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In monetary economics, the demand for money is the desired holding of financial assets in the form of money: that is, cash or bank deposits rather than investments. It can refer to the demand for money narrowly defined as M1 (directly spendable holdings) , or for money in the broader sense of M2 or M3.
Monetary economics is the branch of economics that studies the different competing theories of money: it provides a framework for analyzing money and considers its functions, and it considers how money, for example fiat currency, can gain acceptance purely because of its convenience as a public good. The discipline has historically prefigured, and remains integrally linked to, macroeconomics. This branch also examines the effects of monetary systems, including regulation of money and associated financial institutions and international aspects.
Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts, such as taxes, in a particular country or socio-economic context. The main functions of money are distinguished as: a medium of exchange, a unit of account, a store of value and sometimes, a standard of deferred payment. Any item or verifiable record that fulfils these functions can be considered as money.
Money in the sense of M1 is dominated as a store of value (even a temporary one) by interest-bearing assets. However, M1 is necessary to carry out transactions; in other words, it provides liquidity. This creates a trade-off between the liquidity advantage of holding money for near-future expenditure and the interest advantage of temporarily holding other assets. The demand for M1 is a result of this trade-off regarding the form in which a person's funds to be spent should be held. In macroeconomics motivations for holding one's wealth in the form of M1 can roughly be divided into the transaction motive and the precautionary motive. The demand for those parts of the broader money concept M2 that bear a non-trivial interest rate is based on the asset demand. These can be further subdivided into more microeconomically founded motivations for holding money.
A store of value is the function of an asset that can be saved, retrieved and exchanged at a later time, and be predictably useful when retrieved. More generally, a store of value is anything that retains purchasing power into the future.
Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of an economy as a whole. This includes regional, national, and global economies. Macroeconomists study aggregated indicators such as GDP, unemployment rates, national income, price indices, and the interrelations among the different sectors of the economy to better understand how the whole economy functions. They also develop models that explain the relationship between such factors as national income, output, consumption, unemployment, inflation, saving, investment, energy, international trade, and international finance.
Transactions demand, in economic theory, specifically Keynesian economics and monetary economics, is one of the determinants of the demand for money, the others being asset demand and precautionary demand.
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.
In economics, nominal value is measured in terms of money, whereas real value is measured against goods or services. A real value is one which has been adjusted for inflation, enabling comparison of quantities as if the prices of goods had not changed on average. Changes in value in real terms therefore exclude the effect of inflation. In contrast with a real value, a nominal value has not been adjusted for inflation, and so changes in nominal value reflect at least in part the effect of inflation.
In finance and economics, the nominal interest rate or nominal rate of interest is either of two distinct things:
The money supply is the total value of money available in an economy at a specific time. There are several ways to define "money", but standard measures usually include currency in circulation and demand deposits. Each country’s central bank may use its own definitions of what constitutes money for its purposes.
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.
A central bank, reserve bank, or monetary authority is an institution that manages the currency, money supply, and interest rates of a state or formal monetary union, and oversees their commercial banking system. In contrast to a commercial bank, a central bank possesses a monopoly on increasing the monetary base in the state, and also generally controls the printing/coining of the national currency, which serves as the state's legal tender. A central bank also acts as a lender of last resort to the banking sector during times of financial crisis. Most central banks also have supervisory and regulatory powers to ensure the solvency of member institutions, to prevent bank runs, and to discourage reckless or fraudulent behavior by member banks.
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 liquidity trap is a situation, described in Keynesian economics, in which, "after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute in the sense that almost everyone prefers holding cash rather than holding a debt which yields so low a rate of interest."
In economics, elasticity is the measurement of the proportional change of an economic variable in response to a change in another. It shows how easy it is for the supplier and consumer to change their behavior and substitute another good, the strength of an incentive over choices per the relative opportunity cost.
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 income, and L(.) is real money demand. An alternate name for is the liquidity preference function.
In macroeconomic theory, liquidity preference is the demand for money, considered as liquidity. The concept was first developed by John Maynard Keynes in his book The General Theory of Employment, Interest and Money (1936) to explain determination of the interest rate by the supply and demand for money. The demand for money as an asset was theorized to depend on the interest foregone by not holding bonds. Interest rates, he argues, cannot be a reward for saving as such because, if a person hoards his savings in cash, keeping it under his mattress say, he will receive no interest, although he has nevertheless refrained from consuming all his current income. Instead of a reward for saving, interest, in the Keynesian analysis, is a reward for parting with liquidity. According to Keynes, money is the most liquid asset. Liquidity is an attribute to an asset. The more quickly an asset is converted into money the more liquid it is said to be.
The transactions motive for the demand for M1 (directly spendable money balances) results from the need for liquidity for day-to-day transactions in the near future. This need arises when income is received only occasionally (say once per month) in discrete amounts but expenditures occur continuously.
The most basic "classical" transaction motive can be illustrated with reference to the Quantity Theory of Money. According to the equation of exchange MV = PY, where M is the stock of money, V is its velocity (how many times a unit of money turns over during a period of time), P is the price level and Y is real income. Consequently, PY is nominal income or in other words the number of transactions carried out in an economy during a period of time. Rearranging the above identity and giving it a behavioral interpretation as a demand for money we have
or in terms of demand for real balances
Hence in this simple formulation demand for money is a function of prices and income, as long as its velocity is constant.
The amount of money demanded for transactions however is also likely to depend on the nominal interest rate. This arises due the lack of synchronization in time between when purchases are desired and when factor payments (such as wages) are made. In other words, while workers may get paid only once a month they generally will wish to make purchases, and hence need money, over the course of the entire month.
The most well-known example of an economic model that is based on such considerations is the Baumol-Tobin model. In this model an individual receives her income periodically, for example, only once per month, but wishes to make purchases continuously. The person could carry her entire income with her at all times and use it to make purchases. However, in this case she would be giving up the (nominal) interest rate that she can get by holding her income in the bank. The optimal strategy involves holding a portion of one's income in the bank and portion as liquid money. The money portion is continuously run down as the individual makes purchases and then she makes periodic (costly) trips to the bank to replenish the holdings of money. Under some simplifying assumptions the demand for money resulting from the Baumol-Tobin model is given by
where t is the cost of a trip to the bank, R is the nominal interest rate and P and Y are as before.
The key difference between this formulation and the one based on a simple version of Quantity Theory is that now the demand for real balances depends on both income (positively) or the desired level of transactions, and on the nominal interest rate (negatively).
While the Baumol–Tobin model provides a microeconomic explanation for the form of the money demand function, it is generally too stylized to be included in modern macroeconomic models, particularly dynamic stochastic general equilibrium models. As a result, most models of this type resort to simpler indirect methods which capture the spirit of the transactions motive. The two most commonly used methods are the cash-in-advance model (sometimes called the Clower constraint model) and the money-in-the-utility-function (MIU) model (as known as the Sidrauski model).
In the cash-in-advance model agents are restricted to carrying out a volume of transactions equal to or less than their money holdings. In the MIU model, money directly enters agents' utility functions, capturing the 'liquidity services' provided by money.
The precautionary demand for M1 is the holding of transaction funds for use if unexpected needs for immediate expenditure arise.
The asset motive for the demand for broader monetary measures, M2 and M3, states that people demand money as a way to hold wealth. While it is still assumed that money in the sense of M1 is held in order to carry out transactions, this approach focuses on the potential return on various assets (including money broadly defined) as an additional motivation.
John Maynard Keynes, in laying out speculative reasons for holding money, stressed the choice between money and bonds. If agents expect the future nominal interest rate (the return on bonds) to be lower than the current rate they will then reduce their holdings of money and increase their holdings of bonds. If the future interest rate falls, then the price of bonds will increase and the agents will have realized a capital gain on the bonds they purchased. This means that the demand for money in any period will depend on both the current nominal interest rate and the expected future interest rate (in addition to the standard transaction motives which depend on income).
The fact that the current demand for money can depend on expectations of the future interest rates has implications for volatility of money demand. If these expectations are formed, as in Keynes' view, by "animal spirits" they are likely to change erratically and cause money demand to be quite unstable.
The portfolio motive also focuses on demand for money over and above that required for carrying out transactions. The basic framework is due to James Tobin, who considered a situation where agents can hold their wealth in a form of a low risk/low return asset (here, money) or high risk/high return asset (bonds or equity). Agents will choose a mix of these two types of assets (their portfolio) based on the risk-expected return trade-off. For a given expected rate of return, more risk averse individuals will choose a greater share for money in their portfolio. Similarly, given a person's degree of risk aversion, a higher expected return (nominal interest rate plus expected capital gains on bonds) will cause agents to shift away from safe money and into risky assets. Like in the other motivations above, this creates a negative relationship between the nominal interest rate and the demand for money. However, what matters additionally in the Tobin model is the subjective rate of risk aversion, as well as the objective degree of risk of other assets, as, say, measured by the standard deviation of capital gains and losses resulting from holding bonds and/or equity.
Friedman and Schwartz in their 1963 work A Monetary History of the United States argued that the demand for real balances was a function of income and the interest rate. For the time period they were studying this appeared to be true. However, shortly after the publication of the book, due to changes in financial markets and financial regulation money demand became more unstable. Various researchers showed that money demand became much more unstable after 1975. Ericsson, Hendry and Prestwich (1998) consider a model of money demand based on the various motives outlined above and test it with empirical data. The basic model turns out to work well for the period 1878 to 1975 and there doesn't appear to be much volatility in money demand, in a result analogous to that of Friedman and Schwartz. This is true even despite the fact that the two world wars during this time period could have led to changes in the velocity of money. However, when the same basic model is used on data spanning 1976 to 1993, it performs poorly. In particular, money demand appears not to be sensitive to interest rates and there appears to be much more exogenous volatility. The authors attribute the difference to technological innovations in the financial markets, financial deregulation, and the related issue of the changing menu of assets considered in the definition of money.
Later work by Lawrence Ball suggests that the use of adapted aggregates, such as near monies, can produce a more stable demand function. Through his research, Ball was able to show that using the return on near monies produced smaller deviations than previous models.
If the demand for money is stable then a monetary policy which consists of a monetary rule which targets the growth rate of some monetary aggregate (such as M1 or M2) can help to stabilize the economy or at least remove monetary policy as a source of macroeconomic volatility. Additionally, if the demand for money does not change unpredictably then money supply targeting is a reliable way of attaining a constant inflation rate. This can be most easily seen with the quantity theory of money equation given above. When that equation is converted into growth rates we have
which says that the growth rate of money supply plus the growth rate of its velocity equals the inflation rate plus the growth rate of real output. If money demand is stable then velocity is constant and . Additionally, in the long run real output grows at a constant rate equal to the sum of the rates of growth of population, technological know-how, and technology in place, and as such is exogenous. In this case the above equation can be solved for the inflation rate:
Here, given the long-run output growth rate, the only determinant of the inflation rate is the growth rate of the money supply. In this case inflation in the long run is a purely monetary phenomenon; a monetary policy which targets the money supply can stabilize the economy and ensure a non-variable inflation rate.
This analysis however breaks down if the demand for money is not stable — for example, if velocity in the above equation is not constant. In that case, shocks to money demand under money supply targeting will translate into changes in real and nominal interest rates and result in economic fluctuations. An alternative policy of targeting interest rates rather than the money supply can improve upon this outcome as the money supply is adjusted to shocks in money demand, keeping interest rates (and hence, economic activity) relatively constant.
The above discussion implies that the volatility of money demand matters for how monetary policy should be conducted. If most of the aggregate demand shocks which affect the economy come from the expenditure side, the IS curve, then a policy of targeting the money supply will be stabilizing, relative to a policy of targeting interest rates. However, if most of the aggregate demand shocks come from changes in money demand, which influences the LM curve, then a policy of targeting the money supply will be destabilizing.
James Tobin was an American economist who served on the Council of Economic Advisers and the Board of Governors of the Federal Reserve System, and taught at Harvard and Yale Universities. He developed the ideas of Keynesian economics, and advocated government intervention to stabilize output and avoid recessions. His academic work included pioneering contributions to the study of investment, monetary and fiscal policy and financial markets. He also proposed an econometric model for censored endogenous variables, the well-known "Tobit model". Tobin received the Nobel Memorial Prize in Economic Sciences in 1981 for "creative and extensive work on the analysis of financial markets and their relations to expenditure decisions, employment, production and prices."
In economics, inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation reflects a reduction in the purchasing power per unit of money – a loss of real value in the medium of exchange and unit of account within the economy. The measure of inflation is the inflation rate, the annualized percentage change in a general price index, usually the consumer price index, over time. The opposite of inflation is deflation, a sustained decrease in the general price level of goods and services.
The IS–LM model, or Hicks–Hansen model, is a macroeconomic tool that shows the relationship between interest rates (ordinate) and assets market. The intersection of the "investment–saving" (IS) and "liquidity preference–money supply" (LM) curves models "general equilibrium" where supposed simultaneous equilibria occur in both the goods and the asset markets. Yet two equivalent interpretations are possible: first, the IS–LM model explains changes in national income when price level is fixed short-run; second, the IS–LM model shows why an aggregate demand curve can shift. Hence, this tool is sometimes used not only to analyse economic fluctuations but also to suggest potential levels for appropriate stabilisation policies.
An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited or borrowed. The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, the compounding frequency, and the length of time over which it is lent, deposited or borrowed.
Monetary policy is the policy adopted by the monetary authority of a country that controls either the interest rate payable on very short-term borrowing or the money supply, often targeting inflation or the interest rate to ensure price stability and general trust in the currency.
The General Theory of Employment, Interest and Money of 1936 is the last and most important book by the English economist John Maynard Keynes. It created a profound shift in economic thought, giving macroeconomics a central place in economic theory and contributing much of its terminology – the "Keynesian Revolution". It had equally powerful consequences in economic policy, being interpreted as providing theoretical support for government spending in general, and for budgetary deficits, monetary intervention and counter-cyclical policies in particular. It is pervaded with an air of mistrust for the rationality of free-market decision making.
An open market operation (OMO) is an activity by a central bank to give liquidity in its currency to a bank or a group of banks. The central bank can either buy or sell government bonds in the open market or, in what is now mostly the preferred solution, enter into a repo or secured lending transaction with a commercial bank: the central bank gives the money as a deposit for a defined period and synchronously takes an eligible asset as collateral. A central bank uses OMO as the primary means of implementing monetary policy. The usual aim of open market operations is—aside from supplying commercial banks with liquidity and sometimes taking surplus liquidity from commercial banks—to manipulate the short-term interest rate and the supply of base money in an economy, and thus indirectly control the total money supply, in effect expanding money or contracting the money supply. This involves meeting the demand of base money at the target interest rate by buying and selling government securities, or other financial instruments. Monetary targets, such as inflation, interest rates, or exchange rates, are used to guide this implementation.
In monetary economics, the quantity theory of money (QTM), invented by Nicolaus Copernicus, states that the general price level of goods and services is directly proportional to the amount of money in circulation, or money supply.
In economics, the Pigou effect is the stimulation of output and employment caused by increasing consumption due to a rise in real balances of wealth, particularly during deflation. The term was named after Arthur Cecil Pigou by Don Patinkin in 1948.
The Mundell–Fleming model, also known as the IS-LM-BoP model, is an economic model first set forth (independently) by Robert Mundell and Marcus Fleming. The model is an extension of the IS-LM model. Whereas the traditional IS-LM model deals with economy under autarky, the Mundell–Fleming model describes a small open economy. Mundell's paper suggests that the model can be applied to Zurich, Brussels and so on.
The real interest rate is the rate of interest an investor, saver or lender receives after allowing for inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approximately the nominal interest rate minus the inflation rate.
In monetary economics, the equation of exchange is the relation:
The Baumol–Tobin model is an economic model of the transactions demand for money as developed independently by William Baumol (1952) and James Tobin (1956). The theory relies on the tradeoff between the liquidity provided by holding money and the interest forgone by holding one’s assets in the form of non-interest bearing money. The key variables of the demand for money are then the nominal interest rate, the level of real income that corresponds to the number of desired transactions, and the fixed transaction costs of transferring one’s wealth between liquid money and interest-bearing assets. The model was originally developed to provide microfoundations for aggregate money demand functions commonly used in Keynesian and monetarist macroeconomic models of the time. Later, the model was extended to a general equilibrium setting by Boyan Jovanovic (1982) and David Romer (1986).
The Cambridge equation formally represents the Cambridge cash-balance theory, an alternative approach to the classical quantity theory of money. Both quantity theories, Cambridge and classical, attempt to express a relationship among the amount of goods produced, the price level, amounts of money, and how money moves. The Cambridge equation focuses on money demand instead of money supply. The theories also differ in explaining the movement of money: In the classical version, associated with Irving Fisher, money moves at a fixed rate and serves only as a medium of exchange while in the Cambridge approach money acts as a store of value and its movement depends on the desirability of holding cash.
A nominal income target is a monetary policy target. Such targets are adopted by central banks to manage national economic activity. Nominal aggregates are not adjusted for inflation. Nominal income aggregates that can serve as targets include nominal gross domestic product (NGDP) and nominal gross domestic income (GDI). Central banks use a variety of techniques to hit their targets, including conventional tools such as interest rate targeting or open market operations, unconventional tools such as quantitative easing or interest rates on excess reserves and expectations management to hit its target. The concept of NGDP targeting was originally proposed by James Meade (1978) and James Tobin (1980).