Understanding Money Understanding Money DemandDemand

Money can be anything that satisfies:

•Store of Value

•Unit of account

•Medium of exchange

Lots of things satisfy these properties

Standard Definitions of MoneyStandard Definitions of Money

Monetary Base (M0): Direct liabilities of the central bankMonetary Base (M0): Direct liabilities of the central bank Currency in circulation + Bank ReservesCurrency in circulation + Bank Reserves

M1: M1: Currency in circulation + Traveler's Checks + Currency in circulation + Traveler's Checks +

Checking accountsChecking accounts M2:M2:

M1 + Savings accounts + Money Market Accounts + M1 + Savings accounts + Money Market Accounts + Small Time Deposits Small Time Deposits

M3: M3: M2 + Large Time Deposits + EurodollarsM2 + Large Time Deposits + Eurodollars

Think of this as a portfolio allocation problem. You have a fixed amount of income and you are allocating it over several assets.

Less Liquid Higher Return

More Liquid Lower Return

$5,000/month

Cash $400

Checking Account$2,000

Savings Account$600

Stock/Bonds $2,000

M1 M2

Suppose you plan on Suppose you plan on spending $120 over spending $120 over the upcoming month. the upcoming month. You can withdraw the You can withdraw the $120 from your $120 from your savings account savings account immediately, or you immediately, or you can make several trips can make several trips to the ATM. to the ATM.

M1 Money DemandM1 Money Demand

ATM Withdrawals

Cash Balance Hits Zero

Suppose you go to the bank three times per month (every 10 days)

More generally, you make plan on Spending More generally, you make plan on Spending PY dollars per month. If you make dollars per month. If you make N trips to the ATM trips to the ATM

Average Cash Balances =

0 +PY

N

2

Real Money Demand

=MP =

Y2N

= Money Demand

There are two costs associated with money:There are two costs associated with money:

N

yi

2 Cost Interest

tN Cost n Transactio

If you make very few trips to the bank (N is small), you will need to withdraw more cash – having more cash entails more lost interest

If you make a lot of trips to the bank, you will withdraw less each time (less interest cost), but you will pay more in transaction costs

Choosing NChoosing N

tNN

yiMinimize

N 2

02 2

tN

yiTake the derivative with respect to ‘N’

t

yiN

2 Solve for N

M1 Money DemandM1 Money Demand

t

yiN

2

As the interest rate goes up, you hold less cash. Therefore, you make more trips to the bank

As ATM fees rise, you make less trips to the bank, but withdraw more each time

This is the optimal behavior (i.e. trips to the ATM per month)

M1 Money DemandM1 Money Demand

i

yt

N

y

P

M d

22

Real Money Demand

Real Income

Nominal Interest Rate

Transaction Costs

Generally Speaking….

tiyMP

M d

,,

Real Money Demand

Real Income (+)

Nominal Interest Rate (-)

Transactions Costs (Cost of obtaining money) (+)

“is a function of…”

Cambridge Money Demand

A common form of money demand can be written as follows:

ytikP

M d

),(

Money demand is equal to a fraction (k is between zero and one) of real income. That fraction depends on interest rates (-) and transaction costs

The Quantity Theory of Money

MV = Py

Nominal Income

Velocity – Measures the number of times a dollar changes hands

Money Supply

For example, if PY = $100 (there are $100 worth of goods and services to buy) and M = $50 (there are $50 worth of cash available), the V = 2 (each dollar changes hands twice)

The Quantity Theory of Money and Cambridge Money Demand

When money demand drops (either interest rates rise or transaction costs fall), individuals do not want to hold onto as much money as before. To get rid of it, they pass it on to someone else – velocity increases.

ytikP

M),( PyMV

),(

1

tikV

Trend

Money Demand Rises from 1980 - 1993

M1 Money Demand falls dramatically starting in 1995

In 1995, we saw a dramatic change in household portfolio decisions…why?

Is interest rates rose, households switched out of checking accounts and into savings accounts….technology (online banking, ATMs, etc. made this transition easier)

Rising Demand for M2

Falling demand for M2

M2 Money DemandM2 Money Demand

Recall that M2 includes everything in M1 Recall that M2 includes everything in M1 (cash + checking accounts) plus savings (cash + checking accounts) plus savings accounts. Therefore, any model of M2 accounts. Therefore, any model of M2 demand would need to explain why demand would need to explain why households hold savings/checking households hold savings/checking accounts rather than less liquid assets accounts rather than less liquid assets such as T-Billssuch as T-Bills

M2 Money DemandM2 Money Demand

Any M2 money demand should have the Any M2 money demand should have the same characteristics as the previously same characteristics as the previously derived M1 demandderived M1 demandPositively related to income/consumptionPositively related to income/consumptionNegatively related to interest rates Negatively related to interest rates

M2 Money DemandM2 Money Demand

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Positively related to consumption

Negatively related to interest rates