The demand for money is the desired holding of financial assets in the form of money: that is, cash

or bank deposits. It can refer to the demand for money narrowly defined as M1 (non-interest-bearing holdings), or for money in the broader sense of M2 or M3. Money in the sense of M1 is dominated as a store of value by interest-bearing assets. However, money is necessary to carry out transactions; in other words, it provides liquidity. This creates a trade-off between the liquidity advantage of holding money and the interest advantage of holding other assets. The demand for money is a result of this trade-off regarding the form in which a person's wealth should be held. In macroeconomics motivations for holding one's wealth in the form of money can roughly be divided into the transaction motive and the asset motive. These can be further subdivided into more micro economically founded motivations for holding money. Generally, the nominal demand for money increases with the level of nominal output (price level times real output) and decreases with the nominal interest rate. The real demand for money is defined as the nominal amount of money demanded divided by the price level. For a given money supply the locus of income-interest rate pairs at which money demand equals money supply is known as the LM curve. Conditions under which the LM curve is flat, so that increases in the money supply have no stimulatory effect (a liquidity trap), play an important role in Keynesian theory. This situation occurs when the demand for money is infinitely elastic with respect to the interest rate. A typical money-demand function may be written as

Where Md is the nominal amount of money demanded, P is the price level, R is the nominal interest rate, Y is real output, and L(.) is real money demand. An alternate name for L(R,Y) is the liquidity preference function. Money Demand The demand for money represents the desire of households and businesses to hold assets in a form that can be easily exchanged for goods and services. Spendability, or liquidity, is the key aspect of money that distinguishes it from other types of assets. For this reason, the demand for money is sometimes called the demand for liquidity. The demand for money is often broken into two distinct categories: the transactions demand and the speculative demand. Transactions Demand for Money The primary reason people hold money is because they expect to use it to buy something sometime soon. In other words, people expect to make transactions for goods or services. How much money a person holds onto should probably depend upon the value of the transactions that are anticipated. Thus, a person on vacation might demand more money than on a typical day. Wealthier people might also demand more money because their average daily expenditures are higher than the average person.

However, in this section we are not interested so much in an individual's demand for money, but rather in what determines the aggregate, economy-wide demand for money. Extrapolating from the individual to the group, we could conclude that the total value of all transactions in the economy during a period of time would influence the aggregate transactions demand for money Anytime GDP rises, there will be a demand for more money to make the transactions necessary to buy the extra GDP. If GDP falls, then people demand less money for transactions. Thus, if the amount of goods and services produced in the economy rises while the prices of all products remain the same, then total GDP will rise and people will demand more money to make the additional transactions. On the other hand, if the average prices of goods and services produced in the economy rises, then even if the economy produces no additional products, people will still demand more money to purchase the higher valued GDP, hence the demand for money to make transactions will rise. Speculative Demand for Money Speculative demand money for arises by considering the opportunity cost of holding money. Recall, that holding money is just one of many ways to hold value or wealth. Alternative opportunities include holding wealth in the form of savings deposits, certificate of deposits, mutual funds, stock, or even real estate. For many of these alternative assets interest payments, or at least a positive rate of return, may be obtained. Most assets considered money, such as coin and currency and most checking account deposits do not pay any interest. If one does hold money in the form of a NOW account (a checking account with interest) the interest earned on that deposit will almost surely be less than on a savings deposit at the same institution. Thus to hold money implies giving up the opportunity of holding other assets that pay interest. The interest one gives up is the opportunity cost of holding money. Since holding money is costly, i.e., there is an opportunity cost, people's demand for money should be affected by changes in it's cost. Since the interest rate on each person's next best opportunity may differ across money holders, we can use the average interest rate, i$, in the economy as a proxy for the opportunity cost. It is likely that as average interest rates rise, the opportunity cost of holding money for all money holders will also rise, and vice versa. And, as the cost of holding money rises, people should demand less money. The Demand for Money The demand for money is affected by several factors, including the level of income, interest rates, and inflation as well as uncertainty about the future. The way in which these factors affect money demand is usually explained in terms of the three motives for demanding money: the transactions, the precautionary, and the speculative motives. Transactions motive. The transactions motive for demanding money arises from the fact that most transactions involve an exchange of money. Because it is necessary to have money available for transactions, money will be demanded. The total number of transactions made in an economy tends to increase over time as income rises. Hence, as income or GDP rises, the transactions demand for money also rises. Precautionary motive. People often demand money as a precaution against an uncertain future. Unexpected expenses, such as medical or car repair bills, often require immediate payment. The need to have money available in such situations is referred to as the precautionary motive for demanding money. Speculative motive. Money, like other stores of value, is an asset. The demand for an asset depends on both its rate of return and its opportunity cost. Typically, money holdings provide no rate of return and often depreciate in value due to inflation. The opportunity cost of holding money is the interest rate that can be earned by lending or investing one's money holdings. The speculative motive for

demanding money arises in situations where holding money is perceived to be less risky than the alternative of lending the money or investing it in some other asset. For example, if a stock market crash seemed imminent, the speculative motive for demanding money would come into play; those expecting the market to crash would sell their stocks and hold the proceeds as money. The presence of a speculative motive for demanding money is also affected by expectations of future interest rates and inflation. If interest rates are expected to rise, the opportunity cost of holding money will become greater, which in turn diminishes the speculative motive for demanding money. Similarly, expectations of higher inflation presage a greater depreciation in the purchasing power of money and therefore lessen the speculative motive for demanding money.

1 Ch. 4DEMAND FOR MONEY Money is what we use when we demand other goods. Demand for money is a question of how much of wealth individuals wish to holdin the form of money at any point in time. Individuals must decide how to allocatetheir wealth between different kinds of assets, for example a house, income-earning securities, a checking account, and cash. It is important to note the demand for money is demand for the actual servicesyielded by the possession of a real stock of money, and not simply a demand for anominal amount of cash denominated in any currency. Cost of holding money 1.Money earns little or no interest .2.There is an opportunity cost of holding money, which is interest rate (or anytype of return) foregone minus transactions cost 3. Money loses purchasing power to inflation. Reasons to hold money Why would anyone hold part of his wealth as money, whether cash or checkingdeposits? Wouldn't it be more sensible to hold all wealth in the form of assets thatyield income? Some theories that will be discussed below attempted to answer these questions. THEORIES OF MONEY DEMANDFirst: Quantity Theory of Money Quantity theory of money is a classical theory that related the amount of money inthe economy to nominal income. Nominal income is determined solely bymovements in the quantity of money. It states the changes in the quantity of money tend to affect the purchasing powerof money inversely, that is, with every increase in the quantity of money, eachmonetary unit (such as dinar or dollar) tends to buy a smaller quantity of goods andservices while a decrease in the quantity of money has the opposite effect.Although a change in the quantity of money may eventually affect all prices, itdoes not and cannot affect all prices in the same manner, to the same degree or atthe same time. Economist Irving Fisher is given credit for the development of this theory. Itbegins with an identity known as the equation of exchange :

MV = PY, Where M is the quantity of money (or money supply). V is velocity, which serves as the link between money and output. P is the price level. Y is aggregate output (aggregate income). PY is the total amount of spending on final goods and services produced in theeconomy (aggregate nominal income or nominal GDP). The equation of exchange states that the quantity of money multiplies by numberof times this money is spent in a given year must equal to nominal GDP (PY). Rearranging the equation of exchange we get the velocity of money equation MoneyQuantityof ing TotalSpend M PY V == Velocity of money (V ) is the average number of times per year that a monetaryunit such as dinar or dollar is spent used to buy goods and services produced in theeconomy. Because this theory tells us how much money is held for a given amount of aggregate income, it is also a theory of demand for money The most important feature of this theory is that it suggests that interest rates haveno effect on the demand for money. Example:If nominal GDP (P x Y) = BD5 Billion and quantity of money (M) = BD 2 BillionThen, 5.225V =, which means that the average Bahraini dinar bill is spent 2.5times in purchasing final goods and services. The equation of exchange is an identity because it must be true that the quantity of money, times how many times it is used to buy goods equals the amount of goodstimes their price. To move towards the quantity theory of money, Fisher makes two keyassumptions:1. Fisher viewed velocity as constant in the short run. This is because he felt thatvelocity is affected by institutions and technology that change slowly over time.2. Fisher, like all classical economists, believed that flexible wages and pricesguaranteed output, Y, to be at its full-employment level, so it was also constantin the short run. Putting these two assumptions together lets look again at the equation of exchange: MV = PY If both V and Y are constant, then changes in M must cause changes in P to preserve the equality between MV and PY . This is the quantity theory of money: a change in the money supply,M , results inan equal percentage change in the price level P

Third: Friedmans Modern Quantity Theory of Money

 Milton Friedman (another Nobel Prize winner) developed a theory of demand formoney. He stated that the M d is influenced by the same factors that influence thedemand for any asset. He then applied the theory of asset demand to money. The theory of asset demand indicates that the demand for money should be afunction of the resources available to individuals (their wealth) and the expectedreturns on other assets relative to the expected return on money. Friedmans demand function for real money balances is)r ,r r ,r r ,Y ( f P M mememb p d = where,pM d is the demand for real balances, Y p is permanent income (expected average of long run income) which is Friedmans measure of wealth, r m is the expected returnon money, r b is the expected return on bonds, r e is the expected return on equity,and e is the expected inflation rate Money demand is positively related to permanent income. Since permanent income is a long-run average, it is more stable than currentincome, so this will not be the source of a lot of fluctuation in money demand The other terms in Friedman's money demand function are the expected returns onbonds, stocks and goods relative to the expected return on money ( r b -r m ,r e -r m ,and e -r m ).

These terms are negatively related to money demand: the higher the returns of bonds, equity and goods relative to the expected return on money, the lower thequantity of money demanded. For example, if the expected inflation rate is 10%, then goods prices are expectedto increase at a 10% rate and their expected return is 10%. If this expectationincreases, the relative expected return on money decreases and M d decreases aswell.

10 Friedman did not assume the return on money to be zero. The return on moneydepends on the services provided on bank deposits (check cashing, bill paying, etc)and the interest on some checkable deposits. Distinguishing between the Friedman and Keynesian Theories When comparing the money demand frameworks of Friedman and Keynes, severaldifferences arise1. While Keynes put all financial assets in one category bonds- because he feltthat their returns generally move together, Friedman introduces several assetsas alternative to money and considers multiple relative rates of return to beimportant2. Friedman viewed money and goods as substitutes. People choose between themwhen deciding how much money to hold3. Friedman viewed permanent income as more important than current income indetermining money demand4. Friedman believed that changes in interest rates have little effect on theexpected returns on other assets relative to money. Thus, in contrast to Keyneshe viewed interest rate ( i) has insignificant impact on M d .5. Friedman differed from Keynes in stressing that the M d function does notundergo substantial shifts and is therefore stable. Therefore, Friedmans M d function depends essentially on Y p 6. In contrast to Keynes, Friedman suggested that random fluctuations in the M d are small and M

d can be predicted accurately by M d function. When thiscombined with his view that the M d is insensitive to changes in i, this meansthat V is highly predictable )Y ( f Y V p = Because the relationship between Y and Y p is usually predictable, V is alsopredictable. 11 In brief, o Keynesians : generally argue that M d relatively unstable (implying greatvariability in velocity) and MS effectively endogenous beyond authoritiescontrol. They Play down the importance of Monetary Policy per se andadvocate superiority of Fiscal Policy. o Monetarists: generally argue that M d is relatively stable (implying stable if not constant velocity) and monetary authorities can control MS effectively,reinforcing belief in efficacy of Monetary policy. However, There is a broad agreement that1. Income (however defined) is positively related to M d ;2. Interest rate is negatively related with M d

.These two relations are supported by almost all empirical evidence, butconsiderable variation in values of regression coefficients.