Real Money Balances Demand

Posted on 16-08-2021 by admin

A Model of Aggregate Money Demand The aggregate demand for money can be expressed by: Md = P x L(R,Y) where: P is the price level Y is real national income R is a measure of nominal interest rates L(R,Y) is the aggregate real money demand Alternatively: Md/P = L(R,Y) Aggregate real money demand is a function of national income and the nominal.

Demand And Supply Of Money
Demand For Real Money Balances Depends On
Real Money Balances Demand Graph
The Quantity Of Real Money Balances Demanded

Real Balances and the Demand for Money

Vol. 78, No. 6 (Nov. - Dec., 1970), pp. 1340-1354 (15 pages)

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Current issues are now on the Chicago Journals website. Read the latest issue.One of the oldest and most prestigious journals in economics, the Journal of Political Economy (JPE) presents significant and essential scholarship in economic theory and practice. The journal publishes highly selective and widely cited analytical, interpretive, and empirical studies in a number of areas, including monetary theory, fiscal policy, laboreconomics, development, microeconomic and macroeconomic theory, international tradeand finance, industrial organization, and social economics.

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20.2 Friedman’s Modern Quantity Theory of Money

Learning Objective

What is the quantity theory of money, and how was it improved by Milton Friedman?

Building on the work of earlier scholars, including Irving Fisher of Fisher Equation fame, Milton Friedman improved on Keynes’s liquidity preference theory by treating money like any other asset. He concluded that economic agents (individuals, firms, governments) want to hold a certain quantity of real, as opposed to nominal, money balances. If inflation erodes the purchasing power of the unit of account, economic agents will want to hold higher nominal balances to compensate, to keep their real money balances constant. The level of those real balances, Friedman argued, was a function of permanent income (the present discounted value of all expected future income), the relative expected return on bonds and stocks versus money, and expected inflation.

More formally,

M_{d} / P : f (Y p <+>, r_{b} - r_{m} <->, r_{s} - r_{m} <->, π^{e} - r_{m} <->)

where

M_d/P = demand for real money balances (M_d = money demand; P = price level)

f means “function of” (not equal to)

Y_p = permanent income

r_b − r_m = the expected return on bonds minus the expected return on money

r_s − r_m = the expected return on stocks (equities) minus the expected return on money

π^e − r_m = expected inflation minus the expected return on money

<+> = increases in

<−> = decreases in

Demand And Supply Of Money

So the demand for real money balances, according to Friedman, increases when permanent income increases and declines when the expected returns on bonds, stocks, or goods increases versus the expected returns on money, which includes both the interest paid on deposits and the services banks provide to depositors.

Stop and Think Box

As noted in the text, money demand is where the action is these days because, as we learned in previous chapters, the central bank determines what the money supply will be, so we can model it as a vertical line. Earlier monetary theorists, however, had no such luxury because, under a specie standard, money was supplied exogenously. What did the supply curve look like before the rise of modern central banking in the twentieth century?

The supply curve sloped upward, as most do. You can think of this in two ways, first, by thinking of interest on the vertical axis. Interest is literally the price of money. When interest is high, more people want to supply money to the system because seigniorage is higher. So more people want to form banks or find other ways of issuing money, extant bankers want to issue more money (notes and/or deposits), and so forth. You can also think of this in terms of the price of gold. When its price is low, there is not much incentive to go out and find more of it because you can earn just as much making cheesecake or whatever. When the price of gold is high, however, everybody wants to go out and prospect for new veins or for new ways of extracting gold atoms from what looks like plain old dirt. The point is that early monetary theorists did not have the luxury of concentrating on the nature of money demand; they also had to worry about the nature of money supply.

Demand For Real Money Balances Depends On

This all makes perfectly good sense when you think about it. If people suspect they are permanently more wealthy, they are going to want to hold more money, in real terms, so they can buy caviar and fancy golf clubs and what not. If the return on financial investments decreases vis-à-vis money, they will want to hold more money because its opportunity cost is lower. If inflation expectations increase, but the return on money doesn’t, people will want to hold less money, ceteris paribus, because the relative return on goods (land, gold, turnips) will increase. (In other words, expected inflation here proxies the expected return on nonfinancial goods.)

The modern quantity theory is generally thought superior to Keynes’s liquidity preference theory because it is more complex, specifying three types of assets (bonds, equities, goods) instead of just one (bonds). It also does not assume that the return on money is zero, or even a constant. In Friedman’s theory, velocity is no longer a constant; instead, it is highly predictable and, as in reality and Keynes’s formulation, pro-cyclical, rising during expansions and falling during recessions. Finally, unlike the liquidity preference theory, Friedman’s modern quantity theory predicts that interest rate changes should have little effect on money demand. The reason for this is that Friedman believed that the return on bonds, stocks, goods, and money would be positively correlated, leading to little change in r_b − r_m, r_s − r_m, or π^e − r_m because both sides would rise or fall about the same amount. That insight essentially reduces the modern quantity theory to M_d/P = f(Y_p <+>).