chapter 22. demand for money quantity theory of money keynes & liquidity preference friedman’s...
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![Page 1: Chapter 22. Demand for Money Quantity Theory of Money Keynes & Liquidity Preference Friedman’s Modern Quantity Theory Friedman vs. Keynes Empirical Evidence](https://reader033.vdocuments.us/reader033/viewer/2022061414/56649d435503460f94a1fe48/html5/thumbnails/1.jpg)
Chapter 22. Demand for MoneyChapter 22. Demand for MoneyChapter 22. Demand for MoneyChapter 22. Demand for Money
• Quantity Theory of Money
• Keynes & Liquidity Preference
• Friedman’s Modern Quantity Theory
• Friedman vs. Keynes
• Empirical Evidence
• Quantity Theory of Money
• Keynes & Liquidity Preference
• Friedman’s Modern Quantity Theory
• Friedman vs. Keynes
• Empirical Evidence
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Monetary TheoryMonetary TheoryMonetary TheoryMonetary Theory
• link between MS and other economic variables• price level• output
• link between MS and other economic variables• price level• output
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I. Quantity Theory of MoneyI. Quantity Theory of MoneyI. Quantity Theory of MoneyI. Quantity Theory of Money
• classical economists• Irving Fisher
• relates quantity of money to nominal income
• classical economists• Irving Fisher
• relates quantity of money to nominal income
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equation of exchangeequation of exchangeequation of exchangeequation of exchange
• MV = PY
• where• M = quantity of money• P = price level• Y = real output = real income• V = velocity
= # times money used to purchase output
• MV = PY
• where• M = quantity of money• P = price level• Y = real output = real income• V = velocity
= # times money used to purchase output
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2 assumptions2 assumptions2 assumptions2 assumptions
• V is constant in short-run• depends on institutions,
technology that change slowly
• Y is at full employment level• also constant in short-run
• V is constant in short-run• depends on institutions,
technology that change slowly
• Y is at full employment level• also constant in short-run
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MV = PYMV = PYMV = PYMV = PY
• if V, Y constant then
A change in M must cause an equal % change in P• Quantity Theory of Money
• if V, Y constant then
A change in M must cause an equal % change in P• Quantity Theory of Money
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money demandmoney demandmoney demandmoney demand
• MV = PY
• M = (1/V)PY
• M = kPY let (1/V) = k
• Md = M in equilibrium• Md = kPY• Md is depends on income NOT
interest rates
• MV = PY
• M = (1/V)PY
• M = kPY let (1/V) = k
• Md = M in equilibrium• Md = kPY• Md is depends on income NOT
interest rates
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Is V constant?Is V constant?Is V constant?Is V constant? NO.NO.
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II. Liquidity PreferenceII. Liquidity PreferenceII. Liquidity PreferenceII. Liquidity Preference
• Keynes 1936
• 3 motives to holding money• transactions motive• precautionary motive• speculative motive
• Keynes 1936
• 3 motives to holding money• transactions motive• precautionary motive• speculative motive
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transactions motivetransactions motivetransactions motivetransactions motive
• people hold money to buy stuff• as income rises,• Md rises
• people hold money to buy stuff• as income rises,• Md rises
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precautionary motiveprecautionary motiveprecautionary motiveprecautionary motive
• people hold money for emergencies• car breakdown• job loss
• Md rises with income
• people hold money for emergencies• car breakdown• job loss
• Md rises with income
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speculative motivespeculative motivespeculative motivespeculative motive
• suppose store wealth as money or bonds
• high interest rates• bonds more attractive, hold less
money
• Md negatively related to interest rate
• suppose store wealth as money or bonds
• high interest rates• bonds more attractive, hold less
money
• Md negatively related to interest rate
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real quantity of moneyreal quantity of moneyreal quantity of moneyreal quantity of money
• M/P
• if prices rise, must hold more money to buy same amount of stuff
• M/P
• if prices rise, must hold more money to buy same amount of stuff
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money demand (M/P)money demand (M/P)money demand (M/P)money demand (M/P)
• depends on• income• interest rates
M/P = f(i,Y)
• depends on• income• interest rates
M/P = f(i,Y)
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Keynes & velocityKeynes & velocityKeynes & velocityKeynes & velocity
• MV = PY• M/P = Y/V
• M/P = f(i,Y)
• Y/V = f(i,Y)
• V = Y/f(i,Y)• velocity fluctuates with the interest rate
-- both are procyclical
• MV = PY• M/P = Y/V
• M/P = f(i,Y)
• Y/V = f(i,Y)
• V = Y/f(i,Y)• velocity fluctuates with the interest rate
-- both are procyclical
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Tobin & money demandTobin & money demandTobin & money demandTobin & money demand
• further extended Keynes approach• transaction demand negatively
related to the interest rate• people hold money even when is
has a lower return, b/c it is less risky
• further extended Keynes approach• transaction demand negatively
related to the interest rate• people hold money even when is
has a lower return, b/c it is less risky
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III. Friedman’s modern quantity III. Friedman’s modern quantity theorytheoryIII. Friedman’s modern quantity III. Friedman’s modern quantity theorytheory
• Milton Friedman• Md as asset demand
-- wealth
-- return relative to other assets
• Milton Friedman• Md as asset demand
-- wealth
-- return relative to other assets
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• Yp = permanent income
• rb = expected bond return
• rm = expected money return
• re = expected equity return
e = expected inflation
• Yp = permanent income
• rb = expected bond return
• rm = expected money return
• re = expected equity return
e = expected inflation
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• rb - rm = relative return on bonds
e = expected return on goods
• rb - rm = relative return on bonds
e = expected return on goods
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• increase in Yp will increase Md
• increase in relative returns of bonds, equity or money• decrease Md
• increase in Yp will increase Md
• increase in relative returns of bonds, equity or money• decrease Md
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Friedman vs. KeynesFriedman vs. KeynesFriedman vs. KeynesFriedman vs. Keynes
• Friedman:• multiple rates of return• relative returns• money & goods are substitutes• Yp more important than current
income
• Friedman:• multiple rates of return• relative returns• money & goods are substitutes• Yp more important than current
income
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stability of Mdstability of Mdstability of Mdstability of Md
• Friedman’s Md function is more stable• Yp more stable than current income• spread between returns is more
stable than returns
-- interest rates have little impact on Md
• Friedman’s Md function is more stable• Yp more stable than current income• spread between returns is more
stable than returns
-- interest rates have little impact on Md
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IV. empirical evidenceIV. empirical evidenceIV. empirical evidenceIV. empirical evidence
• which Md function is right?• Keynes or Friedman
• test• how does Md respond to i?• how stable is Md?
• which Md function is right?• Keynes or Friedman
• test• how does Md respond to i?• how stable is Md?
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Md is sensitive to interest ratesMd is sensitive to interest ratesMd is sensitive to interest ratesMd is sensitive to interest rates
• a lot of research reaches same conclusion
• sensitivity does not change over time
• a lot of research reaches same conclusion
• sensitivity does not change over time
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stability of Mdstability of Mdstability of Mdstability of Md
• what does that mean?• relationship between Md, income,
interest rates does not change over time• does Md function of 1930s still
predict Md in 1950s?
• what does that mean?• relationship between Md, income,
interest rates does not change over time• does Md function of 1930s still
predict Md in 1950s?
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• up until mid 1970s, Md very stable
• after 1974, Md becomes less stable (M1)• old relationships overpredicting Md• financial innovations changed
behaviors
• Md stability for M2 breaks down in 1990s
• up until mid 1970s, Md very stable
• after 1974, Md becomes less stable (M1)• old relationships overpredicting Md• financial innovations changed
behaviors
• Md stability for M2 breaks down in 1990s