Money Demand

Reading: AB, chapter 7, sections 2 and 3.

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The demand for money

Consumption and saving decisions indirectly involve a decision about how much money to hold

• Individuals need money for transactions involving consumption goods and services. This is the transactions demand for money.
• Given income, what is not consumed is saved. Individuals must then decide how divide their savings into various kinds of assets: cash, savings accounts, government bonds, stocks etc. This is the asset allocation or portfolio problem. Since money pays very little interest (has a low return) the higher the interest rate on non-money assets the higher the opportunity cost of holding money.

Simplifying assumptions

Since the general asset allocation problem involves many different kinds of assets with different risk and return characteristics we simplify this decision by assuming that there are only two kinds of financial assets in the economy.

• Money assets - low return, high liquidity and low risk. i_m = nominal interest rate on money assets.
• Non-money assets (bonds) - higher return than on money assets and less liquidity. We assume that the risk associated with investing in bonds is not too high (think of government bonds as the generic non-money asset). Let i denote the nominal interest rate on non-money assets. Note that, by assumption, i > i_m. Also, recall that i = r + ^e, where r denotes the real return on non-money assets and ^e denotes expected inflation.

Model for money demand

Our model for the demand for nominal money balances takes the following form:

where

M^d = demand for nominal money balances (demand for M1)

L^d = demand for liquidity function

P = aggregate price level (CPI or GDP deflator)

Y = real income (real GDP)

I = nominal interest rate on non-money assets

r = real interest rate on non-money assets

^e = expected inflation

Remarks

• Nominal money demand is proportional to the price level. For example, if prices go up by 10% then individuals need 10% more money for transactions.
• As Y increases, desired consumption increases and so individuals need more money for the increased number of desired transactions.
• As the nominal interest rate on non-money assets, i, increases the opportunity cost of holding money increases and so the demand for nominal money balances decreases.
• Since i = r + ^e, we can decompose the effects on an increase in i into real interest rate increases (holding expected inflation fixed) and expected inflation increases (holding the real interest rate fixed).

The demand for real balances

Since the demand for nominal balances is proportional to the aggregate price level, we can divide both sides of the nominal money demand equation by P. This gives the liquidity demand function or the demand for real balances function:

The left-hand-side of the above equation is the demand for nominal balances divided by the aggregate price level or the demand for real balances (the real purchasing power of money). The right-hand side is the liquidity demand function. The demand for real balances is decomposed into a transactions demand for money (captured by Y) and a portfolio demand for money (captured by i).

The real money demand function is graphed below:

The demand for real balances is graphed as a function of the real interest rate holding income and expected inflation fixed. When the real interest rate is high the opportunity cost of holding money - keeping income and expected inflation fixed - is high so that real money demand is low. Conversely, when the real interest rate is low the opportunity cost of holding money is low so that money demand is high (due to the liquidity convenience of money over bonds). Whenever income or expected inflation change the real money demand curves shifts. For example, if Y increases the real money demand function shifts up and right; if expected inflation increases the real money demand function shifts down and left.