The
demand for money is the desired holding of money balances in the form of cash or bank deposits.
Money is dominated as
store of valueTo act as a store of value, a commodity, a form of money, or financial capital must be able to be reliably saved, stored, and retrieved - and be predictably useful when it is so retrieved....
by interest bearing assets. However, money is necessary to carry out transactions, or in other words, it provides liquidity. This creates a trade off between holding money versus holding other assets. The demand for money is a result of this trade off regarding the form in which a person's wealth should be held. In
macroeconomicsMacroeconomics is a branch of economics that deals with the performance, structure, and behavior of a national or regional economy as a whole. Along with microeconomics, macroeconomics is one of the two most general fields in economics. It is the study of the behavior and decision-making of entire...
motivations for holding one’s wealth in the form of money can roughly be divided in to the
transaction motiveTransactions demand is the demand for financial assets, e.g., securities, money or foreign currency. It is used for purposes of business transactions and personal consumption.The need to accommodate a firm's expected cash transactions....
and the
asset motiveSpeculative demand is the demand for financial assets, such as securities, money or foreign currency that is not dictated by real transactions such as trade, or financing.The need for cash to take advantage of investment opportunities that may arise....
. These can be further subdivided into more micro economically founded motivations for holding money.
Generally, demand for money increases with the level of nominal output (price level times real output) and decreases with the nominal interest rate. The demand for
real balances is defined as the amount of money demanded divided by the price level. For a given
money supplyIn economics, money supply or money stock, is the total amount of money available in an economy at a particular point in time. There are several ways to define "money", but standard measures usually include currency in circulation and demand deposits....
the locus of income-interest rate pairs at which money demand equals money supply determines the LM curve.
The magnitude of volatility of money demand has crucial implications for the optimal way in which a
Central BankA central bank, reserve bank, or monetary authority is a banking institution granted the exclusive privilege to a lend a government its currency...
should carry out monetary policy and its choice of a nominal anchor.
Conditions under which the LM curve is flat, so that changes in money supply have no stimulatory effect (a
liquidity trapThe term liquidity trap is used in Keynesian economics to refer to a situation where the demand for money becomes infinitely elastic, i.e. where the demand curve is horizontal, so that further injections of money into the economy will not serve to further lower interest rates...
) play an important role in Keynesian theory.
A typical
money-demand function may be written as
where is amount of money demanded, P is the price level, R is the nominal interest rate and Y is real output. An alternate name for a term such as is the
liquidity preferenceLiquidity preference in macroeconomic theory refers to the demand for money, considered as liquidity. The concept was first developed by John Maynard Keynes in his book The General Theory of Employment, Interest and Money to explain determination of the interest rate by the supply and demand for...
function.
Transaction Motive
The transaction motive for holding money focuses on the provision of liquidity by money assets (generally cash and checking deposits).
Quantity Theory
The most basic "classical" transaction motive can be illustrated with reference to the
Quantity Theory of MoneyIn monetary economics, the quantity theory of money is the theory that money supply has a direct, positive relationship with the price level.The theory was challenged by Keynesian economics, but updated and reinvigorated by the monetarist school of economics...
. According to the equation of exchange , where M is the stock of money, V is its velocity (how many times a unit of money turns over during a period of time), P is the price level and Y is real income. Consequently PY is nominal income or in other words the amount of transactions carried out in an economy during a period of time. Rearranging the above identity and giving it a behavioral interpretation as a demand for money we have
or in terms of demand for real balances
Hence in this simple formulation demand for money is a function of prices and income, as long as its velocity is constant.
Inventory Models
The amount of money demanded for transactions however is also likely to depend on the nominal interest rate. This arises due the lack of synchronization in time between when purchases are desired and when factor payments (such as wages) are made. In other words while workers may get paid only once a month they generally will wish to make purchases, and hence need money, over the course of the entire month.
The most famous example of an economic model that is based on such considerations is the
Baumol-Tobin modelThe Baumol-Tobin model is an economic model of the transactions demand for money as developed independently by William Baumol and James Tobin . The theory relies on the trade off between the liquidity provided by holding money and the interest foregone by holding one’s assets in the form of...
. In this model an individual receives her income periodically, for example, only once per month, but wishes to make purchases continuously. The person could carry her entire income with her at all times and use it to make purchases. However, in this case she would be giving up the (nominal) interest rate that she can get by holding her income in the bank. The optimal strategy involves holding a portion of one's income in the bank and portion as liquid money. The money portion is continuously run down as the individual makes purchases and then she makes periodic (costly) trips to the bank to replenish the holdings of money. Under some simplifying assumptions the demand for money resulting from the Baumol-Tobin model is given by
where t is the cost of a trip to the bank, R is the nominal interest rate and P and Y are as before.
The key difference between this formulation and the one based on a simple version of Quantity Theory is that now the demand for real balances depends on both income (positively) or the desired level of transactions, and on the nominal interest rate (negatively).
Microfoundations for money demand
While the Baumol-Tobin provides a microeconomic explanation for the form of the money demand function it is generally too stylized to be included in modern macroeconomic models, particularly DSGE models. As a result most models of this type resort to simpler indirect methods which capture the spirit of the transaction motive. The two most commonly (exclusively?) used methods are
Cash-In-AdvanceThe cash-in-advance constraint is an idea used in economic theory to capture monetary phenomena...
(sometimes called the
Clower Constraint) and Money in the utility function (sometimes referred to as the 'MIU' or the Sidrauski model).
In the Cash-In-Advance model agents are restricted to carrying out a volume of transactions equal or less than their money holdings. In the MIU model, money directly enters agents' utility functions capturing the 'liquidity services' provided by money.
ChartalismChartalism is a monetary theory of fiat money, emphasizing its differences from commodity money. Many Chartalists go from scientific description to political prescription, arguing that these differences make a fiat system preferable, and should be exploited, particularly in using government deficit...
is a monetary theory that states the initial demand for fiat money is generated by its ability to extinguish tax liabilities.
Asset Motive
The asset motive treats money as a particular type of a financial asset among many others. While it is still assumed that money is held in order to carry out transactions, this approach focuses on the potential return on various assets (including money) as an additional motivation.
Speculative Motive
John Maynard KeynesJohn Maynard Keynes, 1st Baron Keynes, CB was a British economist whose ideas have been a central influence on modern macroeconomics, both in theory and practice...
, in laying out speculative reasons for holding money, stressed the choice between money and bonds. If agents expect the future nominal interest rate (the return on bonds) to be lower than the current rate they will then reduce their holdings of money and increase their holdings of bonds. If the future interest rate does fall, then the price of bonds will increase and the agents will have realized a capital gain on the bonds they purchased. This means that the demand for money in any period will depend on both the current nominal interest rate and the expected future interest rate (in addition to the standard transaction motives captured by Y).
The fact that current demand for money can depend on expectations of the future interest rates has implications for volatility of money demand. If these expectations are formed, as in Keynes' view by "animal spirits" they are likely to change erratically and cause money demand to be quite unstable.
Portfolio Motive
The portfolio motive also focuses on demand for money over and above that required for carrying out transactions. The basic framework is due to
James TobinJames Tobin was an American economist who in his lifetime, had served on the Council of Economic Advisors, the Board of Governors of the Federal Reserve System, and had taught at Harvard and Yale Universities. He developed the ideas of Keynesian economics, and advocated government intervention to...
who considered a situation where agents can hold their wealth in a form of a low risk/low return asset (here, money) or high risk/high return asset (bonds or equity). Agents will choose a mix of these two types of assets (their portfolio) based on the risk-expected return trade off. For a given expected rate of return, more risk averse individuals will choose a greater share for money in their portfolio. Similarly, given a person's degree of risk aversion, a higher expected return (nominal interest rate) will cause agents to shift away from safe money and into risky assets. Like in the other motivations above, this creates a negative relationship between the nominal interest rate and the demand for money. However, what matters additionally in the Tobin model is the subjective rate of risk aversion, as well as the objective degree of risk of other assets, as, say, measured by the standard deviation of capital gains and losses resulting from holding bonds and/or equity.
Is money demand stable?
FriedmanMilton Friedman was an American economist, statistician and public intellectual, and a recipient of the Nobel Memorial Prize in Economics...
and
SchwartzAnna Jacobson Schwartz is an economist at the National Bureau of Economic Research in New York City, and according to Paul Krugman "one of the world's greatest monetary scholars"...
in their 1963 work
A Monetary History of the United States argued that the demand for real balances was a stable function of income and the interest rate. For the time period they were studying this appeared to be true. However, shortly after the publication of the book, due to changes in financial markets and financial regulation money demand became more unstable. Ericsson, Hendry and Prestwich (1998) show that money demand became much more unstable after 1975. They consider a model of money demand based on the various motives outlined above and test it with empirical data. The basic model turns out to work well for the period 1878 to 1975 and there doesn't appear to be much volatility in money demand, in a result analogous to that of Friedman and Schwartz. This is true even despite the fact that the two world wars during this time period could have led changes in the velocity of money. However, when the same basic model is used on data spanning 1976 to 1993, it performs poorly. In particular, money demand appears not to be sensitive to interest rates and there appears to be a lot more exogenous volatility. The authors attribute the difference to technological innovations in the financial markets, financial deregulation, and, relatedly, the changing definition of money.
Reasons for changes in money demand volatility
Financial deregulation.
Financial innovationThere are several interpretations of the phrase financial innovation. In general, it refers to the creating and marketing of new types of securities.- Why does financial innovation occur? :...
.
Changing definition of money.
Importance of money demand volatility for monetary policy
If the demand for money is stable then a monetary policy which consists of a monetary rule which targets the growth rate of some monetary aggregate (such as M1 or M2) can help to stabilize the economy or at least remove monetary policy as a source of macroeconomic volatility. Additionally, if the demand for money does not change much then money supply targeting is a reliable way of attaining a constant inflation rate. This can be most easily seen with the quantity theory of money equation given above. When that equation is converted into growth rates we have
which says that the growth rate of money supply plus the growth rate of its velocity equals inflation plus growth rate of real output. If money demand is stable then the velocity is constant and . Additionally, in the long run real output grows at a constant rate equal to rate of growth of technology and as such is exogenous. In this case the above equation reduces to
where real output is assumed to grow at an exogenously given rate of 2% and so the only determinant of inflation is the growth rate of money supply. In this case "inflation is always and everywhere a monetary phenomenon". In this case a monetary policy which targets the money supply can stabilize the economy and ensure a non variable inflation rate.
This analysis however breaks down if the demand for money is not stable, for example, if the velocity in the above equation is not constant. In that case, shocks to money demand under money supply targeting will translate into changes in real and nominal interest rate and result in economic fluctuations. An alternative policy of targeting interest rates rather money supply can improve upon this outcome as money supply is adjusted to shocks in money demand keeping interest rates (and hence, economic activity) relatively constant.
The above discussion implies that the volatility of money demand matters for how monetary policy should be conducted. If most of the aggregate demand shocks which affect the economy come from the expenditure side, the IS curve, then a policy of targeting the money supply will be stabilizing, relative to a policy of targeting interest rates. However, if most of the aggregate demand shocks come from changes in money demand, the LM curve, then a policy of targeting the money supply will be destabilizing.
Choice of nominal anchor by the Central Bank.