The Opportunity Cost Of Holding Real Money Balances Is The Cost
The Opportunity Cost Of Holding Real Money Balances Is The Number
The Opportunity Cost Of Holding Real Money Balances Is The Amount
The Opportunity Cost Of Holding Real Money Balances Is The Value

Economics 330

Spring 2002

Lecture 14

We’ve spent time looking at the Keynesian Model, the ISLM Model, and the AD/AS Model.Before we go on to use the AD/AS Model to consider its implications let’s turn our attention to alternative approaches to the demand for money.

The four approaches to the demand for money that we will consider are

The cost of money is the opportunity cost of holding money in hands instead of investing it. The trade-off between money now (holding money) and money later (investing) depends on, among other things, the rate of interest that can be earned by investing. An investor with money has two options: to spend it right now or to save it. I Each trip incurs a cost ( shoeleather cost') of K I Let m t denote average real balances holdings over the period. Opportunity cost of holding money is i tm t I Each time you withdraw money, you withdraw 2m t dollars. Total trips to bank is Y 2m t I Objective is to pick m t to minimize: min m t i tm t +K Y 2m t 25/37. The opportunity cost of holding money is the cost that could be realized if money were invested instead of held. In other words, it is the interest rate that money is earning in a chosen investment. Typically, it is the interest rate that is set on a bond, particularly a government bond.

The opportunity cost of holding real money balances is the amount

The Quantity Theory of Money
The Cambridge Approach to Money Demand
Keynes’ Liquidity Preference Theory (we have already talked a bit about this, but let’s spend a little more time on this idea)
Friedman’s Modern Quantity Theory of Money Demand

7) The opportunity cost of holding money balances increases when the purchasing power of money rises. The interest rate rises. The price of goods and services falls. The opportunity cost of holding money rather than bonds is A) the rate of interest earned on bonds. B) the price level. C) forgone consumption. D) forgone liquidity. E) zero - there is no opportunity cost of holding money.

We can think of this as the Classical approach to the theory of money demand.

It is based on the Equation of Exchange

Where M = Money Supply, V = velocity, P = price level, Y = real GDP

If we look more closely at this equation we will see that PY is the price level times the level of real GDP, or in other words, nominal income.This equation suggests that there is a relationship between the level of the money supply and the level of nominal GDP.

But, what about velocity?What is this concept?

Velocity is the rate of turnover of money.It is the average number of times per year that a dollar is spent in buying the total amount of goods and services produced in an economy.What does a relatively low velocity mean?What does a relatively high velocity imply?

So, what determines velocity in the Classical Model?

Fisher thought that velocity was a function of the institutions that affect the way people make transactions.

Furthermore, Fisher believed that institutions changed slowly over time and thus, he concluded that velocity was fairly constant in the short run.

The Equation of Exchange is an IDENTITY:that is, it is a statement that is true by definition.

If we look at the Equation of Exchange we can note a few more things given our understanding of the Classical View of the Economy:

The Classical View of the economy holds that the economy will produce at the full employment level of output:what does this imply about Y, the real GDP?

The Classical View holds that velocity is fairly constant and can even be considered a constant in the Equation of Exchange:what does this imply about the relationship between the money supply and the price level?

The Classical View holds that the price level changes only with changes in the money supply:a doubling of the money supply will result in a doubling of the price level.

So, how does the Equation of Exchange relate to money demand?

First, we can note that the money supply can be written as

And then, in equilibrium we know that the money supply equals money demand:

So,

Money demand = kPY where k = (1/v)

How do we interpret this?

For Fisher the demand for money is purely a function of income…interest rates have no effect on money demand.We can say that money demand is insensitive to interest rates.

Money Demand is a function then of the institutions in the economy affecting the way people make transactions (v, k),and the level of transactions generated by the level of nominal income (PY).

Marshall and Pigou thought that interest rate affects on the demand for money should not be ruled out.

Question:How much money would people want to hold, given a set of circumstances?

People hold money

·To carry out transactions:money as a medium of exchange

·As a store of wealth

Money demand = k PY where k is a constant of proportionality

These two approaches differ with regard to their initial starting points:the Classical View is a mechanical definition while the Cambridge Approach has a transaction focus.Yet, both approaches yield similar results.

For both of these approaches there’s a problem:velocity fluctuates too much to be considered a constant:so why didn’t the Classical Economists realize this?

Data on GDP and the money supply not readily available when these theories were being developed

Keynes’ Liquidity Preference Theory

Keynes’ Theory of Demand for Money emphasizes the importance of interest rates

Money Demand is a function of transactions motive, precautionary motive, speculative motive.

·Transactions motive:money as a medium of exchange.This was assumed to be proportional to income

·Precautionary motive:assumed to be proportional to income

·Speculative motive:store of wealth: income and interest rates are important here

Keynes thought of consumers as having two choices:

1.Hold money or

2.Hold Bonds

As we talked about briefly in an earlier lecture, money carries no interest return and thus as interest rates increase the opportunity cost of holding money will increase.This implies that the relationship between interest rates and money demand is an inverse one.

Graph:

So, the demand for real money balances (Money Demand/Price Level) is a function of interest rates, and the level of income (or real GDP) in the economy.

***This is a real departure from Fisher because of the emphasis on the importance of interest rates and their impact on money demand.Keynes is less of a departure from the Cambridge School because they did not explicitly rule out the possibility that interest rates were related to money demand.***

It is interesting to note, however that Keynes’ approach can be mathematically examined to yield the result that velocity does not have to be a constant and instead can be a variable.In addition, this theory is able to explicitly model the idea that money demand is dependent on the level of the interest rate.Let’s look at these relationships in more detail.

Recent Developments in the Keynesian Approach:Keynes illustrated the importance of interest rates and their impact on speculative demand.Is it possible to illustrate the importance of interest rates with regard to transactions demand…after all, transactions demand is the most important of the three motives for holding money.

Let’s look at the Baumol-Tobin Transactions Demand Approach:

Initially:

If interest rates increase, then

When the interest rate increases, the individual reduces his cash holdings and his cash balances in order to earn more interest.Thus, Baumol and Tobin suggest that all three motives—transactions motive, precautionary motives, and speculative motives – are all inversely related to interest rates.

Friedman’s Modern Quantity Theory of Money

The Opportunity Cost Of Holding Real Money Balances Is The