Money Demand
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he demand for money is the desired holding of financial assets in the form of money: that is, cash or bank deposits. It can refer to the demand for money narrowly defined asM1 (non-interest-bearing holdings), or for money in the broader sense of M2 or M3 . Money in the sense of M1 is dominated as a store of value by interest- bearing assets. However, money is necessary to carry out transactions; in other words, it provides liquidity . This creates a trade-off between the liquidity advantage of holding money and the interest advantage of holding other assets. The demand for money is a result of this trade-off regarding the form in which a person's wealth should be held. In macroeconomics motivations for holding one's wealth in the form of money can roughly be divided into thetransaction motive and the asset motive . These can be further subdivided into more microeconomically founded motivations for holding money. Generally, the nominal demand for money increases with the level of nominal output (price level times real output) and decreases with the nominal interest rate . The real demand for money is defined as the nominal amount of money demanded divided by the price level. For a given money supply the locus of income-interest rate pairs at which money demand equals money supply is known as the LM curve . The magnitude of the volatility of money demand has crucial implications for the optimal way in which a central bank should carry out monetary policy and its choice of a nominal anchor . Conditions under which the LM curve is flat, so that increases in the money supply have no stimulatory effect (a liquidity trap ), play an important role in Keynesian theory. This situation occurs when the demand for money is infinitely elastic with respect to the interest rate. A typical money-demand function may be written as where is the nominal amount of money demanded, P is the price level, R is the nominal interest rate, Y is real output, and L(.) is real money demand. An alternate name for is the liquidity preference function. Contents [hide ]
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demand for money
Transcript of Money Demand
he demand for money is the desired holding of financial assets in the form of money: that is, cash or bank deposits. It can refer to the demand for money narrowly defined asM1 (non-interest-bearing holdings), or for money in the broader sense of M2 or M.Money in the sense of M1 is dominated as a store of !al"e by interest-bearing assets. #owe!er, money is necessary to carry o"t transactions$ in other words, it pro!ides li%"idity. &his creates a trade-off between the li%"idity ad!antage of holding money and the interest ad!antage of holding other assets. &he demand for money is a res"lt of this trade-off regarding the form in which a person's wealth sho"ld be held. In macroeconomics moti!ations for holding one's wealth in the form of money can ro"ghly be di!ided into thetransaction moti!e and the asset moti!e. &hese can be f"rther s"bdi!ided into more microeconomically fo"nded moti!ations for holding money.(enerally, the nominal demand for money increases with the le!el of nominal o"tp"t (price le!el times real o"tp"t) and decreases with the nominal interest rate. &he real demand for money is defined as the nominal amo"nt of money demanded di!ided by the price le!el. )or a gi!en money s"pply the loc"s of income-interest rate pairs at which money demand e%"als money s"pply is known as the *M c"r!e.&he magnit"de of the !olatility of money demand has cr"cial implications for the optimal way in which a central bank sho"ld carry o"t monetary policy and its choice of a nominal anchor.+onditions "nder which the *M c"r!e is flat, so that increases in the money s"pply ha!e no stim"latory effect (a li%"idity trap), play an important role in ,eynesian theory. &his sit"ation occ"rs when the demand for money is infinitely elastic with respect to the interest rate.- typical money-demand function may be written aswhere is the nominal amo"nt of money demanded, P is the price le!el, R is the nominal interest rate, Y is real o"tp"t, and L(.) is real money demand. -n alternate name for isthe liquidity preference function.Contents.hide/ 1Moti!es for holding moneyo 1.1&ransaction moti!e 1.1.10"antity theory 1.1.2In!entory models 1.1.Microfo"ndations for money demando 1.2-sset moti!e 1.2.11pec"lati!e moti!e 1.2.22ortfolio moti!e 23mpirical estimations of money demand f"nctionso 2.1Is money demand stable4 Importance of money demand !olatility for monetary policy 51ee also 67eferencesMotives for holding money.edit/Transaction motive.edit/Main article: Transactions demand&he transactions moti!e for money demand res"lts from the need for li%"idity for day-to-day transactions in the near f"t"re. &his need arises when income is recei!ed only occasionally (say once per month) in discrete amo"nts b"t e8pendit"res occ"r contin"o"sly.Quantity theory.edit/&he most basic 9classical9 transaction moti!e can be ill"strated with reference to the 0"antity &heory of Money. -ccording to the e%"ation of e8change MV : PY, where M is the stock of money, V is its !elocity (how many times a "nit of money t"rns o!er d"ring a period of time), P isthe price le!el and Y is real income. +onse%"ently PY is nominal income or in other words the n"mber of transactions carried o"t in an economy d"ring a period of time. 7earranging the abo!e identity and gi!ing it a beha!ioral interpretation as a demand for money we ha!eor in terms of demand for real balances#ence in this simple form"lation demand for money is a f"nction of prices and income, as long as its !elocity is constant.Inventory models.edit/&he amo"nt of money demanded for transactions howe!er is also likely to depend on the nominal interest rate. &his arises d"e the lack of synchroni;ation in time between when p"rchases are desired and when factor payments (s"ch as wages) are made. In other words, while workers may get paid only once a month they generally will wish to make p"rchases, and hence need money, o!er the co"rse of the entire month.&he most well-known e8ample of an economic model that is based on s"ch considerations is the are as before.&he key difference between this form"lation and the one based on a simple !ersion of 0"antity &heory is that now the demand for real balances depends on both income (positi!ely) or the desired le!el of transactions, and on the nominal interest rate (negati!ely).Microfoundations for money demand.edit/?hile the
