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The key difference between this formulation and the one based on a simple version of Quantity Theory is that now the demand for real balances depends on both income positively or the desired level of transactions, and on the nominal interest rate negatively.
Microfoundations for money demand[ edit ] While the Baumol—Tobin model provides a microeconomic explanation for the form of the money demand function, it is generally too stylized to be included in modern macroeconomic models, particularly dynamic stochastic general equilibrium models.
As a result, most models of this type resort to simpler indirect methods which capture the spirit of the transactions motive. The two most commonly used methods are the cash-in-advance model sometimes called the Clower constraint model and the money-in-the-utility-function MIU model as known as the Sidrauski model.
In the MIU model, money directly enters agents' utility functionscapturing the 'liquidity services' provided by money.
Precautionary demand The precautionary demand for M1 is the holding of transaction funds for use if unexpected needs for immediate expenditure arise.
Asset motive[ edit ] The asset motive for the demand for broader monetary measures, M2 and M3, states that people demand money as a way to hold wealth.
While it is still assumed that money is held in order to carry out transactions, this approach focuses on the potential return on various assets including money as an additional motivation.
Speculative demand for money John Maynard Keynesin laying out speculative reasons for holding money, stressed the choice between money and bonds. If agents expect the future nominal interest rate the return on bonds to be lower than the current rate they will then reduce their holdings of money and increase their holdings of bonds.
If the future interest rate falls, then the price of bonds will increase and the agents will have realized a capital gain on the bonds they purchased. This means that the demand for money in any period will depend on both the current nominal interest rate and the expected future interest rate in addition to the standard transaction motives which depend on income.
The fact that the current demand for money can depend on expectations of the future interest rates has implications for volatility of money demand.
If these expectations are formed, as in Keynes' view, by "animal spirits" they are likely to change erratically and cause money demand to be quite unstable. Portfolio motive[ edit ] The portfolio motive also focuses on demand for money over and above that required for carrying out transactions.
Agents will choose a mix of these two types of assets their portfolio based on the risk-expected return trade-off. For a given expected rate of return, more risk averse individuals will choose a greater share for money in their portfolio.
Similarly, given a person's degree of risk aversion, a higher expected return nominal interest rate plus expected capital gains on bonds will cause agents to shift away from safe money and into risky assets. Like in the other motivations above, this creates a negative relationship between the nominal interest rate and the demand for money.
Empirical estimations of money demand functions[ edit ] Is money demand stable? For the time period they were studying this appeared to be true.
However, shortly after the publication of the book, due to changes in financial markets and financial regulation money demand became more unstable. Various researchers showed that money demand became much more unstable after Ericsson, Hendry and Prestwich consider a model of money demand based on the various motives outlined above and test it with empirical data.
The basic model turns out to work well for the period to and there doesn't appear to be much volatility in money demand, in a result analogous to that of Friedman and Schwartz.
This is true even despite the fact that the two world wars during this time period could have led to changes in the velocity of money. However, when the same basic model is used on data spanning toit performs poorly. In particular, money demand appears not to be sensitive to interest rates and there appears to be much more exogenous volatility.
The authors attribute the difference to technological innovations in the financial markets, financial deregulation, and the related issue of the changing menu of assets considered in the definition of money.
Later work by Lawrence Ball suggests that the use of adapted aggregates, such as near monies, can produce a more stable demand function.The precautionary demand for M1 is the holding of transaction funds for use if unexpected needs for immediate expenditure arise.
Asset motive. The asset motive for the demand for broader monetary measures, M2 and M3, states that people demand money as a way to hold wealth.
The Relationship Between Exchange Rate and Inflation in Pakistan by Shagufta Kashif Abstract. There has been a long-standing interest in studying the factors that are responsible for uneven vacillation in the stable growth of the world economies.
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Martin Uribe - Research Department of Economics Columbia University The Neo-Fisher Effect: Econometric Evidence from Empirical and Optimizing Models, Martín Uribe, NBER working paper , September Slides.