unit 3

• Quantity Theory of Money

  A theory that discusses how the nominal value of aggregate income is determined. It is also a theory of money demand since it tells how much money is held for a given amount of aggregate income.
• Velocity of Money


  The rate of turnover of money. It is the average number of times that a unit of currency is spent in buying the total amount of goods and services produced in the economy. It provides the link between money supply and nominal income.
• Quantity Theory of Money

  1. MV = PY

  2. V = PY/M

  3. M = PY/V
• According to classicalists, velocity of money depends on institutional and technological factors related to the paying behavior of people. It is therefore assumed to be constant in the short run since institutions and technologies do not change in the short-run.
• Classicalists assume that the aggregate real income (Y) will remain constant at the equilibrium level in the short-run since prices and wages are completely flexible.
• An increase in the supply of money


  Leads to an increase in average price level, but everything else (real income, velocity of money etc) will not be affected.
• Quantity Theory of Money

  Money is neutral with respect to the real sector of the economy and movements in the price level results solely from changes in the quantity of money.
• Deriving the formula for money demand

  1. M = PY/V

  2. Md = 1/v*PY

  3. Md = kPY
• The classicalists' theory of money demand shows that money demand is not a function of interest rate and this is backed by the assumption that people demand money only for transaction purpose.
• Cambridge Approach to Money Demand

  People demand money because it serves as a medium of exchange (transaction motive) and as a store of value. The demand for money as a store of value depends on wealth and the relative expected return of money.
• If interest rate on bonds increases

  Less money will be demanded as a store of value and the whole quantity of demand for money will decrease though quantity of money demanded for transaction purposes will not be affected.
• Keynes's Liquidity Preference Theory

  Identifies three motives for demanding money: transaction motive, precautionary motive and speculative motive.
• Transaction Motive


  People demand money to fulfill their current consumption demand of goods and services. This part of the demand for money is determined by the amount of current consumption which is proportional to income.
• Precautionary Motive


  People demand money as a cushion against unexpected transactions in the future. This part of the demand for money is primarily dependent on the volume of future expected transactions which is proportional to income.
• Speculative Motive


  People hold their wealth in different assets and money is one alternative. The demand for money under this motive is inversely affected by interest rate.
• The total demand for money according to Keynes is a function of the three motives (transaction, precautionary, and speculative) and is affected by interest rate.
• Keynes's Liquidity Preference Theory


  Keynes developed a theory of demand that emphasized the importance of interest rates like the Cambridge economists, but his approach is more detailed in identifying the different motives for demanding money and the effect of interest rate on money demand
• Motives for demanding money

  • Transaction motive
  • Precautionary motive
  • Speculative motive
• Transaction motive


  Demanding money to fulfill current consumption of goods and services, determined by income and not affected by interest rate
• Precautionary motive


  Demanding money as a cushion against unexpected future transactions, determined by expected future transactions which is proportional to income
• Speculative motive


  Demanding money as a store of value, determined by interest rate as people substitute between money and bonds based on expected returns
• Keynes' demand function for money

  Real money demand is a function of interest rate (inverse) and real income (positive)
• As interest rate increases


  Velocity of money increases
• Baumol-Tobin model


  • Transactions demand for money is also affected by interest rate, not just income
  • Precautionary demand for money is also affected by interest rate
• Speculative demand for money (Tobin)


  People care about risk and diversify their asset holdings, not just expected return
• Recent developments in Keynesian theory imply all three motives for money demand are affected by interest rate, with the strongest effect on speculative motive</b>
• Friedman's modern quantity theory of money is closer to Keynes and Cambridge economists than Fisher's quantity theory
• Tobin


  People do care about risk and more specifically are risk averse. They diversify their holding of assets instead of holding just one asset. They will choose to hold an asset if it can contribute more to expected return than to risk.
• Money


  It has a desirable property since it is riskless (its value does not vary with market conditions unlike other assets like bond whose value may rise or fall)
• Portfolio choice


  There will be a trade-off between risk and return and people will choose to hold a portfolio of assets with the best risk-return structure
• The recent developments on the Keynesian theory of demand for money imply that all the three motives for money demand are affected by interest rate and hence interest rate is very important in determination the demand for money
• The effect of interest rate is the strongest in the speculative motive
• Risk of an asset is also an important consideration and money has an advantage over other assets in this regard since it is risk less
• Friedman's Modern Quantity Theory of Money


  Developed in 1956, closer to Keynes and the Cambridge economists than to Fisher's quantity theory of money
• Friedman's money demand function


  Md = f (Yp,rb - rm,re - rm,Πe -rm)
• Permanent income (Yp)


  Friedman's measure of wealth, the present discounted value of all expected future income, expected average long-run income
• Permanent income (Yp)


  Positively related to money demand
• Expected return on bonds (rb - rm), expected return on equity (re - rm), expected inflation rate (Πe - rm)

  Negatively related to money demand
• Expected return on money (rm)


  Influenced by services provided by banks on deposits and interest payments on money balances
• Friedman's theory differs from Keynes in including many assets as alternatives to money, recognizing that more than one interest rate is important, and viewing money and goods as substitutes