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Understanding Money Demand

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  1. Understanding Money Demand

  2. Money can be anything that satisfies: • Store of Value • Unit of account • Medium of exchange • Lots of things satisfy these properties

  3. 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

  4. 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

  5. M1 Money Demand • 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.

  6. Suppose you go to the bank three times per month (every 10 days) ATM Withdrawals Cash Balance Hits Zero

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

  8. PY 0 + Average Cash Balances N = = Money Demand 2 Real Money Demand M Y = = P 2N

  9. Choosing N • 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

  10. Take the derivative with respect to ‘N’ Solve for N

  11. M1 Money Demand 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

  12. M1 Money Demand Real Income Nominal Interest Rate Real Money Demand Transaction Costs

  13. Generally Speaking…. “is a function of…” Transactions Costs (Cost of obtaining money) (+) Real Income (+) Real Money Demand Nominal Interest Rate (-)

  14. Cambridge Money Demand 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

  15. The Quantity Theory of Money 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)

  16. The Quantity Theory of Money and Cambridge Money Demand 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.

  17. 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

  18. 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

  19. M2 Money Demand • 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

  20. M2 Money Demand • 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

  21. M2 Money Demand Positively related to consumption Negatively related to interest rates