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Monetary economics

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Monetary economics

Money Demand

Standard specification:

(M/P) = f(Y, r)

M = Monetary aggregate

P = Price level

Y = income

r = interest rate

- Why money demand?
- Why does money demand depend on income and interest rate?
- Are there any other determinant of money demand function?
- Is money demand stable?

- Monetary policy affects policy objectives (output, employment and price level) through financial markets (particularly banks).
- The channel is through shift in the interest rate, which has important bearings on interest-sensitive components of aggregate expenditure.
- As such, policymakers need to gauge the level of money demand such that the level of money supply can be set. In this way, interest rate will not be too high or too low.
- At the same time, other determinants of money demand need to be identified such that policymakers can counter any shift in money demand.
- Stability of money demand is a pre-requisite for monetary aggregate targeting framework.

- Quantity Theory of Money
- Cambridge approach to Money Demand
- Keynes’s Liquidity Preference Theory
- Baumol-Tobin Transactions Demand for Money
- Friedman’s Restatement of the Quantity Theory
- Tobin’s Portfolio Balance Model

- The foundation of the QTM is the equation of exchange
- Equation of Exchange: MV = PY
P = PriceM = Quantity of money

Y = IncomeV = Velocity

- Velocity is the average number of times per year a Ringgit is spent.
- This is the early theory of price determination.
- Namely, Fisher views V to be constant and Y is relatively constant in the short run, the quantity of money is the sole determinant of the price level.

Quantity theory

Cambridge money demand

- From the QTM, we have M = (1/V)PY
- Md = kPY
- The monetary holding is determined by the amount of transactions (PY)
- There is no room for the interest rate to affect money demand.
- The institutional factor also affects Md through its effect on velocity

- Similar simulation:
Md = kPY

- However, the Cambridge theory acknowledges the role of wealth in addition to transactions, both of which are proportional to nominal income (PY).
- Money is a part of wealth. Thus, the store of value function is recognized.
- Individuals decide to hold wealth in the form of money, proportional to nominal income.
- k is allowed to fluctuate in conjunction with the decision of economic agents to hold other assets as well.
- Accordingly, velocity can fluctuate.

Motives for monetary holdings

- Transaction motive – a medium of exchange to carry out transactions
- Precautionary motive – a cushion against an unexpected event
- Speculative motive – a store of wealth that allows individuals to reallocate wealth between money and bonds
(Md/P) = f (Y, r)

- According to Friedman, money demand is influenced by the same factors as those influencing assets.
- Yp is permanent income, which is the expected average long run income.
- Implications:
- interest rate will have only marginal impact on money demand

- money demand is a stable function

- Tobin’s portfolio balance theory considers MONEY and BONDS (non-money assets collectively termed bonds) as alternative assets in wealth portfolio.
- Money is viewed to yield no return and it is risk free.
- Meanwhile, bonds give positive returns and risky
- Individuals try to balance their portfolios considering risk-return tradeoff such that satisfaction is maximum.
- Thus, Tobin theory is based on mean-variance optimization.

- Consider:
- Money ~ (0, 0); (1 – B): share of money

- Bonds ~ (µ, 2); B: share of bonds

- Portfolio mean:
- Portfolio risk:
- From portfolio mean and risk, we can construct mean return – risk line faced by individuals:
- That is:
- Individuals: performing mean-variance optimization subject to the above line.

- Is velocity stable?
- Is Money demand stable?
- Will interest-free “money” be stable?
- Why is there breakdown in the money demand function?
- What is the role of recent financial uncertainty on money demand?
- How does money demand interacts with the money supply process?