Economics 374-01A Dr. John F. Olson

Monetary Theory and Policy Spring 2007

Study Guide for First Test

The bulleted points below are from the end of the chapter “Summary of Critical Conclusions” in the text by Handa. See/study the appropriate chapter sections of the text for details. I have also inserted annotations in italics.

Chapter 1 – Introduction

• The appropriate definition of money keeps changing. There are currently two definitions of money in common usage. These include M1 and M2; there are broader monetary aggregates.

You should know the component definitions of M1 and M2. (See the assigned hand-out on current measures of the money stock and the assigned Federal Reserve web-documents on the measurement of the money stock and components.)

• All definitions of money include currency in the hands of the public and demand/checking deposits in commercial banks.

The increased use of U.S. currency in foreign countries, either as day-to-day currency or as a store of value against domestic currency depreciation, creates a measurement problem (especially since 1985) – while the estimates vary, about 50% of U.S. currency outstanding is abroad.

• Banks are one type of financial intermediaries but are different from others in that their liabilities in the form of checking and savings deposits are the most liquid of all assets in the economy.

Other financial intermediaries do have (and create) liabilities, but these instruments are not very liquid and, thus, are not used as monies; this is one feature that makes banks “different” from other financial institutions.

• Financial assets are created, so that an unregulated financial system tends to create a multiplicity of differentiated assets.

The differentiated financial assets arise because of the different needs (return vs. risk, liquidity, term to maturity) of financial market participants (savers-lenders, intermediaries, and borrowers-spenders).

• Monetary policy has to be studied in the context of a macroeconomic model.
• The two main paradigms for macroeconomics are the classical and the Keynesian paradigms.
• The classical paradigm focuses on the general equilibrium of the competitive economy.

The evolution of the classical paradigm includes the traditional classical ideas, the neo-classical model, monetarism, the modern classical model (incorporating rational expectations), and the new classical model (with Ricardian equivalence).

• The Keynesian paradigm focuses on the deviations from the general equilibrium of the competitive economy. There can be a variety of reasons for such deviations, requiring different models for their explanations.

Other key elements of this chapter/unit: the functions of money, why does money exist – how does it arise as a social invention from economic decisions, definitional distinctions between the money supply and money stock, nominal vs. real values, and notions of the “money market” in macroeconomic models. See also the assigned Introductory Class Notes.

Chapter 2 – Money and Prices

• The quantity theory consisted of several approaches in its evolutionary history. They asserted that, in equilibrium, a change in the money supply will cause a proportionate change in the price level, but will not affect output and unemployment. These assertions are also implied by the neoclassical and the modern classical approaches—currently the dominant approaches in macroeconomics.

This assertion is the neutrality of money. You should be able to discuss the perspectives of Fisher, the Cambridge approach, Pigou, and Wicksell to the QTM.

• The quantity theory allowed that the changes in the money supply would affect output and employment in disequilibrium. This is consistent with the neoclassical approach. It is a fundamental aspect of Keynesian ideas.

The QTM disequilibrium changes are, of course, short-run adjustment processes in moving to the new long-run equilibrium.

• Wicksell shifted the transmission mechanism (from money to aggregate demand) from the direct transmission one to the indirect one.

Wicksell noted the connection between the banking system’s creation of money and credit (and its price – the market rate of interest) and the real economy’s saving=investment equilibrium (at the normal rate of interest). Explain the different concepts or views of the transmission mechanism (see the final two bulleted conclusions below).

• Keynes expanded the reasons for holding money to encompass the transactions motive, the precautionary motive and the speculative motive. Keynesians subsequently provided distinctive analyses for each of these motives.

Present and explain the economic reasoning underlying each of the three Keynesian motives for holding money.

• Friedman, although ostensibly claiming to provide a ‘restatement’ of the quantity theory, in fact provided an integrated version of the neoclassical and the Keynesian ideas on the demand for money. However, his replacement of current income by permanent income as the scale determinant of money demand belonged in neither the quantity theory nor the Keynesian traditions.
• Keynes and the Keynesians integrated the analysis of the money market and the price level into the general macroeconomic model, rather than leaving it as an appendage to the analysis of the commodity markets. They also introduced bonds as an alternative asset to money in the demand for money and made the bond market a component of the macroeconomic analysis.

Recall that the classical view assumes there is no money illusion and, thus, there is the classical dichotomy between the real (commodity markets) and nominal (money) economies. Money is primarily a transactions asset with few or no good substitutes.

• There are three potential transmission mechanisms through which the changes in the money supply impact on aggregate demand. These are the direct transmission mechanism, the indirect one and the lending one. The Keynesians and the modern classical macroeconomic schools, following Wicksell and Keynes, have based their IS-LM analysis on the indirect mechanism, with the direct one being ignored for the modern financially developed economies.
• The lending channel has been proposed by some economists. Whether it is distinctive from the indirect one and whether it is also significant for the modern financially developed economies is not generally accepted. Its role for financing investment in financially under-developed economies is likely to be much greater.

Chapter 4 – The Transactions Demand for Money

In addition to the basic inventory analysis (aka the Baumol-Tobin) model used to derive the transaction demand for money, you should also understand the “shopping-time” model developed and presented in class (see the handout from the McCallum text).

• The transactions demand for real balances has an elasticity of one-half with respect to real income.

More correctly, it will be between one and one-half; recall that visits to the bank must be measured in integers and when this is taken into account, the real-income-elasticity will be an average of the mix of households (some having unit-elastic demands, others having elasticity values of one-half).

• The transactions demand for real balances has an elasticity of zero with respect to the price level while that of nominal balances has a unit elasticity.

This is just re-asserting that it is the demand for “real” money that matters (what money can purchase in “real” terms). People do not suffer “money illusion” – they are not fooled by nominal prices increases; as the price level increases, they accordingly increase the amount of nominal money they want to hold in order to maintain the level of their real money holdings.

• The transactions demand for real balances has an elasticity between one-half and unity with respect to nominal income.
• The transactions demand for real balances has an elasticity of one-half with respect to the rate of return on bonds if interest is not paid on money balances.

As above, more correctly, it will be between zero and one-half; for the same reason (integer bank visits), the elasticity will be an average of the mix of households (some having zero interest-elasticity, others having one-half).

• If interest is paid on money balances, the transactions demand for real balances has an elasticity of one-half with respect to their user cost (that is, the difference between the return on bonds and the interest rate paid on money balances), but not with respect to the return on bonds.
• Efficient and centralized cash management reduces the transactions demand for money.

Think, for example, how increased availability and use of credit cards might affect cash management and the transactions demand for money by households. And what about recent and historical changes in financial and cash management practices in business and financial firms?

Notes on Portfolio Selection & the Speculative Demand for Money

The transactions demand for money may include the interest rate as a variable affecting the demand for money, usually reflecting an opportunity cost of holding value in money (as opposed to in an interest-earning asset). Portfolio analysis (or speculative demand) approaches provide an alternative explanation for inclusion of the interest rate in the money demand function.

For example, Keynes relied upon the inverse relationship between interest rates and bond prices. He argued that as interest rates deviated from their long-run trend (or expected) levels, individuals would adjust their holdings of money and bonds. In order to avoid subsequent capital losses on bonds when interest rates were currently low and would be expected to rise in the future, individuals’ money holdings would be high. And to seek capital gains on bonds when interest rates were currently high and would be expected to fall in the future, individuals’ money holdings would be low. Thus, in the speculative demand for money, the quantity of money demanded changes inversely as interest rates vary.

• The speculative demand for money is analyzed for money balances as an asset when the yields on other assets are uncertain.

Money is, relative to other assets, risk-less.

First, from a portfolio selection analysis with the proper assumptions, the optimally-composed portfolio (in terms of risk and return) will include more money (the risk-less asset) as the relative expected return(s) on the risky assets decreases – that is, people (who are typically risk averse) will try to lower risk by holding more money if the returns on risky assets go down.

Second, portfolio selection analysis suggests that the money demand function might be very unstable (fluctuate a lot) because of the volatile expectations of returns and risks of non-money assets. That is just another way of saying it moves around so much and so quickly that would be hard to usefully predict even if you had all the necessary data to do so in a timely manner.

• The speculative demand for M1 and even M2 may be zero in the modern financially developed economy with alternative assets that are risk-less but have higher yields.

Chapter 7 – The Estimating Function for the Demand for Money

This chapter begins addressing some practical problems in estimating the money demand function.

• The appropriate scale variable for the demand for money may be current income, expected income or permanent income.
• Rational expectations is more suitable than adaptive expectations for estimating expected income for the next period.

RE is more suitable from a theoretical perspective, but the modeling and informational requirements may not be worth the effort in estimation.

• Adaptive expectations is the more appropriate statistical method for estimating permanent income since this concept specifies the average expected income over the future.

AE is more appropriate statistically than RE – see above.

• The unanticipated component of income is usually estimated as income less the statistical estimate of expected income.
• The partial adjustment model provides one way of capturing the lagged adjustment of actual to desired money demand.

If there are costs to adjusting into or out of money balances in response changes in equilibrium holdings, then a partial adjustment model needs to be incorporated.

• There are considerable theoretical and econometric problems in the accurate estimation of the money demand function. In particular, the relevant time series must be stationary. If they are not stationary, the appropriate technique is co-integration with an error correction model.

Beside stationarity, other problems include single-equation (partial equilibrium) vs. general equilibrium estimation, imposing coefficient restrictions, the identification problem, multi-collinearity, and serial or auto-correlation of the error terms. Another issue is the selection of the functional form for estimation – usually a log-linear form is employed because the coefficients can be directly interpreted as elasticities – the choice is often determined by the relative empirical performance of different forms.

Chapter 9 – Money Demand and Empirical Findings

While empirical estimation of the money demand function yields some meaningful results, the endeavor also demonstrates the difficulties and problems described in previous chapters.

• The income elasticity of the demand for M1 is less than one. The income elasticity of M2 demand is higher than for M1 demand and is sometimes estimated to be greater than one.
• The negative interest elasticity of the demand for money, no matter how it is defined, is now beyond dispute.
• Incorporating more than one interest rate into the estimated money demand function or an interest rate and the expected inflation rate usually introduces multi-collinearity which leads to biased estimates.
• Empirical studies do not show convincing evidence of the liquidity trap, even for data covering the 1930s.
• Financial innovations during the last three decades rendered the money demand function unstable for this period. Numerous attempts and innovative variations in estimation have not established a stable demand function, with a specific form and invariant coefficients, for out-of-sample data.

Money has changed and, accordingly, so has the demand function.

• M1 has done better than broader monetary aggregates during some periods and worse in others. Several recent studies have supported the use of M1 over M2 and broader aggregates. Empirical evidence shows very limited evidence of currency substitution.
• For the 1960s and 1970s, estimates based on a partial adjustment model often indicated a low-impact income elasticity for the first quarter but a long-run elasticity close to one, indicating a slow adjustment of money demand to its long-run level.
• Most of the variables relevant to the money demand function have proved to be non-stationary. Therefore, most empirical studies now use co-integration analysis with an error-correction model.
• Even the co-integration techniques have not provided estimates that are robust or that consistently favor one monetary aggregate over others.
• There is evidence of buffer stock holdings of money balances. Therefore, in the short run, money demand is not independent of money supply.