 1973?

Answer 33

The rapid pace of financial innovation changed which items could be used as money. This led to substantial instability in estimated money demand functions.

Question 34

As the money demand function has become unstable, velocity is…

Answer 34

Now harder to predict.

Question 35

The recent instability of th money demand function calls into question whether our theories and empirical analyses are inadequate. What important implications does this have?

Answer 35

It has important implications for the way monetary policy should be conducted because it casts doubt on the usefulness of the money demand function as a tool to provide guidance to policymakers.

Question 36

According to the quantity theory of money (both Fisher’s and Friedman’s version), a change in M is supposed to cause a…

Answer 36

Predictable change in Aggregate Income (P×Y).

Question 37

The problem is that the exact impact of this change in M is very difficult to quantify as…

Answer 37

The velocity of money in practice is likely to be unstable and unpredictable.

Question 38

The main central banks (Bank of England and the Fed) share the view that…

Answer 38

Setting rigid money supply targets to control aggregate spending in the economy may not be an effective way to conduct monetary policy (money targeting). This was successful in Germany until the 1990s. During the 1980s, the UK and US abandoned monetary targeting and pursued other strategies such as inflation targeting.