The demand for money has often played a central role in the debate concerning the appropriate stance for monetary policy. Changes in the money supply have a direct impact on interest rates, which provides the first link in the chain of the monetary transmission mechanism. Monetarists believe that the money supply has an effect on real output in the short run (three to five years) but in the long run real output returns to its ‘natural rate’ and any monetary expansion is dissipated in price rises (inflation). In an open economy the money supply also influences the exchange rate and may even cause the latter to overshoot, with consequent short-run effects on price competitiveness, exports, imports and hence real output.
In analysing money demand we assume that in the long run, desired nominal money holdings rise one-for-one with the price level so that the purchasing power of money (i.e. real money balances) remains constant (ceteris paribus). In economies that suffer from hyperinflation (e.g. some Latin American countries, emerging economies of eastern Europe and Russia) the main determinant of real money demand is the expected rate of inflation. The higher that the latter is, the more people wish to move out of money and into goods. Here the rate of inflation represents the rate of loss of purchasing power of money or, more technically, the opportunity cost of money.
In industrialized countries (with moderate inflation rates) a key determinant of (real) money holdings is the level of (real) transactions undertaken. If the desired demand for money Md is proportional to money income PY then Md=kPY. In equilibrium money supply Ms must equal money demand so that Ms=kPY. Hence as long as ‘k’ remains constant, any increase in the money supply Ms will cause an increase in prices P or real output Y. If, in the long run, real output growth is determined by the underlying growth in productivity, then the price level rises one-for-one with an increase in the money supply.
Given the underlying growth in output and a desired path for prices and an estimate of k, one can calculate the required growth of the money supply. Often debates about monetary policy are conducted in terms of the ‘velocity of circulation’ which is defined as PY/M. Given our above assumption about proportionality in the demand for money, we see that this implies that velocity is a constant (i.e. V=1/k).
As well as the transactions motive for holding money, we have the ‘asset motive’, which is based on the fact that money is a ‘store of value’. Faced with the choice between two assets, money which earns interest rm and bonds which earn interest rb, the individual will (in general) choose to hold both assets (i.e. diversified portfolio). However, the individual will hold more wealth in money (and less in bonds) if either the interest rate on bonds falls or the interest rate on money rises, or if bonds are perceived to have become more risky. This model of the demand for money has its origins in the so-called mean-variance approach to asset demands. If we consider the transactions motive and the asset motive together, this more complex demand for money function poses much greater problems in setting monetary targets.
To predict the demand for money consistent with a desired or feasible path for output and prices one needs to be able to predict the behaviour of the interest rate spread, namely the own rate of interest on money less the rate on bonds. Movements in this spread depend in part on the objectives (e.g. profit maximizing behaviour) of commercial banks. If the authorities by open market sales of bonds, raise interest rates on bonds in an attempt to reduce the demand (and hence supply) for money, the commercial banks may respond by raising the interest rate they pay on large deposits (e.g. certificates of deposit), thus ‘attracting back’ the funds to the banks and keeping monetary growth high. Also, the financial sector will look for ways of creating new types of deposits (i.e. financial innovation). For example, in the USA, ‘money market mutual funds’ are deposits which are invested in a portfolio of short-term assets (e.g. Treasury bills, commercial bills), yet customers of the bank can easily draw cheques on such funds. In addition, if there are no capital controls, residents can either place funds in offshore banks in the home currency (e.g. US dollars of US residents held in the Caribbean) or in foreign currencies. Currency substitution may then take place between the domestic and foreign currencies. This may provide an additional source of difficulty when trying precisely to define what constitutes ‘money’ and in determining the demand for the domestic currency.
All in all, while the demand for narrow (i.e. transactions) and broad money (which includes savings accounts) tended to move broadly together in the 1950s and 1960s, this has ceased to be the case in the 1980s and 1990s in many industrialized countries. In technical language, the demand for money (or ‘velocity’) has become more unpredictable in the 1970s (UK and US broad money), the early 1980s (e.g. ‘the great velocity decline’ in the USA) and even in Germany, in the 1992–4 period. Hence for any given change in the money supply, it is much more difficult to predict the course of prices (inflation) over the ensuing five years (i.e. there are ‘long and variable lags’ in the system). This has led to a move away from sole reliance on the money supply as the means of combating inflation. Instead there has been either a move towards setting nominal interest rates (to achieve a desired level of real interest rates) in closed economies (like the USA) or in open economies, fixing the domestic exchange rate to a low inflation anchor currency (e.g. to the Deutsche Mark in European countries).
Keith Cuthbertson
City University Business School
Further reading
Cuthbertson, K. (1985) The Supply and Demand for Money, Oxford.
Cuthbertson, K. and Gripaios, P. (1993) The Macroeconomy: A Guide for Business, 2nd edn, London.
Laidler, D.E.W. (1992) The Demand for Money Theories and Evidence, 3rd edn, New York.
