Demand for money
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.
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.
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.
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.
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 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.
Empirical estimations of money demand functions[edit]
Is money demand stable?[edit]
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. Other researchers confirmed this finding with recent data and over a longer period. Money demand appears to be time varying which also depends on household's real balance effects.[7]
Laurence M. Ball suggests that the use of adapted aggregates, such as near monies, can produce a more stable demand function. He shows that using the return on near monies produced smaller deviations than previous models.[8]