im23 - Part 6 The Financial System and the Macroeconomy...

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Part 6 The Financial System and the Macroeconomy Chapter 23 The Demand for Money Overview This chapter presents a thorough analysis of the demand for money. In courses where most students will have taken a course in intermediate macroeconomics, the material in this chapter will be mostly review. Instructors in courses with a strong institutional emphasis may omit the chapter or assign it as background reading while devoting little class time to it. The chapter begins by reviewing the distinction between nominal and real balances and goes on to discuss the equation of exchange and the assumptions necessary to convert it into a behavioral theory of money demand: the quantity theory of money. Data on M1 and M2 velocity are presented and explanations for their movements are reviewed. The significant decline in M1 velocity during the 1980s is attributed to the inclusion in M1 of interest-bearing substitutes for checkable deposits, the drop in interest rates on nonmoney assets during the early 1980s and the increasing use of sweep programs by banks in the 1990s in which checkable deposits are converted, usually overnight, into repurchase agreements or money market funds. The relationship between M2 and nominal GDP was more stable during the period after the early 1950s, although it too deteriorated during the early 1990s. The transactions demand for money is discussed within the Baumol-Tobin framework where the interest rate is viewed as the opportunity cost of holding money balances for transactions purposes. Movements in money balances cannot be entirely explained by movements in the volume of transactions. The additional influences on money demand are analyzed using the theory of portfolio selection first discussed in Chapter 5. This discussion of the portfolio approach includes an analysis of the contributions of J. M. Keynes’s liquidity preference approach and of Milton Friedman’s use of permanent income in the money demand function and of a wider range of assets available for portfolio substitution. The chapter concludes with a discussion of the issues involved in measuring money demand. Outline I. Transactions Motives A) Early theories about money demand were based on the idea that the most obvious reason that households and businesses demand money is for use in making transactions. B) The term used in all money demand models to represent the money balances that people hold to make transactions is real money balances , or M/P . C) Irving Fisher developed a model of money demand that contained a variable called the velocity of money , or the average number of times a dollar is spent in the economy each year on a purchase of goods and services.
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133 Hubbard • Money, the Financial System, and the Economy, Sixth Edition D) Fisher derived the equation of exchange: MV = PY , where M represents the quantity of money, P is price level, and Y is a measure of aggregate output or aggregate income. 1. Fisher assumed that velocity,
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im23 - Part 6 The Financial System and the Macroeconomy...

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