A Stable Money Demand - Term Paper Example

Running Head: Transactions Demand of Money Reasons for Believing That Transactions Demand for Money May Be Interest Elastic [Institution's Name] Reasons for Believing That Transactions Demand for Money May Be Interest Elastic Introduction The demand for money is the desire of a household and business to hold their assets in such a form that they can easily exchange for goods and services. The demand for money is an important part of the market activates. There are three possibilities related with the demand for money that are "Transactions demand, Precautionary demand and Speculative demand (also known as saving demand). All of these three demands are affected by the interest rate (Robert, p2, 2007). In addition to the level of interest the money demand is also influenced by the level of price, level of GDP and pace of financial innovation (Pedro Zhou, p50, 2005). The Transactional demand is basically to hold money in a non interest bearing form with the intention to make day to day transactions (Robert, p2, 2007). While focusing specifically on the transactions demand of money, this paper is aimed at examining the relationship between the interest rate and money demand in the context of a general assumption held by the financial experts that the transactions demand for money may be interest elastic. In this regard the issues related with the interest elasticity of transactions demand for money are discussed to have deep understanding of the issue. Transactions Demand for Money and Interest Rate In order to find out the evidences about the interest elasticity of the transactions demand for money it is imperative to have deep understanding of the concept of transactions demand for money and its relationship with interest rate within a market. The transactions demand for money could be denoted by M or Lt that refers to the volume of money that is required to meet the financial expenditures. The equation of exchange is a crucial element for the transactions demand of money. According to the equation of exchange M * v = P * Y. In this equation the Lt or M stands for the transactions demand for money, v is the velocity of the money, P refers to the GDP deflator whereas Y represents the real income. The relationship between the transactions demand for money and the interest rate possesses great important from the perspective that states that there is a pressure to economize on one's transactional case balance and this pressure is originated from the rate of interest. The holders of the transactions money used to buy bonds and also pay fee and brokerage services and as a result they expect high return on their money due to interest rate. In a market the higher is the interest, the more people get as a final return for their money. Due to this reason most of the households use the transaction money to get benefit from the high rates of interest and for this purpose they make investments in bonds etc. (Nouriel Backus, p6, 1998) The relationship between transaction money demand and interest rates has been a major concern for the economists for a long period of time. The transactions demand is believed to be interest elastic because the interest rate and the transactions demand are closely linked with each other. The holder of the cash strived to take maximum benefit from the money he holds and in such situation the equilibrium balance of money is held. In the transactions demand of money the holder has to deal with the Marginal cost as well as with the Marginal revenues. The marginal cost is the interest that has to be certainly paid by the holder and the marginal revenue is the psychological interest rate that is earned by the holder of money due to overcoming the worries that he might face about non having cash money in hand. It is believed by he economists that the more income a person earns, the more cash he might holds and more he became in a position to afford the loss of interest (Robert, p2, 2007). There are two important implications associated with interest elasticity of money demand that are also called as implications. The first one is a normative implication refers to the situation where there is higher interest-elastic money demand and marginal rise in the short term interest rate causes a dead weight loss to the holder of the money. The second implication is the positive implication that refers to the situation where the central bank does not make a certain commitment related with the permanent rise in the supply of money. In this situation the current nominal prices are not responsive towards the change in the supply of money because the transactions money demand is interest elastic. (Kiyotaka, Saito, p2, 2006) Such situation is reached when the participants of the financial market don't have expectations regarding the supply of money in the long run and they act shortsightedly. The interest elasticity of the transactions money demand in well covered under the Keynes theory. Keynes was a British economist that worked on different aspects of money demand in 1930s. Keynes explained that MDT = f(Y) that means that the transactions demand for money depends upon the income. Another economist and the follower of Keynes James Tobin put forward this theory with the help of empirical research. He conducted an empirical research to find evidences about the relationship between the interest rate and the transactions demand for money. He also like Keynes and other economist came to the point that the transactions demand for money is sensitive to the interest rate thus there is great interest elasticity in the transactions demand for money (Tobin, p124, 1947). By using the US data Tobin strived to find out the link between the interest rate and the demand for money. In order to find evidences about the interest elasticity of the transactions demand of money, Tobin separated the transactions balances of money from the other money balances that were referred as "idle balances" by him. He assumed that the transactional balances are proportionate with the income only whereas the idle balances are proportional only with the rates of interest. While focusing on the financial data during the time period of 1922 to 1941, Tobin looked to find out if his measures of the idle balances are inversely proportional to the rate of interest. For this measurement he used the average level of idle balances for each year and plotted these balanced against the average rate of interest that was on the commercial paper during that particular year. As a result of this plotting of data and measurement, a clear inverse relationship between the rate of interest and the idle balances was found and in the light of the results of the measurement Tobin concluded that the demand for money is sensitive to the rates of interest and this empirical research also confirmed that the transactions demand for money is interest elastic. (Tobin, p124, 1947) There were some more empirical researched conducted to find out the evidences about the interest elasticity of transactions demand of money and the findings of the Tobin research were further confirms from the results of the other researches. For example in 1963, two economists Brunner and Meltzer also studied the link between the demand for money and the interest rate. They used the data from 1930s and found that the stability of the money demand is stable when there is a liquidity trap. When there is stable function of the money demand then the interest sensitivity or elasticity of the money demand also remains stable over a period of time. However the demand for money and its estimated interest elasticity within a specific period of time could not be same for another period of time and there could be variations in the transactions demand for money and its interest elasticity however the link between the money demand and interest rate always remain established and the transactions demand for money is found interest elastic in all time periods (Brunne, Meltzer, p319, 1963). He observed that in the post war period the progress of the economic sector in terms of real GDP growth and output kept on fluctuating and the prolong depression compelled him to worked for a theory that can explain the money demands and the issues associated with it. The classical theory of the demand for money was found having some flaws and incomplete angles that's why there was great requirement of a new and advanced theory that could satisfy the economists, related people and could act as a model that uncovers the relationship between the money demand and different variables. The work done by Keynes provided some authentic information and evidences about the interest elasticity of demands of money. The classical theory of money demand covers the relation between the money supply and different economic variables and it was explained in the theory that when there is rise in the level of supply of the money, there will be rise in the price level but there will be no real effects on the level of exchange rate. The rise in the money supply will also raise the inflation and the nominal interest will also be affected. This theory was unsatisfactory for Keynes and to explain the relationship between the transaction demand of money and the interest rate and price, Keynes developed a model that is called as IS/LM model. This name has been given to the models because the model is based on two curves that are IS and LM curves. The basic concept presented in the Keynesian's IS.LM models is that in short run the prices are not flexible. Another important element of this model that is relevant with this discussion is the concept of money market. Keynes provided an equation for the equilibrium in the money market: M/P = L (i, Y) = L (r, Y) In this equation M stands for the amount of currency that is provided by the Fed to the general public. This theory states that in a market equilibrium there exists a relationship between the real interest rate and the real output and it is denoted by the LM curve. In the light of the Keynes Model the relationship between the transactions demand for money could be demonstrated with the help of a traditional curve that shows that interest rate and transactions demand for money are inversely related with each other and rise in the interest rate causes a fall in the transaction demand for money. Figure 1 explains the relationship between interest rate and transactional demand for money. Fig 1: Relationship between Interest and Transactions Money demand (according to Keynesian Model) It is clearly indicated in the figure that an increase in the interest rate (from i* to i**) lead to a decline in the transactions demand for money (from M* to M**). The theory of Keynes also explains that the elasticity of the transactions demand for money also results in the shift of the money demand within market. Figure 2 shows that rise in the interest results in the shift of the money demand curve. Fig 2: Shift in Demand Curve due to increase in Interest Rate This shift in the transactions demand of money occurs because the when there is increase in the income, the transactions also possibility rises and there is expansion in the business cycle that is represented by a shift in the curve of the transaction demand for money. Thus it is revealed form the Keynes theory that the transactions demand for money is interest elastic as a change in the interest rate causes a change in the transactions demand for money as well. In fact the basic properties of the IS/LM curve model are dependent upon the interest elasticity of the transactions demand for money. The LM curve also expresses the interest elasticity of demand. If the transactions demand for money is highly elastic then the LM curve is very flat whereas of the transactions demand for money is less elastic or highly inelastic to the interest rate then the LM curve goes steep. Hence the elasticity of the transactions demand for money determines the position of the LM Curve. Figure 3 shows the LM curve that is positioned according to the interest elasticity of the transactions demand for money. Fig 3: LM Curve shows the interest elasticity of the transactions demand for money In contrast with the research work done by Keynes, Tobin and other economists, Milton Friedman who was a Noble Price Winner economist came up with a different model for the demand for money. He explains that the demand for money is dependent upon the rate of interest but at the same time there are other factors like the demand for other assets and returns of other assets that affects the transaction demand for money. He presented the following models to explain the demand for money. In the above equation, presented by Freidman Yp stands for permanent income, rb stands for expected return on bonds, rm donates the expected return on money, and re represents the expected return on stocks whereas pi (e) is the expected inflation rate. Hence Freidman included the other important economic variables in the model of the money demand and it is explained that the transactions demand for money is sensitive to the returns on bond, money and stock. All of these returns are determined by the level of interest and in this way the study of Freidman also came up with the conclusion that the interest rate has a major role to play in the transactions demand for money because Md is affected and depended upon the interest rate. The nature of the relation ship between the money demand and the interest could also be studied from the Freidman research work. He revealed that the more return people get from the bonds, stocks and money, the less they demand for money hence the high return cause by high interest rate are negatively related with the transactions demand for money. Keynes in his IS/LM model also presented the same nature of relationship between the interest rate and the transactions demand for money. Analysis and Discussion of the Main issue The above discussion was aimed at highlighting the relationship between the interest and the transactions demand for money so that reasons could be found out for a common belief held by the economists and public that the transactions demand for money is interest elastic. It is found that there is close relationship between interest and transactions demand for money. This relation ship is studied and examined by different economists like Keynes and Tobin during different time periods and it is revealed from the results of their researches that the transactions demand for money is very sensitive to the interest rate and a change in the interest also bring a change in the transactions demand for money. The relationship between these two economic variables is established on the basis of a fact the people hold transactions money so that they can get benefit from the money they have, in terms of high returns on their expenditures on bonds etc. The returns on the money spend by the people is determined by the level of interest that is provided to the people in case of their money transactions. Freidman also confirm the interest elasticity of the transactions demand for money in the light of his researches and explained that there is negative link between interest rate and money demand that makes the money demand interest elastic. The interest rate determines the returns on expenditures and people spend to get high returns. This cycle is the base for the creation of a link between the interest and transactions demand for money. The elasticity of the transactions demand for the money is also due to the fact that that people demand money to acquire returns through the interest rates. Thus the reasons for believing upon the interest elasticity of the transactions demand for money are found and discussed above and finally the paper concludes that the strong and close relationship between the interest rate level and the transactions demand for money is the main reason due to which the people use to believe that the transactions demand for money is interest elastic. This relationship has been discussed above and the researches of the economists have clearly identified the link between the transactions demand for money and interest rate to prove the interest elasticity of the transactions demand for money. References Karl Brunner and Allan H. Meltzer (1963), "Predicting Velocity: Implications for Theory and Policy," p319-354, Journal of Finance Vol. 18 Pedro Teles and Ruilin Zhou (2005) "A stable money demand: Looking for the right monetary aggregate", p50, Federal Reserve Bank of Chicago Dr. Robert Eyler (2007), "Money demand", p1-3, ECON 375, Sonoma State University, spring 2007 Kiyotaka Nakashima, Makoto Saito (2006), "Uncovering highly interest-elastic money demand: Evidence from the Japanese money market with a low interest-rate policy", p2-3, Kyoto Gakuen University James Tobin (1947), "Liquidity Preference and Monetary Policy," p124-131, Review of Economics and Statistics Vol. 29 Nouriel Roubini and David Backus (1998), "Lectures in Macroeconomics, Chapter 9. The IS/LM Model", p3-6, Stern School of Business, New York University Read More