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* * * * * * Copyright ? 2010 Pearson Addison-Wesley. All rights reserved. 18-* Copyright ? 2010 Pearson Addison-Wesley. All rights reserved. Chapter 19 The Demand for Money Velocity of Money and The Equation of Exchange Quantity Theory Velocity fairly constant in short run Aggregate output at full-employment level Changes in money supply affect only the price level Movement in the price level results solely from change in the quantity of money Quantity Theory of Money Demand Divide both sides by V When the money market is in equilibrium M = Md Let Because k is constant, the level of transactions generated by a fixed level of PY determines the quantity of Md. The demand for money is not affected by interest rates Quantity Theory of Money Demand Demand for money is determined by: The level of transactions generated by the level of nominal income PY The institutions in the economy that affect the way people conduct transactions and thus determine velocity and hence k Cambridge Approach Looks at motives for holding money 1. Medium of exchange—related to Y 2. Store of wealth—related to Y Md = k ? PY Looks like Quantity Theory, but is different 1. k could fluctuate in short-run because of change in i and RETe on other assets Is velocity constant? 1. Classicals thought V constant because didn’t have good data 2. After Great Depression, economists realized velocity far from constant FIGURE 1 Change in the Velocity of M1 and M2 from Year to Year, 1915–2008 Sources: Economic Report of the President; Banking and Monetary Statistics; /releases/h6/hist/h6hist1.txt. Keynes’s Liquidity Preference Theory Why do individuals hold money? Transactions motive Precautionary motive Speculative motive Distinguishes between real and nominal quantities of money The Three Motives The Three Motives (cont’d) Velocity is not constant: The procyclical movement of interest rates should induce procyclical movements in velocity. Velocity will change as expectations about future normal level