Theories Of Demand For Money And Empirical Works Economics

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The demand for money theory is the chief component of the pecuniary economic sciences theory and an indispensable portion in the macroeconomic theory. At the same clip, each state ‘s authorities, policy shaper and economic expert takes it earnestly on economic control. From the 1970, the western states experienced a worse state of affairs of increasing rising prices. A batch of economic experts considered that demand for money map was unstable due to fiscal invention, and it became hard to command by pecuniary section. Then, it led to a haste of research the demand for money which includes the Keynes system, pecuniary system, rational expected system and so on. In this portion, I will discourse three theories of the demand for money. They are the classics theory, the modern measure theory and Keynes theory. In extra, two empirical plants will be looked into – An economic analysis of UK money demand by Milton Friedman and Anna J. Schwartz ; and the demand for wide money in the United Kingdom by Hendry, Ericsson and Prestwich.

The authoritative theory

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At nowadays of the money theory came from two different theories: one is measure theory which belongs to the authoritative theory ; the other is Keynesian theory. ( Handa, 2000, p25 ) . In the authoritative theory, the economic system ever keeps the full-employment degree and monetary value can set any clip to maintain the balance in the market. Although the authoritative theory did non advert the demand for money, it was noticed on minutess speed of circulation of money.

Irving Fisher ‘s version of the measure theory

In 1911 Irving Fisher ‘s published a book- “ power of money ” which emphasized money ‘s map was the medium of exchange. ( Fisher, 1911 ) . The book shows the equation about the measure of trade good dealing being equal to the measure of currency dealing. Fisher tried to utilize the measure equation to discourse the measure theory in that book. In the equation ( 1 ) : Meter is the measure of money, V is the figure of times it turns over, P is the monetary value degree, and T is the volume of dealing. PT is the entire value of trade good dealing or nominal national income ; MV is the entire value of currency dealing. “ The measure of money ( M ) is determined independently of any of the three other variables and at any clip can be taken as given. “ ( Laidler,1985, p.44 ) . In the long tally, economic system with full employment degree, the T can be taken as given excessively. Fisher assumes that it has a fixed ratio between volume of minutess and degree of end product. The V is besides treated like M, that is, independently of any other variables. Therefore, the value of variable P is dependent on the interaction of other variables. In another word, harmonizing to Laidler ( 1985, p45 ) : “ The demand for nominal money depends on the current value of the dealing to be conducted in the economic system and is equal to a changeless fraction of those minutess. ”

MV=PT ( 1 )

Cambridge attack

The British economic experts Marshall and Pigou analyzed the demand for money in another manner. Rather than discoursing map provided by Fisher ‘s work, they discussed what determination people wish to keep the sum money in the trading. They emphasized that peoples ‘ behaviour when they choosing.

In the Pigou ‘s article “ the value of money ” shows he analyzed the legal stamp which included the currency and demand sedimentations in the Bankss. He considered that people hold the currency and demand sedimentations because it has two intents. First is the “ proviso of convenience ” . When people hold hard currency, they can easy to make their day-to-day concern. Second is the “ proviso of security ” . It can forestall him to confront the unexpected demand or the some trade goods monetary value increasing. ( Handa, 2000, p.31 ) . Therefore, the two intents would convey the demand for currency and sedimentation.

The demand for money determined by the proportion of wealth that the people choose it. Hence, Pigu ( 1971 ) considered that people direct concerned about the proportion of hard currency in their whole resources, and non the demand for the currency and sedimentation. Further, “ this ration of money demand to resources is a map of the internal rate of return on investing and of the fringy satisfaction forgone signifier less ingestion. ” ( Handa, 2000, p31 ) . Under the other thing changeless, the nominal money demand and nominal outgo became a proportion. The equation is: Md/Y=k ( R ) ( 1 )

The R represents the internal rate of return on investing. Y is nominal outgo, Md nominal money demand.

The equation can alter to: Md=k ( R ) Y ( 2 )

Besides Y= py. P is the monetary value, Y is the existent sum of goods

Md=k ( R ) py ( 3 )

Md *1/k ( R ) = py, ( 4 )

Use V= 1/k ( R ) , ( 5 ) the V means speed. In the equation ( 5 ) shows the Velocity determined by the involvement rate “ R ” . In the Welsh theoretical account, it already showed the involvement rate a variable has an of import factor for the demand for money.

Keynesian theory

Keynes showed the liquidness penchant theory in 1936. He advanced the job of demand for money from Cambridge attack and made a more careful analyzed about motive that people to keep money. ( Laidler 1985, p50 ) . He considered that people like to keep money because it can maintain the flexibleness on payment. He stressed the function of involvement rate and gave up the authoritative theory about speed. The Keynesian theory divided into dealing demand, precautional demand and bad demand.

The dealing demand for money indicated when people hold money to do day-to-day trading ; it brought the demand for money. Keynesian considered that higher end product and income would use the day-to-day trading size, so it led the higher degree of dealing demand for money. However, he ignored function of involvement rate in dealing demand for money. In fact, it was consistent with the authoritative currency measure theory. Hence, measure of dealing demand for money merely depends on income degree and non involvement rate. Let dealing demand for money Mt= degree Fahrenheit ( Y ) , it has a positive relationship with national income ( Y ) .

The precautional demand for money indicated “ people find it prudent to keep some hard currency in instance they are non able to recognize other assets rapidly plenty to be of usage to them. “ ( Laidler, 1985, P50 ) . Keynes thought it has a positive relationship with Y, it shows on Mp=f ( Y )

The bad demand for money indicated that people hold money waiting for the good investing chance. Keynes assumed people hold finance capital divided by currency and bonds. If people hold the currency, they did non acquire the income ; nevertheless ; the bond got it. The bond monetary value alteration followed the involvement rate. If the involvement rate increased, the bond monetary value would diminish and frailty versa. Therefore for the bondholder, the involvement rate alteration induced the plus net income or loss, but it could non alter value of the currency. The bond provided some net incomes, but hard currency did non, like involvement earning and plus net income when expected interested rate lessening.However, bond is capable to a hazard when expected interested rate addition, the holder will lose their net incomes and involvement earning. In decision, when the expected involvement rate decreased, the demand for money would diminish. The ground is that people expected to hold plus net income when they hold the bonds. However, when the expected involvement rate increased, the demand for money would increase. The ground is that people want to avoid the loss from their bonds. This phenomenon can be explained with the aid of this equation be shows: Mps=f ( R )

We put the three motivations together which show on:

Md= Mt+Mp+Mps ( 2 )

Md= degree Fahrenheit ( R, Y ) ( 3 )

The equation ( 3 ) shows the demand for money depend on involvement rate ( R ) and income ( Y ) .In add-on, it has a positive relationship with ( Y ) and negative relationship with ( R ) .

The Keynesian ‘s liquidness penchant theory has a great advancement relation to the Fisher ‘s classical theory and Marshall ‘s Cambridge attack. He agreed that one point from authoritative theory that the minutess demand for money is stable, and introduced that the current income and involvement rate has a relationship with the demand for money.

Friedman and modern measure theory


In 1956, Milton Friedman wrote a thesis about pecuniary measure theory which advanced the Modern measure theory. Friedman did non merely concentrate on analyze the motive of people hold money ; he besides analyze the determiner the measure of people hold it under different state of affairss, and mentioned the money is an plus in the wealth. Friedman considered that money was a replacement for bond, stock and trade good. In extra, the demand for money depended on measure of all wealth, but the wealth can non to be step ; so allow usage lasting income alternatively of it. By and large, the higher income or wealth increased the demand for money. However, Friedman thought the lasting income of people was stable, so the ingestion would non alter when the current income additions.

Modern measure theory

The modern measure theory introduced the capital portfolios. The portfolio included Multi-financial plus like: bond, hard currency, stock and so on. The demand for money was regard as the demand for assets. Therefore, the demand for money theory became the demand for diversified portfolios theory. This theory developed the Friedman ‘s modern measure theory and it reflected the diversified finance plus portfolios and the uncertainness of investing income induced the rational pick. It besides developed the Keynes ‘s plus pick from two simple assets to diversified portfolios theory. Furthermore, the Tobin and Baumol developed the research of demand for money from limited money market to diversified finance market.

The development of liquidness penchant theory

The Baumol and Tobin have advanced the Keynes theory on minutess demand for money and precautional demand for money in 1950. They show the demand for money non merely depends on current income, but besides on the sensitiveness of involvement rate. ( Handa, 2000, p.86 ) . In add-on, they introduced the chance cost.Their theoretical account ‘s basic position is people ‘s chance cost when they hold the hard currency, and the advantage was avoiding the dealing cost. In the day-to-day trading, the chance cost of people from keeping hard currency was higher than minutess cost it they hold bond, so they will give up a portion of hard currency to turn to the bond, and frailty versa. It besides indicated the demand for money has sensitiveness to the involvement rate. The theoretical account could demo by the mathematics: = ( 4 )

In the equation ( 4 ) , b represent the dealing cost of the bonds, the Baumol calls securities firm fee ( Laidler, 1985, p.60 ) . T represent the existent income of bargainer, R represents the involvement rate. K represents the existent value when bond turns to hard currency. The equation besides shows some different consequence when the variables change. If the income additions, people will acquire more hard currency and keep it ; if the B ( minutess cost ) addition, people will keep more hard currency, the demand for bond will diminish at same clip. If the involvement rate additions, the demand for bond will increase. In the Laidler ( 1985, p61-63 ) book introduced a “ pay ” in the dealing demand and it consequence on the demand for money.He considered the “ B ” will alter for the different people in a certain clip. It is because “ B ” came from clip when people change net income plus to hard currency, so its value will alter along with people in different times. In add-on, the dealing cost depended on person ‘s pay rate. If people have a higher pay, it means they need more clip to alter net income plus to hard currency. Baumol and Tobin advanced demand for money depends on allocate and degree of gaining.

An American economic expert Whalen introduced the interested rate in precautional demand for money in 1966 ( Handa, 2000, p.130 ) . Whalen considered that the uncertainness determined the precautional demand for money. Peoples were non warrant of the same payout and earning at a certain clip, so they hold hard currency for exigency. Therefore, people hold hard currency ever higher than projected net payout, the extra portion was came from the precautional demand for money. He thought there are two major factors finding the size of precautional demand for money: the cost of keeping hard currency and the position of gaining and payout. The cost of keeping hard currency is divided into illiquid cost and lost involvement rate cost. The position of gaining and payout: when merely the net payout exceeds precautional keeping hard currency, it need the non-monetary plus bend to the pecuniary. Therefore, the position of payout and earning aroused alteration of precautional demand for money. The Whalen advanced the maximization expression.


In the bad demand for money, Tobin applied the diversified portfolios theory to it. Tobin assumes investors are all hazard averse, and they sought the balance between income and hazard, made the maximal public-service corporation. In add-on, he assumes investors merely have two diversified portfolios: hard currency and bond. Cash is risk free plus, but bond is hazardous plus. Under other conditions fixed, when the involvement rate increased, the bond is more attractive for the investor, so the measure of demand for bond would increase, the demand for money would diminish at same clip. Although Keynes and Tobin analyzes the different demand for money, but they both showed the same consequence which is the demand for money has a negative relationship with involvement rate.

The empirical plants on money demand for money in UK

In 1982, Milton Friedman and Anna Schwarz show a wealth of empirical determination as support for a scope of economic hypotheses which use the phase-average informations to happen the relationship between income, monetary value, involvement rate and money tendencies from 1871 to 1975 in United Kingdom. They built four theoretical accounts which use money, nominal income, monetary value and end product. The information from Freidman and Schwartz are wide money stock ( M ) , existent net national income ( I ) , short run nominal involvement rate ( RS ) , long run nominal involvement rate ( Rl ) and high-octane money ( H ) , and monetary value degree ( p* ) . However, the Hendry and Ericsson raise troubles for the concluding theoretical account cause the monetary value theoretical account was be invalid due to p and M non stationary. Then Hendry and Ericsson tested stability by Zhou trial which shows that has a broke point because t -statistic exceeds the1 % point of the F-distribution. The T-ratio is biased, therefore the decisions which Friedman and Schwartz draw from their arrested development would be invalid and their theoretical account is non-stationary. Furthermore, Friedman and Schwartz failed on the phase-average informations that induced their consequence shut-in, the same as theoretical account is non stability and trial hypotheses include: monetary value homogeneousness and the absence of tendencies. “ The process of averaging informations over business-cycle stages did non notably cut down the consecutive correlativity in the information series but did lose information, taking to instead severely fitting equation. ” ( Hendry & A ; Ericsson, 1989, p.29 ) . Therefore, the Hendry and Ericsson consider that used the one-year informations better than the averaging informations on the theoretical account.

Hendry and Ericsson developed the Friedman and Schwartz ‘s theoretical account on different informations and add some conditions. The information choose one-year series from 1870 to 1970. The varialble every bit same as Firedman and Schwartz’z theoretical account. Hendry and Ericsson allow money demand conditonal on other variables and simplified to an ECM. The money demand map ( 1 ) and contingent planning theoretical account ( 2 )

( 1 )

( 2 )

Then HE found the long relationship between demand money and variables, so they begin with the co-integration arrested development for Vt and RSt:

( 3 )

There is no RESET, heteroscedastic and ARCH, the residuary are usually distributed about. In fact, the theoretical account is better than the Friedman and Schwartz. However, Hendry and Ericsson found the weak exogeneity of I”pt can being consistent with theoretical account better than monetary value. Therefore the theoretical account shows on stability and consistent with demand for money which determined by conditional monetary value, income and involvement rate. However, they still found the theoretical account existed non-constancy between 1971 and 1975. The ground why is the UK economic altered dramatically that “ competition and recognition control ordinances and of drifting exchange rates ” was introduced after 1970. ( Hendry & A ; Ericsson, 1989, p.30 )

In earlier period, the economic sciences developed many different empirical theoretical accounts to analyse the demand for money. However, all of them considered the interested rate was the of import for the demand for money, ignored the chance cost. In the Hendry and Ericsson theoretical account who added the chance cost and recognition abhorrences to prove demand for money. They considered that a step of chance cost would demo the altered of demand for wide money and fiscal inventions. Therefore, they built a theoretical account for demand money map:

Md= g ( P, I, ,R ) ( 4 )

The theoretical account ( 4 ) shows nominal demand for money Md depends on monetary value degree ( P ) , a sacle variable ( I ) , rising prices ( and a vector ( R ) of rates of returns on assorted assets.The original theoretical account ( 4 ) increases the vector R to mensurate the chance cost.

In 1992, Hendry and Ericsson built three empirical theoretical accounts of demand for wide money from 1878 to 1970, 1971 to 1975, 1878 to 1993. They used a mechanistic extension of HE ‘s theoretical account in the 3rd periods. However they find the non-stationary informations in the 2nd period, so they use new samples and re-evaluation the theoretical account.

In the first period, they test the theoretical account by “ dynamic equilibrium rectification model-EqCM ” ( Hendry & A ; Ericsson & A ; Prestiwich, 1997, p7 ) and arrested development by Engle-Granger. They have chosen the one-year value of informations from Freidman and Schwartz which are wide money stock ( M ) , the deflator ( P ) , existent net national income ( I ) , short run nominal involvement rate ( RS ) , long run nominal involvement rate ( Rl ) and high-octane money ( H ) . Hendry and Ericsson besides considered some effects from World War I and II, so they add the dummy variables in the theoretical account which are D1 and D2.As a consequence, the first period equation is changeless through empirical observation model by recursive least squares. ( Hendry & A ; Ericsson & A ; Prestiwich, 1997, p8 ) . The 2nd period: they entered the coefficient on D4t *I”rst in the theoretical account. As a consequence, the 2nd period is changeless excessively.

In the 3rd periods, HE add the new informations in the 2nd periods equation, but it was be rejects by Zhou trial and some residuary trial show insignificant. Harmonizing to the Hendry, Ericsson and Prestiwich ( 1997, p.10 ) mentioned that the insignificant of period 3rd equation because their simplistic to updating the information.

Furthermore, they used the short involvement to mensurate the chance cost, but it is hard to happen the precise informations because the fiscal invention. Therefore, they used a fraction of RS which denoted RN. ( RN= ( H/M ) RS. ( Hendry & A ; Ericsson & A ; Prestiwich, 1997, p.14 ) . They proved the theoretical account is stationary and no residuary diagnostic by the EqCM and least squares.

In decision, the Hendry, Ericsson and Prestiwich indicated the war, chance cost, fiscal invention and deregulating have consequence on demand for wide money. In extra, they use different informations on the theoretical account, seek to happen a stability theoretical account. They found the RN informations instead than the RS, utilizing the silent person variable to explicate the finance invention and war.

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