2
Money Demand
This section is concerned with the determination of money demand. In the quan
tity theory, we assumed that velocity
V
is a ﬁxed number. In the data, this as
sumption is not generally satisﬁed; in particular, velocity appears to vary sys
tematically with inﬂation. To address this observation, we develop a theory of
money demand and use it to infer the relationship between the velocity of money
and inﬂation.
Let
T
be the amount of time (in fractions of a year) between a consumer’s trips
to the bank to get money. If
T
is 1/3, then the consumer goes to the bank every 4
months, or three times a year. For arbitrary
T
, the consumer makes
1
/T
trips to
the bank in a year.
Going to the bank is a pain. It takes time and effort, and the bank may charge for
each withdrawal. We accumulate all such expenses into some cost
γ
. We could
derive
γ
by: (i) calculating the consumer’s opportunity cost of time; (ii) multi
plying that by the amount of time required to go to the bank; and (iii) adding
any fees charged by the bank.
γ
is measured in units of consumption, so that the
dollar cost of a trip to the bank is given by
Pγ
.
The cost per year of this consumer’s trips to the bank is just the number of
trips times the cost per trip, so the consumer’s annual transactions costs are:
(1
/T
)(
Pγ
)
. Now, going to the bank is costly, but the consumer still does it because
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 Winter '04
 cai
 Inflation, Interest Rates, Interest Rate, Consumer, 4 months, 2 dollars

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