Of course, money is money. The expectation that bond prices are about to change actually causes bond prices to change. Figure 10.8 “An Increase in Money Demand” shows an increase in the demand for money. Some money deposits earn interest, but the return on these accounts is generally lower than what could be obtained in a bond fund. 3. After 10 days, the money in the checking account is exhausted, and the household withdraws another $1,000 from the bond fund for the next 10 days. When interest rates rise relative to the rates that can be earned on money deposits, people hold less money. At low interest rates, a household does not sacrifice much income by pursuing the simpler cash strategy. Principles of Macroeconomics Chapter 10.2. That will shift the supply curve for bonds to the right, thus lowering their price. This strategy requires one less transfer, but it also generates less interest—$7.50 (= $1,500 × 0.01 × 1/2). Using this approach, Friedman specifies the following as the key determinants of this demand for money: This is the analogue of the budget constraint in the usual theory of consumer choice. PreserveArticles.com: Preserving Your Articles for Eternity, Short Essay on the Friedman’s Wealth Theory of Demand for Money. Total wealth includes both human and non-human wealth, but there exist legal and institutional constraints in converting human into non-human wealth. As a result, holders of bonds not only earn interest but experience gains or losses in the value of their assets. If we think of the alternative to holding money as holding bonds, then the interest rate—or the differential between the interest rate in the bond market and the interest paid on money deposits—represents the price of holding money. The ultimate wealth-holders are households. Content Guidelines 2. Which approach should the household use? The relationship between interest rates and the quantity of money demanded is an application of the law of demand. They will hold smaller speculative balances. It seems likely that if bond prices are high, financial investors will become concerned that bond prices might fall. The speculative demand for money thus depends on expectations about future changes in asset prices. The money held for the purchase of goods and services may be for everyday transactions such as buying groceries or paying the rent, or it may be kept on hand for contingencies such as having the funds available to pay to have the car fixed or to pay for a trip to the doctor. As is the case with all goods and services, an increase in price reduces the quantity demanded. Conversely, if bond prices are already relatively low, it is likely that fewer financial investors will expect them to fall still further. Our mission is to liberate knowledge. Transactions demand, in economic theory, specifically Keynesian economics and monetary economics, is one of the determinants of the demand for money, the others being asset demand and precautionary demand. One way the household could manage this spending would be to leave the money in a checking account, which we will assume pays zero interest. For simplicity, we can think of any strategy that involves transferring money in and out of a bond fund or another interest-earning asset as a bond fund strategy. The division of wealth between human and non-human forms: Since total wealth is assumed to include human wealth and institu­tional constraints limit narrowly the conversion of human into non-human wealth or the reverse, Friedman hypothesises the fraction of total wealth that is in the form of non-human wealth to be an additional important variable. The quantity of money households want to hold varies according to their income and the interest rate; different average quantities of money held can satisfy their transactions and precautionary demands for money. Second, people are more likely to use a bond fund strategy when the cost of transferring funds is lower. Selling a bond means converting it to money. To see why, suppose a household earns and spends $3,000 per month. For example, households need money to buy groceries and firms need money to pay for materials and labor. Such an increase could result from a higher real GDP, a higher price level, a change in expectations, an increase in transfer costs, or a change in preferences. A bond fund is not money. The transactions demand for money is money people hold to pay for goods and services they anticipate buying. If people expect bond prices to fall, for example, they will sell their bonds, exchanging them for money. The Demand Curve for Money. If prices rise very rapidly and people expect them to continue rising, people are likely to try to reduce the amount of money they hold, knowing that it will fall in value as it sits in their wallets or their bank accounts. There is also a chance that the issuer of a bond will default, that is, will not pay the amount specified on the bond to bondholders; indeed, bond issuers may end up paying nothing at all. To them money appears as a durable consumer good. At the beginning of the month, the household deposits $1,000 in its checking account and the other $2,000 in a bond fund. This assumption is commonly made in deriving almost all macro relations from their micro counterparts. People do not know precisely when the need for such expenditures will occur, but they can prepare for them by holding money so that they’ll have it available when the need arises. The equity is identical to the bond except that it contains a cost- of-living escalator so that its income stream always maintains constant purchasing power. An increase in real GDP, the price level, or transfer costs, for example, will increase the quantity of money demanded at any interest rate r, increasing the demand for money from D1 to D2. Among the most important variables that can shift the demand for money are the level of income and real GDP, the price level, expectations, transfer costs, and preferences. Preferences also play a role in determining the demand for money. It spends an equal amount of money each day. The nominal rate of return on money may be zero as on currency, or positive as on saving deposits or even negative if current account deposits are subject to net service charges. Rather than facing the difference of $10 versus $7.50 in interest earnings used in our household example, this small firm would face a difference of $2,500 per month ($10,000 versus $7,500). The nominal rate of return on other assets consists of two parts: first, any currently paid yield or cost, such as interest on bonds, dividends on equities and storage costs on physical assets, and second, expected changes in their nominal prices. Friedman introduces a variable designated by to stand for any influence other than income that can be expected to affect tastes and preferences for money. Figure 10.8. A higher interest rate in the bond market is likely to increase this differential; a lower interest rate will reduce it. Before publishing your articles on this site, please read the following pages: 1. To simplify our analysis, we will assume there are only two ways to hold wealth: as money in a checking account, or as funds in a bond market mutual fund that purchases long-term bonds on behalf of its subscribers. One cannot sort through someone’s checking account and locate which funds are held for transactions and which funds are there because the owner of the account is worried about a drop in bond prices or is taking a precaution. Holding bonds is one alternative to holding money, so these same expectations can affect the demand for money. For very large firms such as Toyota or AT&T, interest rate differentials among various forms of holding their financial assets translate into millions of dollars per day. Other variables. Total wealth, 2. Privacy Policy PreserveArticles.com is a free service that lets you to preserve your original articles for eternity. The expected rates of return on money and other assets and 4. However, instead of worrying about $3,000 per month, even a relatively small firm may be concerned about $3,000,000 per month. The nominal rate of return on money may be zero as on currency or positive as it is on savings deposits, a large part of which is counted as demand deposits, or even negative, if current-account deposits are subject to net service charges. The importance of expectations in moving markets can lead to a self-fulfilling prophecy. The higher the price level, the more money is required to purchase a given quantity of goods and services. 3. Prohibited Content 3. 2. All other things unchanged, if people expect bond prices to fall, they will increase their demand for money. Use this quiz to check your understanding and decide whether to (1) study the previous section further or (2) move on to the next section. That suggests that high bond prices—low interest rates—would increase the quantity of money held for speculative purposes. As we have seen, bonds pay higher interest rates than money deposits, but holding bonds entails a risk that bond prices might fall. Broadly speaking, the demand for money is thought to depend on three major factors: (a) total wealth to be held in various forms of assets; (b) relative price of and return on one form of wealth as compared to the other forms; and (c) tastes and preferences of the wealth-holders. When interest rates fall, people hold more money. The household could also maintain a much smaller average quantity of money in its checking account and keep more in its bond fund. This short quiz does not count toward your grade in the class, and you can retake it an unlimited number of times. People also hold money for speculative purposes. The creation of savings plans, which began in the 1970s and 1980s, that allowed easy transfer of funds between interest-earning assets and checkable deposits tended to reduce the demand for money. Let us call this money management strategy the “bond fund approach.”. Other variables. Money: The nominal rate of return on money may be zero as on currency, or positive as on saving deposits or even negative if current account deposits are subject to net service charges. As the cost of such transfers rises, some consumers will choose to make fewer of them. According to him, wealth-holders are likely to attach considerably more value to liquidity when they expect economic conditions to be unstable than when they expect them to be highly stable. We have seen that the transactions, precautionary, and speculative demands for money vary negatively with the interest rate. The demand curve for money shows the quantity of money demanded at each interest rate, all other things unchanged. Report a Violation, Friedman’s Theory of the Demand for Money (Theory and Criticisms), Theories of Demand of Money: Tobin’s Portfolio and Baumol’s Inventory Approaches, The Cambridge Cash-Balances Approach for Money. Bond prices fluctuate constantly. Obviously, for them the expected rate of change of prices (adjusted for storage costs) gives the appropriate rate of return, and this becomes especially important under conditions of inflation or deflation: Besides the above, there may be other variables that affect the utility attached to the services of money relative to those rendered by other assets, and so should be included in the demand function for money. That is a choice each household must make—it is a question of weighing the interest a bond fund strategy creates against the hassle and possible fees associated with the transfers it requires. With an interest rate of 1% per month, the household earns $10 in interest each month ([$1,000 × 0.01 × 1/3] + [$1,000 × 0.01 × 2/3]). Thus interpreted, the really novel and important feature of Friedman’s formulation is the extension of the margin of substitution for money to stocks of (durable) goods. The cash approach requires a quantity of money demanded of $1,500, while the bond fund approach lowers this quantity to $500.

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