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Money and Banking


3. Money Demand Theories


In this section, we explore theories on what influences the quantity of money that consumers and/or business choose to hold. Money is used as a means of payment for goods and services, so consumers' and businesses' decisions for making purchases influence money demand. Money can also be used to store wealth, and so it may be viewed as a substitute for other financial assets such as stocks or bonds. If this is true, then the returns on these substitute financial assets may influence money demand. Understanding the factors than influence money demand is important because these factors influence equilibrium outcomes in the market for money, particularly the interest rate. We will see in a future section that interest rate outcomes influence consumer and investment demand, and therefore macroeconomic outcomes including employment and real GDP. We close this section with some Pencasts on the equilibrium in the market for money, and demonstrate how shifts in demand or supply of money influence interest rates.


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Quantity Theory of Money

This classical theory of money demand is built from the identity equation that says the nominal value of all final goods and services produced in an economy should be equal to the nominal value of currency transacted over the same time period. From this relationship, we build a theory of money demand that implies that monetary policy (the Federal Reserve changing the supply of money) should only influence the aggregate price level. [Play Pencast]


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Quantity Theory of Money Demand

Here we use the quantity theory of money to develop a theory of money demand. With a theory of money demand constructed from only this theory, we find that nominal money demand depends on the price level, real GDP, and institutional or financial technology factors that may influence the velocity of money. [Play Pencast]


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Keynes' Liquidity Preference Theory

Here we introduce an alternative model of money demand developed by John Maynard Keynes. He proposed three motives for why people choose to hold money. Two of these are related to using money to purchase goods and services, but the third motive involves using money as a store of wealth, i.e. as a financial asset. Doing so, Keynes' introduces another variable that should affect the demand for money: the interest rate. [Play Pencast]


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Modern Quantity Theory of Money

Here we present Milton Friedman's response to Keynes' Liquidity Theory of money demand with his "modern" quantity theory of money demand. Like Keynes' theory, he also adds as a possibility that people may choose to hold money not only to make transactions, but also as a financial asset to store their wealth. He proposes a theory where money demand depends on the returns from making financial investment in equities and bonds. His final conclusion, though, is that money demand should depend on the differences in rates of return, and not the level of the interest rate itself. That is, if interest rates rise and the return from holding money rises with it, so that the differences between the return from holding money and the returns from holding other assets do not also rise, then the change in the interest rate itself should not affect money demand. [Play Pencast]


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Money Supply and Money Market Equilibrium

Here we introduce the concept of money supply and show how the interest rate and quantity of money are determined in equilibrium along with the demand for money. We show how the central bank can change the money supply, thereby changing the interest rate in equilibrium. [Play Pencast]


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Shifts in the Demand For Money

The money demand curve is downward sloping, meaning that individuals' decisions to hold money is negatively related to the interest rate. If something besides the interest rate were to influence people's decisions or ability concerning how much money to hold, this will cause a shift in the money demand curve. We explore two factors that can shift the money demand curve. We will demonstrate how shifts in the money demand curve result in changes in the equilibrium interest rate.[Play Pencast]


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