By the early 1970s, evidence strongly supported the stability of the money
demand function. However, after 1973, the rapid pace of financial innovation
(which changed what items could be counted as money) led to substantial insta-
bility in estimated money demand functions.
The recent instability of the money demand function calls into question
whether our theories and empirical analyses are adequate.
15
It also has impor-
tant implications for the way monetary policy should be conducted because it
casts doubt on the usefulness of the money demand function as a tool to
provide guidance to policymakers. In particular, because the money demand
function has become unstable, velocity is now harder to predict, and, as
discussed in Chapter 18, setting rigid money supply targets in order to control
aggregate spending in the economy may not be an effective way to conduct
monetary policy.
C H A P T E R 2 1
The Demand for Money
569
15
For example, William Barnett, Douglas Fisher, and Apostolos Serletis, Consumer Theory and the
Demand for Money,
Journal of Economic Literature
30 (1992): 2086 2119; William Barnett and Apostolos
Serletis,
The Theory of Monetary Aggregation,
(Amsterdam: North-Holland, 2000); and Apostolos Serletis,
The Demand for Money: Theoretical and Empirical Approaches
(Springer, 2007) are especially critical of
the use of simple-sum monetary aggregates in the empirical research on the demand for money.
1. Irving Fisher developed a transactions-based theory
of the demand for money in which the demand for
real balances is proportional to real income and is
insensitive to interest-rate movements. An implica-
tion of his theory is that velocity, the rate of turnover
of money, is constant. This generates the quantity
theory of money, which implies that aggregate
spending is determined solely by movements in the
quantity of money.
2. The classical Cambridge approach tried to answer
the question of how much money individuals want
to hold. This approach also viewed the demand for
real balances as proportional to real income, but it
differs from Fisher s analysis in that it does not rule
out interest-rate effects on the demand for money.
3. The classical view that velocity can be effectively
treated as a constant is not supported by the data. The
nonconstancy of velocity became especially clear to
the economics profession after the sharp drop in
velocity during the years of the Great Depression.
4. John Maynard Keynes extended
the classical
approach by suggesting three motives for holding
money: the transactions motive, the precautionary
motive, and the speculative motive. His resulting liq-
uidity preference theory views the transactions and
precautionary components of money demand as
proportional to income. However, the speculative
component of money demand is viewed as sensitive
to interest rates as well as to expectations about the
future movements of interest rates. This theory, then,
implies that velocity is unstable and cannot be
treated as a constant.
5. Further developments in the Keynesian approach
provided a better rationale for the three Keynesian
motives for holding money. Interest rates were
found to be important to the transactions and pre-
cautionary components of money demand as well as
to the speculative component.
6. Milton Friedman s theory of money demand used
a similar approach to that of Keynes and the classi-
cal economists. Treating money like any other
asset, Friedman used the theory of asset demand to
derive a demand for money that is a function of the
expected returns on other assets relative to the
expected return on money and permanent income.
In contrast to Keynes, Friedman believed that the
demand for money is stable and insensitive to
interest-rate movements. His belief that velocity is
predictable (though not constant) in turn leads to
the quantity theory conclusion that money is the
primary determinant of aggregate spending.
7. There are two main conclusions from the research on
the demand for money. The demand for money is
sensitive to interest rates, but there is little evidence
that it is or has been ultrasensitive (liquidity trap).
Since 1973, money demand has been found to be
unstable, with the most likely source of the instabil-
ity being the rapid pace of financial innovation.
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