Note it is the demand is for REAL money balances. Thus must control for inflation.

As of 12/31/98. The M1 supply was $1,093 Billion. The average M1 holding was $5,956 per household.

Reasons for holding cash:

Transactions costs

Precautionary motive.

Save for a rainy day (Weis Markets)

Costs and benefits of holding cash.

Benefits: lower transactions costs

Costs: foregone interest

Free Cash flow problem

Overall, Ceteris paribus:

1. THE INTEREST RATE ON NON-MONETARY ASSETS AND THE QUANTITY DEMANDED OF MONEY ARE INVERSELY RELATED. Reason: OPPORTUNITY COST.

2. The HIGHER the transaction costs of converting non-monetary assets to cash, the more cash people will hold.

The same is true for firms as well as individuals.

As interest rates rise, the amount of money held falls. For example, if we use the EOQ model for cash management (that is we Q is the amount of cash we should hold)

Q = Sqr root ( (2 * daily cash needs * 365 + Transaction costs) / interest rate)

Thus as interest rates rise, Q falls. (also common sense—higher opportunity cost associated with holding cash.).

A similar, albeit for slightly different reasons, analysis can involve what Keynes called a speculative demand for money. In this analysis individuals hold cash when they think the value of other financial assets is going to fall. Thus, if we focus on only bonds we would see that as interest rates are low, individuals would hold fewer bonds as the "only " way rates can go is up and this would be associated with a decrease in value of bonds. This can create a liquidity trap whereupon lowering rates does not spur on the economy but rater increases cash holdings.

(Theory sort of breaks down when we allow investors to also hold stocks since as interest rates fall we generally see stocks rise and cost of equity drop so firms accept more projects and economy picks up.)

What happens as real income changes?

Short answer is that people and firms want to hold more cash.

Real income = nominal income divided by price index

As real income rise, individuals are more likely to transact more frequently. Thus, the demand for cash increases. Similarly, some evidence suggests firms are as well. (see Mahar (1998-dissertation).

However, the increase is definitely not linear. There are generally diminishing returns of holding cash. Further, technology as well as interest rates must be taken into account.

(example, credit cards have lowered the need for precautionary cash holdings.)

Additional factors affecting the demand for Real Money Balances

1. Wealth
2. Payment technologies
3. Expected inflation
4. Risk and liquidity of other financial assets
5. Transaction costs

Predicting the supply and demand for money is not as easy as it might appear. The problem is the ceteris paribus assumption does not hold. For example, a rise in income might lead to increased spending with would lead to inflation. Thus which way a fed move goes is up for some debate. Further this uncertainty is why open-market transactions are often necessary. However, we will see that "the market for real money balances always gravitates to the interest rate at which quantity demanded equals quantity supplied."

"Monetarism: school of economic thought that emphasizes importance of money supply as a cause of fluctuations in prices, employment, and output."

Equation of exchange: (identity or tautology)

Money * velocity = GDP = Price * output

If we can assume V is known, then everything is quite easy. Pick your GDP and then solve for the necessary Money supply.

This is quite widely followed (example Milton Friedman) but is far from a precise science as much debate exists as to how constant V is and what Money supply meausre should be used. However, most do agree that money supply is a key variable that goes into how the economy does as well as future prices (there is a lag between Money supply growth and inflation).

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