Demand for money in economic theory

Demand for Money

Money in economics terms can be defined by holding cash or non-interest bearing bank accounts. Since these holdings are less advantages than interest bearing accounts or some form of investment, there has to be some motivation to keep cash or completely liquid assets. There are a range of different motivations that can be used to describe these behaviors. However, most of them use liquidity in one form or another. For example, it is necessary to have liquid assets to make purchases or pay bills for example. So if an individual gets their paycheck they may deposit a portion of the check into some form of investment account, while keeping a portion of it liquid to cover their monthly living expenses.

An individual may also move money to a liquid account if they are planning to make a purchase in the short-term. The demand for holding money can be an indicator for the state of the economy as well on a macro level. For example, if more people are holding money on a macroeconomic level then this could indicate certain trends such as volatility in the market. This research will provide a brief literature review about this indicator as well as perform some basic calculation based on real data obtained from the Saint Louis Federal Reserve Bank.

Literature Review

The demand for money remains one of the topics most extensively studied both theoretically and empirically in macroeconomics and since a study by Goldfeld (1976) on the so-called "missing money," the correct specification of the money demand function has been an issue; more recently, the stability of U.S. money demand remains a hotly debated issue (Davis, Karemera, & Whitesides, 2013). Since the recessions of 1982 and 1993 and more recently 2008 many economists have posited a structural shift in the demand for money. These downturns have provided the foundation for the economics debate because some economists believe that there is a complete structural shift in the demand for money while others believe that the demand changes are more temporary in nature.

There may also be other factors beyond recessions and periods of uncertainty that effect the demand for money. For example technology may play a role. Despite major improvements in payment technologies and their widespread diffusion over the past decades, cash transactions still account for a large share of overall payment transactions, both in terms of total number and value. A recent cross-country comparison by Bagnall, Bounie, Huynh, Kosse, Schmidt, Schuh, and Stix (2014) finds that more than half of the volume of point-of-sale (POS) transactions are paid for with cash, with the highest share of 82% in Austria and the lowest share of 46% in the United States (Huynh, Schmidt-Dengler, & Stix, 2014).

Such trends in banking and payment transactions can influence the relevance of M1 holdings. For example, many banking technology improvements allow consumers to pay for major purchases out of an interest bearing account that would not be traditionally counted in the M1 money segment. Examples of such accounts could include money market accounts that are tied to a checking account or are independent but earn interest and are completely liquid. The technological improvements in banking have worked to blur the lines between interest accounts and not interest accounts and this could also have implications for the calculations of the M1 money supply.

Despite the different measures and factors involved for accounting for the demand for money, the stability of the long-run demand for money is a widely researched topic because stable money demand is relevant for policy makers; an unstable money demand, such as those caused by financial reforms in the 1970s which caused several central banks to switch from money targeting in developed countries to using the interest rate as monetary policy (Dobnik, 2013). New models suggest that money demand might be a function of wealth and could be viewed from a portfolio perspective. For example, if a wealthy investor kept some money in cash or checking accounts to simply have liquidity when they needed it.

There is also some debate about the best way to use monetary policy. The principal purpose of identifying aggregate money demand from households, businesses, and the government sector so that the needed level of money can be maintained to generate the desired level of output, employment, and price stability (Kolluri, Singamsetti, & Wahab, 2012). Some believe that targeting the interest rate is a more effective way to control the money supply while others view the money demand and its stability as an important monetary policy issue due to its direct link with money supply, interest rates, and economic growth; however several studies have examined aggregate demand for money, its stability, and its determinants, particularly, income and interest rates; yet these studies have reported different results, and have reached differing conclusions which makes it hard to form a clear consensus of opinions on the matter (Kolluri, Singamsetti, & Wahab, 2012).

Model

The demand for money is a function of how much wealth is to be held in M1 money at any given time. There is an opportunity cost to holding money because it represents a loss in the ability to use the funds to earn interest on other investments. The simplest explanation of why people hold money is because they want to purchase things with it. There is no intrinsic value gained by holding money because money in itself does not actually provide anything for an individual unless it is used as a transaction. For example, you cannot eat money but you can use it to buy a meal. Thus the value inherent in money is only through an exchange for another good or service.

Figure 1 - M1 Money Stock over Time (Federal Reserve Bank of St. Louis, 2014)

If buying stocks and bonds were costless and immediate, the M1 account would be virtually zero. However it normally takes time and money to convert non-liquid assets into liquid ones. Therefore most people hold a certain level of money on average in their budget to pay for their immediate needs and this perspective is referred to as the transaction demand for money. Therefore the transaction demand for money depends on three things (Charusheela & Danby, 1998):

a) Interest rate: as we have noted above, the interest rate is in effect the price of holding money balances. It is the income I forego when I hold money balances. If the interest rate goes up, then the returns on moving in and out of money into other assets and back will increase, so people will hold a lower level of money balances. If the interest rate falls, then the returns on moving out of money balances and into assets are not so great. In this case, it is not worth it to move out of money into other assets and then back when you need to make payments on transactions, so you will hold a higher level of money balances.

b) Aggregate income: if the volume of income and output produced in the goods markets increases, then clearly there will be a larger volume of transactions and exchanges taking place. People will need to hold a larger volume of money to meet all these transactions and make payments.

c) Price level: if prices rise, then people will need to hold a higher level of money balances to meet their payments transactions. If prices fall, people will need a lower volume of money balances to support a given level of transactions.

To model these factors, the Fred data tool was added to excel. This software add in automatically downloads the Feds data into different workbooks for easy viewing. However, using the software is complex and it can be difficult to find the relevant workbooks to determine the demand for money. The first attempt plotted GDP, M1, and interest rates to look for patterns in graphical form. Although this exercise was interesting, it did not provide the needed measure and for some reason the M1 data cutoff in approximately the year 2000.

Another model was identified that was based on the Keynesian Money Market model. The workbook describes the Money Demand (L) as:

MONEY DEMAND (L)

Money demand can be confusing because it sounds like "How much money do you want?" This makes little sense because most people would say things like "as much as there is" or "a billion trillion." The question answered by money demand is actually this, "How much of your assets do you want to hold as money?" You need money to buy things (this is called the transactions demand for money), but the thing about money is that it does not earn interest. So every dollar you hold is a dollar sitting idle instead of working for you (like a dollar of ownership in a stock or bond).

Thus, the interest rate can be viewed as the price of holding money.

As the interest rate rises, it becomes more expensive to hold assets as money and money demand falls. On the other hand, as the interest rate falls, it makes sense that we are willing to hold more of our assets in the form of money, since we are not giving up as much interest.

Another variable that affects money demand is income. It stands to reason people with higher income will hold more money because they buy more stuff.

Money demand is also known as liquidity preference and, therefore, the money demand function is represented with the letter L.

Liquidity preference is a phrase popularized by Keynes to emphasize that money was useful because it easily accepted as a means of payment and how money demand depended on the interest rate.

The money demand function reports how much money people want to hold as a function of a variety of variables such as the interest rate, income, and so on.

The simplest money demand function depends only on the interest rate.

General

Linear Simplification

L = L (r)

L = L0 + Lrr where L1 < 0

We can add income as another variable to get a more advanced money demand function:

General

Linear Simplification

L = L (r, Y)

L = L0 + Lrr + LYY where Lr < 0

Notice the notation, the subscript on the slope coefficient indicates the variable.

MONEY SUPPLY (M)

We will assume the central bank directly sets the amount of money available in the economy and this amount does not depend on anything.

In macroeconomics, the supply ofmoney is often called money balances or just balances, for short. Furthermore, it is often divided by the price level (P)

to get a measure of the real money supply or real balances.

This Excel implementation of the money market will follow this convention, giving us a money supply equation that looks like this:

Ms = M/P

In our most basic model, the price level is fixed so we won't be using P. To do anything, but later on, we will relax the assumption of a fixed price level.