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Understanding Money DemandPowerPoint Presentation

Understanding Money Demand

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- Money can be anything that satisfies:
- Store of Value
- Unit of account
- Medium of exchange

- Lots of things satisfy these properties

Standard Definitions of Money

- Monetary Base (M0): Direct liabilities of the central bank
- Currency in circulation + Bank Reserves

- M1:
- Currency in circulation + Traveler's Checks + Checking accounts

- M2:
- M1 + Savings accounts + Money Market Accounts + Small Time Deposits

- M3:
- M2 + Large Time Deposits + Eurodollars

Think of this as a portfolio allocation problem. You have a fixed amount of income and you are allocating it over several assets.

More Liquid Lower Return

Less Liquid Higher Return

$5,000/month

Cash $400

Checking Account

$2,000

Savings Account

$600

Stock/Bonds $2,000

M1

M2

M1 Money Demand fixed amount of income and you are allocating it over several assets.

- Suppose you plan on spending $120 over the upcoming month. You can withdraw the $120 from your savings account immediately, or you can make several trips to the ATM.

Suppose you go to the bank three times per month (every 10 days)

ATM Withdrawals

Cash Balance Hits Zero

- More generally, you make plan on Spending days)PY dollars per month. If you make N trips to the ATM

Choosing N days)

- There are two costs associated with money:

If you make very few trips to the bank (N is small), you will need to withdraw more cash – having more cash entails more lost interest

If you make a lot of trips to the bank, you will withdraw less each time (less interest cost), but you will pay more in transaction costs

Take the derivative with respect to ‘N’ days)

Solve for N

M1 Money Demand days)

This is the optimal behavior (i.e. trips to the ATM per month)

As the interest rate goes up, you hold less cash. Therefore, you make more trips to the bank

As ATM fees rise, you make less trips to the bank, but withdraw more each time

Generally Speaking…. days)

“is a function of…”

Transactions Costs (Cost of obtaining money) (+)

Real Income (+)

Real Money Demand

Nominal Interest Rate (-)

Cambridge Money Demand days)

A common form of money demand can be written as follows:

Money demand is equal to a fraction (k is between zero and one) of real income. That fraction depends on interest rates (-) and transaction costs

The Quantity Theory of Money days)

MV = Py

Money Supply

Nominal Income

Velocity – Measures the number of times a dollar changes hands

For example, if PY = $100 (there are $100 worth of goods and services to buy) and M = $50 (there are $50 worth of cash available), the V = 2 (each dollar changes hands twice)

The Quantity Theory of Money and Cambridge Money Demand days)

When money demand drops (either interest rates rise or transaction costs fall), individuals do not want to hold onto as much money as before. To get rid of it, they pass it on to someone else – velocity increases.

In 1995, we saw a dramatic change in household portfolio decisions…why?

M1 Money Demand falls dramatically starting in 1995

Money Demand Rises from 1980 - 1993

Trend

Is interest rates rose, households switched out of checking accounts and into savings accounts….technology (online banking, ATMs, etc. made this transition easier)

Falling demand for M2

Rising Demand for M2

M2 Money Demand accounts and into savings accounts….technology (online banking, ATMs, etc. made this transition easier)

- Recall that M2 includes everything in M1 (cash + checking accounts) plus savings accounts. Therefore, any model of M2 demand would need to explain why households hold savings/checking accounts rather than less liquid assets such as T-Bills

M2 Money Demand accounts and into savings accounts….technology (online banking, ATMs, etc. made this transition easier)

- Any M2 money demand should have the same characteristics as the previously derived M1 demand
- Positively related to income/consumption
- Negatively related to interest rates

M2 Money Demand accounts and into savings accounts….technology (online banking, ATMs, etc. made this transition easier)

Positively related to consumption

Negatively related to interest rates

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