Demand for Money

-Rafiqul Alam Khan

Dhaka, October 24, 201

Ackno!led"ement

All the praise and appreciation to Allah, the most merciful and beneficent who has enabled us to submit this humble work. We would like to express our special thanks and honour to our course teacher, Sk. Alamgir Hossain, who guide us in every minute whenever we sought, and who showed us the right track to conduct the study. We would like to express our special thanks and gratitude to the Group members of Group !" for their co#operation and help to conduct this study.

$inally, we would be happy if the findings of this study could make any contribution in the field of business studies and economics.

Ab#tract

A stable money demand forms the cornerstone in formulating and conducting monetary policy. Consequently, numerous theoretical and empirical studies have been conducted in both industrial and developing countries to evaluate the determinants and the stability of the money demand function. This study briefly reviews the theoretical work, tracing the contributions of several researchers beginning from the classical economists and explains relevant empirical issues in modeling and estimating money demand function. Notably, it summari es the salient features of a numbers of recent studies that applied co integration models and it features a bibliography to aid in research in demand for money.

$able of %ontent#

%ha&ter

'relude

Money

%ontent# (ntroduction Rationale of the *tudy Ob+ecti,e# *co&e Methodolo"y of the *tudy .imitation 0tymolo"y 1i#tory 2unction# $y&e# of Money Moti,e# for holdin" money $ran#action moti,e A##et moti,e *&eculati,e moti,e 'ortfolio moti,e *tability of Money Demand (m&ortance of Money Demand Demand cur,e for Money (ncrea#e in Money Demand %onclu#ion 5iblio"ra&hy

'a"e no ) ) )-/ 11 11 1 14 22 22 24 24 24 23 24 2) 2 /

$heoretical Analy#i# 0m&irical 0#timation#

Introduction

%n the preludes we wanted to notify that this paper actually have three basic parts. %n the first part, we&ve discussed about what money is, its functions and its types. 'hen in the second part we described about the theoretical assumptions of demand for money. 'he theory suggests that the demand for money is demand for real balances and is a function of scale variable as a measure of economic activity and a set of opportunity cost variables to indicate the foregone earnings by not holding assets which are
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alternatives to money. 'his findings has in general, been confirmed by various theoretical framework such as inventory models, asset theories, and consumer demand theory approach. However they differ in terms of specification and representation of these variables. %n the third part, the empirical research takes this conclusion as the starting point and attempts to model the demand for money by blending the concepts from these theories. %n this regard it employs a variety of formulations, functional relationships and data series to analy(e the determinants and the stability of demand for money.

Rationale of the Study 'o know about what is money, its functions and its types. 'o investigate who demands the money. 'o link up between the theoretical and practical framework of demand for money. 'o increase our professionalism in the economic sector.

Objective of the Report We have done this study because our course teacher gave this topic as our assignment. 'he primary ob)ective of this report is that is to find out the real demand for money. We have tried our best to make this term paper relevant. We have tried our best to prepare this assignment perfectly and correctly. %f our course teacher satisfied, our primary ob)ective will be successful.

Scope of the Study 'here was huge scope to work in the arena of the report. *onsidering the dead line, the scope and exposure of the paper has been wide#ranging. 'he study, +emand for money" has covered overall procedures of the context of demand for money. ,y

preparing this report it becomes more understandable about the real macroeconomic condition of our country.

Methodology of the Study -ethodology is the process or purpose of collecting data and information, which are re.uired in connecting with findings tools for best possible outcome. 'here are various approaches to collect data for the report. ,ut we should carefully select the way according to nature of the report. We have designed the study carefully planned to yield result that are ob)ective as possible. 'he main lookout of the report is to discover why people demand money. %n this section, we would like to emphasis on empirical process that we have conduct while we were preparing the term paper. 'his process consists of the some steps. *ource# of data Here the secondary sources of information were used. 'he secondary sources are6 Web sites ,ooks +ifferent /conometric 0ublication 1 'hesis 0aper Limitation of the study We have tried our best to prepare this report perfectly. ,ut we are not completely satisfied. We have faced many problems. 'hese problems have created lots of difficulties for us. Some problems2 limitations were yet present there3

Lack of Experience 'he work of collecting the information re.uires much experience. ,ut we had no ade.uate idea, knowledge, and previous experience about the report. 'herefore it is very normal that error comes into existence in the report.
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Lack of facilities3 At the time of data collection we have faced several problems due to lack e# articles on the websites.

Money
-oney is any ob)ect or record that is generally accepted as payment for goods and services and repayment of debts in a given socio#economic context or country. 'he main functions of money are distinguished as3 a medium of exchange4 a unit of account4 a store of value4 and, occasionally in the past, a standard of deferred payment. Any kind of ob)ect or secure verifiable record that fulfills these functions can be considered money. -oney is historically an emergent market phenomenon establishing a commodity money, but nearly all contemporary money systems are based on fiat money. $iat money, like any check or note of debt, is without intrinsic use value as a physical commodity. %t derives its value by being declared by a government to be legal tender4 that is, it must be accepted as a form of payment within the boundaries of the country, for 5all debts, public and private5. Such laws in practice cause fiat money to ac.uire the value of any of the goods and services that it may be traded for within the nation that issues it. 'he money supply of a country consists of currency and. ,ank money, which consists only of records mostly computeri(ed in modern banking, forms by far the largest part of the money supply in developed nations. 0tymolo"y 'he word 5money5 is believed to originate from a temple of Hera, located on *apitoline, one of 6ome7s seven hills. %n the ancient world Hera was often associated with money. 'he temple of 8uno -oneta at 6ome was the place where the mint of Ancient 6ome was located. 'he name 58uno5 may derive from the /truscan goddess 9ni which means 5the one5, and 5-oneta5 either from the :atin word 5monere5 means remind.
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%n the Western world, a prevalent term for coin#money has been specie, stemming from :atin in specie, meaning 7in kind7.

1i#tory

A 440 5% one-third #tater electrum coin from .ydia 'he use of barter#like methods may date back to at least ;<<,<<< years ago, though there is no evidence of a society or economy that relied primarily on barter. %nstead, non#monetary societies operated largely along the principles of gift economics and debt. When barter did in fact occur, it was usually between either complete strangers or potential enemies. -any cultures around the world eventually developed the use of commodity money. 'he shekel was originally a unit of weight, and referred to a specific weight of barley, which was used as currency. 'he first usage of the term came from -esopotamia circa =<<< ,*. Societies in the Americas, Asia, Africa and Australia used shell money > often, the shells of the cowry According to Herodotus, the :ydians were the first people to introduce the use of gold and silver coins. %t is thought by modern scholars that these first stamped coins were minted around !?<> !<< ,*. 'he system of commodity money eventually evolved into a system of representative money. 'his occurred because gold and silver merchants or banks would issue receipts to their depositors > redeemable for the commodity money deposited. /ventually, these receipts became generally accepted as a means of payment and were used as money. 0aper money or banknotes were first used in *hina during the Song +ynasty. 'hese banknotes, known as 5)iao(i5, evolved from promissory notes that had been used since the @th century. However, they did not displace commodity money, and were used alongside coins. %n the ;=th century, paper money became known in /urope through the accounts of travelers, such as -arco 0olo and William
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of 6ubruck. -arco 0olo7s account of paper money during the Auan +ynasty is the sub)ect of a chapter of his book, The Travels of Marco Polo, titled 5How the Great Baan *auseth the ,ark of 'rees, -ade into Something :ike 0aper, to 0ass for -oney All Cver his *ountry.5 ,anknotes were first issued in /urope by Stockholms ,anco in ;!!;, and were again also used alongside coins. 'he gold standard, a monetary system where the medium of exchange are paper notes that are convertible into pre#set, fixed .uantities of gold, replaced the use of gold coins as currency in the ;@th#;Dth centuries in /urope. 'hese gold standard notes were made legal tender, and redemption into gold coins was discouraged. ,y the beginning of the E<th century almost all countries had adopted the gold standard, backing their legal tender notes with fixed amounts of gold. After World War %%, at the ,retton Woods *onference, most countries adopted fiat currencies that were fixed to the 9S dollar. 'he 9S dollar was in turn fixed to gold. %n ;D@; the 9S government suspended the convertibility of the 9S dollar to gold. After this many countries de#pegged their currencies from the 9S dollar, and most of the world7s currencies became unbacked by anything except the governments7 fiat of legal tender and the ability to convert the money into goods via payment.

2unction# %n Money and the Mechanism of Exchange (1875) , William Stanley 8evons famously analy(ed money in terms of four functions3 A medium of exchange, A common measure of value For unit of accountG, A standard of value For standard of deferred paymentG, And a store of value. ,y ;D;D, 8evons7s four functions of money were summari(ed in the couplet3 5-oney7s a matter of functions four, a -edium, a -easure, a Standard, a Store.5 'his couplet would later become widely popular in macroeconomics textbooks.

'here have been many historical disputes regarding the combination of money7s functions, some arguing that they need more separation and that a single unit is insufficient to deal with them all. Cne of these arguments is that the role of money as a medium of exchange is in conflict with its role as a store of value3 its role as a store of value re.uires holding it without spending, whereas its role as a medium of exchange re.uires it to circulate. Cthers argue that storing of value is )ust deferral of the exchange, but does not diminish the fact that money is a medium of exchange that can be transported both across space and time. 'he term 7financial capital7 is a more general and inclusive term for all li.uid instruments, whether or not they are a uniformly recogni(ed tender. Medium of e7chan"e When money is used to intermediate the exchange of goods and services, it is performing a function as a medium of exchange. %t thereby avoids the inefficiencies of a barter system, such as the 7double coincidence of wants7 problem. 8nit of account A unit of account is a standard numerical unit of measurement of the market value of goods, services, and other transactions. Also known as a 5measure5 or 5standard5 of relative worth and deferred payment, a unit of account is a necessary prere.uisite for the formulation of commercial agreements that involve debt. 'o function as a 7unit of account7, whatever is being used as money must be3

+ivisible into smaller units without loss of value4 precious metals can be coined from bars, or melted down into bars again. $ungible3 that is, one unit or piece must be perceived as e.uivalent to any other, which is why diamonds, works of art or real estate are not suitable as money. A specific weight, or measure, or si(e to be verifiably countable. $or instance, coins are often milled with a reeded edge, so that any removal of material from the coin Flowering its commodity valueG will be easy to detect.

*tore of ,alue 'o act as a store of value, a money must be able to be reliably saved, stored, and retrieved > and be predictably usable as a medium of exchange when it is retrieved. 'he value of the money must also remain stable over time. Some have argued that inflation, by reducing the value of money, diminishes the ability of the money to function as a store of value.
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*tandard of deferred &ayment While standard of deferred payment is distinguished by some texts, particularly older ones, other texts subsume this under other functions. A 5standard of deferred payment5 is an accepted way to settle a debt > a unit in which debts are denominated, and the status of money as legal tender, in those )urisdictions which have this concept, states that it may function for the discharge of debts. When debts are denominated in money, the real value of debts may change due to inflation and deflation, and for sovereign and international debts via debasement and devaluation. Mea#ure of ,alue -oney acts as a standard measure and common denomination of trade. %t is thus a basis for .uoting and bargaining of prices. %t is necessary for developing efficient accounting systems. ,ut its most important usage is as a method for comparing the values of dissimilar ob)ects. Market liquidity -arket li.uidity describes how easily an item can be traded for another item, or into the common currency within an economy. -oney is the most li.uid asset because it is universally recogni(ed and accepted as the common currency. %n this way, money gives consumers the freedom to trade goods and services easily without having to barter. :i.uid financial instruments are easily tradable and have low transaction costs. 'here should be no For minimalG spread between the prices to buy and sell the instrument being used as money. $y&e# of money *urrently, most modern monetary systems are based on fiat money. However, for most of history, almost all money was commodity money, such as gold and silver coins. As economies developed, commodity money was eventually replaced by representative money, such as the gold standard, as traders found the physical transportation of gold and silver burdensome. $iat currencies gradually took over in the last hundred years, especially since the breakup of the ,retton Woods system in the early ;D@<s. %ommodity money

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A ;D;H ,ritish Gold sovereign -any items have been used as commodity money such as naturally scarce precious metals, conch shells, barley, beads etc., as well as many other things that are thought of as having value. *ommodity money value comes from the commodity out of which it is made. 'he commodity itself constitutes the money, and the money is the commodity. /xamples of commodities that have been used as mediums of exchange include gold, silver, copper, rice, salt, peppercorns, large stones, decorated belts, shells, alcohol, cigarettes, cannabis, candy, etc. 'hese items were sometimes used in a metric of perceived value in con)unction to one another, in various commodity valuation or 0rice System economies. 9se of commodity money is similar to barter, but a commodity money provides a simple and automatic unit of account for the commodity which is being used as money. Although some gold coins such as the Brugerrand are considered legal tender, there is no record of their face value on either side of the coin. 'he rationale for this is that emphasis is laid on their direct link to the prevailing value of their fine gold content. American /agles are imprinted with their gold content and legal tender face value. Re&re#entati,e money %n ;I@?, the ,ritish economist William Stanley 8evons described the money used at the time as 5representative money5. 6epresentative money is money that consists of token coins, paper money or other physical tokens such as certificates, that can be reliably exchanged for a fixed .uantity of a commodity such as gold or silver. 'he value of representative money stands in direct and fixed relation to the commodity that backs it, while not itself being composed of that commodity. 2iat money

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Gold coins are an example of legal tender that are traded for their intrinsic value, rather than their face value. $iat money or fiat currency is money whose value is not derived from any intrinsic value or guarantee that it can be converted into a valuable commodity such as gold. %nstead, it has value only by government order FfiatG. 9sually, the government declares the fiat currency typically notes and coins from a central bank, such as the ,angladesh ,ank in ,angladesh to be legal tender, making it unlawful to not accept the fiat currency as a means of repayment for all debts, public and private. Some bullion coins such as the Australian Gold Jugget and American /agle are legal tender, however, they trade based on the market price of the metal content as a commodity, rather than their legal tender face value which is usually only a small fraction of their bullion value. $iat money, if physically represented in the form of currency Fpaper or coinsG can be accidentally damaged or destroyed. However, fiat money has an advantage over representative or commodity money, in that the same laws that created the money can also define rules for its replacement in case of damage or destruction. $or example, the ,+ government will replace mutilated ,angladesh ,ank notes F,, fiat moneyG if at least half of the physical note can be reconstructed, or if it can be otherwise proven to have been destroyed. ,y contrast, commodity money which has been lost or destroyed cannot be recovered. %oina"e 'hese factors led to the shift of the store of value being the metal itself3 at first silver, then both silver and gold, at one point there was bron(e as well. Jow we have copper coins and other non#precious metals as coins. -etals were mined, weighed, and stamped into coins. 'his was to assure the individual taking the coin that he was
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getting a certain known weight of precious metal. *oins could be counterfeited, but they also created a new unit of account, which helped lead to banking. Archimedes7 principle provided the next link3 coins could now be easily tested for their fine weight of metal, and thus the value of a coin could be determined, even if it had been shaved, debased or otherwise tampered with. %n most ma)or economies using coinage, copper, silver and gold formed three tiers of coins. Gold coins were used for large purchases, payment of the military and backing of state activities. Silver coins were used for midsi(ed transactions, and as a unit of account for taxes, dues, contracts and fealty, while copper coins represented the coinage of common transaction. 'his system had been used in ancient %ndia since the time of the -aha)anapadas. %n /urope, this system worked through the medieval period because there was virtually no new gold, silver or copper introduced through mining or con.uest. 'hus the overall ratios of the three coinages remained roughly e.uivalent. 'a&er money

1ui9i currency, i##ued in 1140 %n pre modern *hina, the need for credit and for circulating a medium that was less of a burden than exchanging thousands of copper coins led to the introduction of paper money, commonly known today as banknotes. 'his economic phenomenon was a slow and gradual process that took place from the late 'ang +ynasty F!;I> D<@G into the Song +ynasty FD!<>;E@DG. %t began as a means for merchants to exchange heavy coinage for receipts of deposit issued as promissory notes from shops of wholesalers, notes that were valid for temporary use in a small regional
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territory. %n the ;<th century, the Song +ynasty government began circulating these notes amongst the traders in their monopoli(ed salt industry. 'he Song government granted several shops the sole right to issue banknotes, and in the early ;Eth century the government finally took over these shops to produce state#issued currency. Aet the banknotes issued were still regionally valid and temporary4 it was not until the mid ;=th century that a standard and uniform government issue of paper money was made into an acceptable nationwide currency. 'he already widespread methods of woodblock printing and then 0i Sheng7s movable type printing by the ;;th century was the impetus for the massive production of paper money in pre modern *hina. At around the same time in the medieval %slamic world, a vigorous monetary economy was created during the @th>;Eth centuries on the basis of the expanding levels of circulation of a stable high#value currency Fthe dinarG. %nnovations introduced by -uslim economists, traders and merchants include the earliest uses of credit, che.ues, promissory notes, savings accounts, transactional accounts, loaning, trusts, exchange rates, the transfer of credit and debt, and banking institutions for loans and deposits. %n /urope, paper money was first introduced in Sweden in ;!!;. Sweden was rich in copper, thus, because of copper7s low value, extraordinarily big coins had to be made. 'he advantages of paper currency were numerous3 it reduced transport of gold and silver, and thus lowered the risks4 it made loaning gold or silver at interest easier, since the specie Fgold or silverG never left the possession of the lender until someone else redeemed the note4 and it allowed for a division of currency into credit and specie backed forms. %t enabled the sale of stock in )oint stock companies, and the redemption of those shares in paper. However, these advantages held within them disadvantages. $irst, since a note has no intrinsic value, there was nothing to stop issuing authorities from printing more of it than they had specie to back it with. Second, because it increased the money supply, it increased inflationary pressures, a fact observed by +avid Hume in the ;Ith century. 'he result is that paper money would often lead to an inflationary bubble, which could collapse if people began demanding hard money, causing the demand for paper notes to fall to (ero. 'he printing of paper money was also associated with wars, and financing of wars, and therefore regarded as part of maintaining a standing army. $or these reasons, paper currency was held in suspicion and hostility in /urope and America. %t was also addictive, since the speculative profits of trade and capital creation were .uite large. -a)or nations established mints to print money and mint coins, and branches of their treasury to collect taxes and hold gold and silver stock.
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At this time both silver and gold were considered legal tender, and accepted by governments for taxes. However, the instability in the ratio between the two grew over the course of the ;Dth century, with the increase both in supply of these metals, particularly silver, and of trade. 'his is called bimetallism and the attempt to create a bimetallic standard where both gold and silver backed currency remained in circulation occupied the efforts of inflationists. Governments at this point could use currency as an instrument of policy, printing paper currency such as the 9nited States Greenback, to pay for military expenditures. 'hey could also set the terms at which they would redeem notes for specie, by limiting the amount of purchase, or the minimum amount that could be redeemed.

5anknote# !ith a face ,alue of 3000 of different currencie# ,y ;D<<, most of the industriali(ing nations were on some form of gold standard, with paper notes and silver coins constituting the circulating medium. 0rivate banks and governments across the world followed Gresham7s :aw3 keeping gold and silver paid, but paying out in notes. 'his did not happen all around the world at the same time, but occurred sporadically, generally in times of war or financial crisis, beginning in the early part of the E<th century and continuing across the world until the late E<th century, when the regime of floating fiat currencies came into force. Cne of the last countries to break away from the gold standard was the 9nited States in ;D@;. Jo country anywhere in the world today has an enforceable gold standard or silver standard currency system.
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%ommercial bank money

Demand de&o#it in cheque form *ommercial bank money or demand deposits are claims against financial institutions that can be used for the purchase of goods and services. A demand deposit account is an account from which funds can be withdrawn at any time by check or cash withdrawal without giving the bank or financial institution any prior notice. ,anks have the legal obligation to return funds held in demand deposits immediately upon demand or at call. +emand deposit withdrawals can be performed in person, via checks or bank drafts, using automatic teller machines FA'-sG, or through online banking. *ommercial bank money is created through fractional#reserve banking, the banking practice where banks keep only a fraction of their deposits in reserve as cash and other highly li.uid assets and lend out the remainder, while maintaining the simultaneous obligation to redeem all these deposits upon demand. *ommercial bank money differs from commodity and fiat money in two ways, firstly it is non# physical, as its existence is only reflected in the account ledgers of banks and other financial institutions, and secondly, there is some element of risk that the claim will not be fulfilled if the financial institution becomes insolvent. 'he process of fractional#reserve banking has a cumulative effect of money creation by commercial banks, as it expands money supply Fcash and demand depositsG beyond what it would otherwise be. ,ecause of the prevalence of fractional reserve banking, the broad money supply of most countries is a multiple larger than the amount of base money created by the country7s central bank. 'hat multiple, called the money multiplier is determined by the reserve re.uirement or other financial ratio re.uirements imposed by financial regulators. Di"ital money

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+igital currencies gained momentum in before the E<<< tech bubble. $loo( and ,een( were particularly advertised as an alternative form of money. While the tech bubble caused them to be short lived, many new digital currencies such as bit coin have reached some, albeit generally small user bases.

Demand for Money

$heoretical Analy#i#

'he demand for money is the desired holding of financial assets in the form of money3 that is, cash or bank deposits. %t can refer to the demand for money narrowly defined as -; Fnon#interest#bearing holdingsG, or for money in the broader sense of -E or -=. -oney in the sense of -; is dominated as a store of value by interest#bearing assets. However, money is necessary to carry out transactions4 in other words, it provides li.uidity. 'his creates a trade#off between the li.uidity advantage of holding money and the interest advantage of holding other assets. 'he demand for money is a result of this trade#off regarding the form in which a person7s wealth should be held. %n macroeconomics motivations for holding one7s wealth in the form of money can roughly be divided into the transaction motive and the asset motive. 'hese 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 Fprice level times real outputG and decreases with the nominal interest rate. 'he real demand for money is defined as the nominal amount of money demanded divided by the price level. $or a given money supply the locus of income#interest rate pairs at which money demand e.uals money supply is known as the :- curve.
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'he magnitude of the volatility of money demand has crucial implications for the optimal way in which a central bank should carry out monetary policy and its choice of a nominal anchor. *onditions under which the :- curve is flat, so that increases in the money supply have no stimulatory effect a li.uidity trap, play an important role in Beynesian theory. 'his 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 is the nominal amount of money demanded, P is the price level, ! is the nominal interest rate, " is real output, and #F.G is real money demand. An alternate name for is the li$uidity preference function. Moti,e# for holdin" money $ran#action moti,e 'he transactions motive for money demand results from the need for li.uidity for day#to#day transactions in the near future. 'his need arises when income is received only occasionally say once per month in discrete amounts but expenditures occur continuously. :uantity theory 'he most basic 5classical5 transaction motive can be illustrated with reference to the Kuantity 'heory of -oney. According to the e.uation of exchange M% L P", where M is the stock of money, % is its velocity Fhow many times a unit of money turns over during a period of timeG, P is the price level and " is real income. *onse.uently P" is nominal income or in other words the number of transactions carried out in an economy during a period of time. 6earranging the above identity and giving it a behavioral interpretation as a demand for money we have

or in terms of demand for real balances

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Hence in this simple formulation demand for money is a function of prices and income, as long as its velocity is constant. (n,entory model# 'he amount of money demanded for transactions however is also likely to depend on the nominal interest rate. 'his arises due the lack of synchroni(ation in time between when purchases are desired and when factor payments Fsuch as wagesG are made. %n other words, while workers may get paid only once a month they generally will wish to make purchases, and hence need money, over the course of the entire month. 'he most well#known example of an economic model that is based on such considerations is the ,aumol#'obin model. %n this model an individual receives his income periodically, for example, only once per month, but wishes to make purchases continuously. 'he person could carry his entire income with his at all times and use it to make purchases. However, in this case he would be giving up the nominal interest rate that he can get by holding his income in the bank. 'he optimal strategy involves holding a portion of one7s income in the bank and portion as li.uid money. 'he money portion is continuously run down as the individual makes purchases and then he makes periodic FcostlyG trips to the bank to replenish the holdings of money. 9nder some simplifying assumptions the demand for money resulting from the ,aumol#'obin model is given by

where t is the cost of a trip to the bank, 6 is the nominal interest rate and 0 and A are as before. 'he key difference between this formulation and the one based on a simple version of Kuantity 'heory is that now the demand for real balances depends on both income positively or the desired level of transactions, and on the nominal interest rate negatively. Micro 2oundation# for money demand

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While the ,aumol#'obin model provides a microeconomic explanation for the form of the money demand function, it is generally too styli(ed to be included in modern macroeconomic models, particularly dynamic stochastic general e.uilibrium models. As a result most models of this type resort to simpler indirect methods which capture the spirit of the transactions motive. 'he two most commonly used methods are the cash#in#advance model and the money in the utility function model. %n the cash#in#advance model agents are restricted to carrying out a volume of transactions e.ual to or less than their money holdings. %n the -%9 model, money directly enters agents7 utility functions, capturing the 7li.uidity services7 provided by money. A##et moti,e 'he asset motive treats money, in the broader sense of including interest#bearing bank deposits, as a particular type of a financial asset among many others. While it is still assumed that money is held in order to carry out transactions, this approach focuses on the potential return on various assets including money as an additional motivation. *&eculati,e moti,e 8ohn -aynard Beynes, in laying out speculative reasons for holding money, stressed the choice between money and bonds. %f agents expect the future nominal interest rate the return on bonds to be lower than the current rate they will then reduce their holdings of money and increase their holdings of bonds. %f the future interest rate does fall, then the price of bonds will increase and the agents will have reali(ed a capital gain on the bonds they purchased. 'his means that the demand for money in any period will depend on both the current nominal interest rate and the expected future interest rate in addition to the standard transaction motives which depend on income. 'he fact that the current demand for money can depend on expectations of the future interest rates has implications for volatility of money demand. %f these expectations are formed, as in Beynes7 view, by 5animal spirits5 they are likely to change erratically and cause money demand to be .uite unstable. 'ortfolio moti,e 'he portfolio motive also focuses on demand for money over and above that re.uired for carrying out transactions. 'he basic framework is due to 8ames 'obin,
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who considered a situation where agents can hold their wealth in a form of a low risk2low return asset Fhere, moneyG or high risk2high return asset Fbonds or e.uityG. Agents will choose a mix of these two types of assets Ftheir portfolioG based on the risk#expected return trade#off. $or a given expected rate of return, more risk averse individuals will choose a greater share for money in their portfolio. Similarly, given a person7s degree of risk aversion, a higher expected return Fnominal interest rate plus expected capital gains on bondsG will cause agents to shift away from safe money and into risky assets. :ike in the other motivations above, this creates a negative relationship between the nominal interest rate and the demand for money. However, what matters additionally in the 'obin model is the sub)ective rate of risk aversion, as well as the ob)ective degree of risk of other assets, as, say, measured by the standard deviation of capital gains and losses resulting from holding bonds and2or e.uity.

0m&irical 0#timation# of Money Demand 2unction#

*tability of money demand $riedman and Schwart( in their ;D!= work & Monetary 'istory of the (nited )tates argued that the demand for real balances was a stable function of income and the interest rate. $or the time period they were studying this appeared to be true. However, shortly after the publication of the book, due to changes in financial markets and financial regulation money demand became more unstable. Marious researchers showed that money demand became much more unstable after ;D@?. /ricsson, Hendry and 0restwich F;DDIG consider a model of money demand based on the various motives outlined above and test it with empirical data. 'he basic model turns out to work well for the period ;I@I to ;D@? and there doesn7t appear to be much volatility in money demand, in a result analogous to that of $riedman and Schwart(. 'his is true even despite the fact that the two world wars during this time period could have led to changes in the velocity of money. However, when the same basic model is used on data spanning ;D@! to ;DD=, it performs poorly. %n particular, money demand appears not to be sensitive to interest rates and there appears to be much more exogenous volatility. 'he authors attribute the difference to
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technological innovations in the financial markets, financial deregulation, and the related issue of the changing menu of assets considered in the definition of money. :ater work by :awrence ,all suggests that the use of adapted aggregates, such as near monies, can produce a more stable demand function. 'hrough his research, ,all was able to show that using the return on near monies produced smaller deviations than previous models.

(m&ortance of money demand ,olatility for monetary &olicy %f the demand for money is stable then a monetary policy which consists of a monetary rule which targets the growth rate of some monetary aggregate Fsuch as -; or -EG can help to stabili(e the economy or at least remove monetary policy as a source of macroeconomic volatility. Additionally, if the demand for money does not change unpredictably then money supply targeting is a reliable way of attaining a constant inflation rate. 'his can be most easily seen with the .uantity theory of money e.uation given above. When that e.uation is converted into growth rates we have

which says that the growth rate of money supply plus the growth rate of its velocity e.uals the inflation rate plus the growth rate of real output. %f money demand is stable then velocity is constant and . Additionally, in the long run real output grows at a constant rate e.ual to the sum of the rates of growth of population, technological know#how, and technology in place, and as such is exogenous. %n this case the above e.uation can be solved for the inflation rate3

Here, given the long#run output growth rate, the only determinant of the inflation rate is the growth rate of the money supply. %n this case inflation in the long run is a purely monetary phenomenon4 a monetary policy which targets the money supply can stabili(e the economy and ensure a non#variable inflation rate. 'his analysis however breaks down if the demand for money is not stable N for example, if velocity in the above e.uation is not constant. %n that case, shocks to money demand under money supply targeting will translate into changes in real and nominal interest rates and result in economic fluctuations. An alternative policy of
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targeting interest rates rather than the money supply can improve upon this outcome as the money supply is ad)usted to shocks in money demand, keeping interest rates Fand hence, economic activityG relatively constant. 'he above discussion implies that the volatility of money demand matters for how monetary policy should be conducted. %f most of the aggregate demand shocks which affect the economy come from the expenditure side, the %S curve, then a policy of targeting the money supply will be stabili(ing, relative to a policy of targeting interest rates. However, if most of the aggregate demand shocks come from changes in money demand, which influences the :- curve, then a policy of targeting the money supply will be destabili(ing.

(ntere#t Rate# and the Demand for Money 'he .uantity of money people hold to pay for transactions and to satisfy precautionary and speculative demand is likely to vary with the interest rates they can earn from alternative assets such as bonds. When interest rates rise relative to the rates that can be earned on money deposits, people hold less money. When interest rates fall, people hold more money. 'he logic of these conclusions about the money people hold and interest rates depends on the people&s motives for holding money. 'he .uantity of money households want to hold varies according to their income and the interest rate4 different average .uantities of money held can satisfy their transactions and precautionary demands for money. 'o see why, suppose a household earns and spends ;=,<<< per month. %t spends an e.ual amount of money each day. $or a month with =< days, that is O;<< per day. Cne way the household could manage this spending would be to leave the money in a checking account, which we will assume pays (ero interest. 'he household would thus have O=,<<< in the checking account when the month begins, OE,D<< at the end of the first day, O;,?<< halfway through the month, and (ero at the end of the last day of the month. Averaging the daily balances, we find that the .uantity of money the household demands e.uals O;,?<<. 'his approach to money management, which we will call the cash approach," has the virtue of simplicity, but the household will earn no interest on its funds. *onsider an alternative money management approach that permits the same pattern of spending. At the beginning of the month, the household deposits O;,<<< in its checking account and the other OE,<<< in a bond fund. Assume the bond fund pays
23

;P interest per month, or an annual interest rate of ;E.@P. After ;< days, the money in the checking account is exhausted, and the household withdraws another O;,<<< from the bond fund for the next ;< days. Cn the E<th day, the final O;,<<< from the bond fund goes into the checking account. With this strategy, the household has an average daily balance of O?<<, which is the .uantity of money it demands. :et us call this money management strategy the bond fund approach." 6emember that both approaches allow the household to spend O=,<<< per month, O;<< per day. 'he cash approach re.uires a .uantity of money demanded of O;,?<<, while the bond fund approach lowers this .uantity to O?<<. 'he bond fund approach generates some interest income. 'he household has O;,<<< in the fund for ;< days F;2= of a monthG and O;,<<< for E< days FE2= of a monthG. With an interest rate of ;P per month, the household earns O;< in interest each month FQO;,<<< R <.<; R ;2=S T QO;,<<< R <.<; R E2=SG. 'he disadvantage of the bond fund, of course, is that it re.uires more attentionNO;,<<< must be transferred from the fund twice each month. 'here may also be fees associated with the transfers. Cf course, the bond fund strategy we have examined here is )ust one of many. 'he household could begin each month with O;,?<< in the checking account and O;,?<< in the bond fund, transferring O;,?<< to the checking account midway through the month. 'his strategy re.uires one less transfer, but it also generates less interestN O@.?< FL O;,?<< R <.<; R ;2EG. With this strategy, the household demands a .uantity of money of O@?<. 'he household could also maintain a much smaller average .uantity of money in its checking account and keep more in its bond fund. $or simplicity, we can think of any strategy that involves transferring money in and out of a bond fund or another interest#earning asset as a bond fund strategy. Which approach should the household useU 'hat is a choice each household must makeNit is a .uestion of weighing the interest a bond fund strategy creates against the hassle and possible fees associated with the transfers it re.uires. Cur example does not yield a clear#cut choice for any one household, but we can make some generali(ations about its implications. $irst, a household is more likely to adopt a bond fund strategy when the interest rate is higher. At low interest rates, a household does not sacrifice much income by pursuing the simpler cash strategy. As the interest rate rises, a bond fund strategy becomes more attractive. 'hat means that the higher the interest rate, the lower the .uantity of money demanded.
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Second, people are more likely to use a bond fund strategy when the cost of transferring funds is lower. 'he creation of savings plans, which began in the ;D@<s and ;DI<s, that allowed easy transfer of funds between interest#earning assets and checkable deposits tended to reduce the demand for money. Some money deposits, such as savings accounts and money market deposit accounts, pay interest. %n evaluating the choice between holding assets as some form of money or in other forms such as bonds, households will look at the differential between what those funds pay and what they could earn in the bond market. A higher interest rate in the bond market is likely to increase this differential4 a lower interest rate will reduce it. An increase in the spread between rates on money deposits and the interest rate in the bond market reduces the .uantity of money demanded4 a reduction in the spread increases the .uantity of money demanded. $irms, too, must determine how to manage their earnings and expenditures. However, instead of worrying about O=,<<< per month, even a relatively small firm may be concerned about O=,<<<,<<< per month. 6ather than facing the difference of O;< versus O@.?< in interest earnings used in our household example, this small firm would face a difference of OE,?<< per month FO;<,<<< versus O@,?<<G. $or very large firms such as ,eximco %nc or S.uare, interest rate differentials among various forms of holding their financial assets translate into millions of dollars per day. How is the speculative demand for money related to interest ratesU When financial investors believe that the prices of bonds and other assets will fall, their speculative demand for money goes up. 'he speculative demand for money thus depends on expectations about future changes in asset prices. Will this demand also be affected by present interest ratesU %f interest rates are low, bond prices are high. %t seems likely that if bond prices are high, financial investors will become concerned that bond prices might fall. 'hat suggests that high bond pricesNlow interest ratesNwould increase the .uantity of money held for speculative purposes. *onversely, if bond prices are already relatively low, it is likely that fewer financial investors will expect them to fall still further. 'hey will hold smaller speculative balances. /conomists thus expect that the .uantity of money demanded for speculative reasons will vary negatively with the interest rate.

$he Demand %ur,e for Money

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We have seen that the transactions, precautionary, and speculative demands for money vary negatively with the interest rate. 0utting those three sources of demand together, we can draw a demand curve for money to show how the interest rate affects the total .uantity of money people hold. 'he demand curve for money shows the .uantity of money demanded at each interest rate, all other things unchanged. Such a curve is shown in the below $igure, 'he +emand *urve for -oney". An increase in the interest rate reduces the .uantity of money demanded. A reduction in the interest rate increases the .uantity of money demanded. $he Demand %ur,e for Money

'he demand curve for money shows the .uantity of money demanded at each interest rate. %ts downward slope expresses the negative relationship between the .uantity of money demanded and the interest rate. 'he relationship between interest rates and the .uantity of money demanded is an application of the law of demand. %f we think of the alternative to holding money as holding bonds, then the interest rateNor the differential between the interest rate in the bond market and the interest paid on money depositsNrepresents the price of

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holding money. As is the case with all goods and services, an increase in price reduces the .uantity demanded. Other Determinant# of the Demand for Money We draw the demand curve for money to show the .uantity of money people will hold at each interest rate, all other determinants of money demand unchanged. A change in those other determinants" will shift the demand for money. Among the most important variables that can shift the demand for money are the level of income and real G+0, the price level, expectations, transfer costs, and preferences. Real <D' A household with an income of O;<,<<< per month is likely to demand a larger .uantity of money than a household with an income of O;,<<< per month. 'hat relationship suggests that money is a normal good3 as income increases, people demand more money at each interest rate, and as income falls, they demand less. An increase in real G+0 increases incomes throughout the economy. 'he demand for money in the economy is therefore likely to be greater when real G+0 is greater. $he 'rice .e,el 'he higher the price level, the more money is re.uired to purchase a given .uantity of goods and services. All other things unchanged, the higher the price level, the greater the demand for money. 07&ectation# 'he speculative demand for money is based on expectations about bond prices. All other things unchanged, if people expect bond prices to fall, they will increase their demand for money. %f they expect bond prices to rise, they will reduce their demand for money. 'he expectation that bond prices are about to change actually causes bond prices to change. %f people expect bond prices to fall, for example, they will sell their bonds, exchanging them for money. 'hat will shift the supply curve for bonds to the right, thus lowering their price. 'he importance of expectations in moving markets can lead to a self#fulfilling prophecy. /xpectations about future price levels also affect the demand for money. 'he expectation of a higher price level means that people expect the money they are
27

holding to fall in value. Given that expectation, they are likely to hold less of it in anticipation of a )ump in prices. /xpectations about future price levels play a particularly important role during periods of hyperinflation. %f prices rise very rapidly and people expect them to continue rising, people are likely to try to reduce the amount of money they hold, knowing that it will fall in value as it sits in their wallets or their bank accounts. 'oward the end of the great German hyperinflation of the early ;DE<s, prices were doubling as often as three times a day. 9nder those circumstances, people tried not to hold money even for a few minutesNwithin the space of eight hours money would lose half its valueV $ran#fer %o#t# $or a given level of expenditures, reducing the .uantity of money demanded re.uires more fre.uent transfers between non money and money deposits. As the cost of such transfers rises, some consumers will choose to make fewer of them. 'hey will therefore increase the .uantity of money they demand. %n general, the demand for money will increase as it becomes more expensive to transfer between money and non money accounts. 'he demand for money will fall if transfer costs decline. %n recent years, transfer costs have fallen, leading to a decrease in money demand. 'reference# 0references also play a role in determining the demand for money. Some people place a high value on having a considerable amount of money on hand. $or others, this may not be important. Household attitudes toward risk are another aspect of preferences that affect money demand. As we have seen, bonds pay higher interest rates than money deposits, but holding bonds entails a risk that bond prices might fall. 'here is also a chance that the issuer of a bond will default, that is, will not pay the amount specified on the bond to bondholders4 indeed, bond issuers may end up paying nothing at all. A money deposit, such as a savings deposit, might earn a lower yield, but it is a safe yield. 0eople&s attitudes about the trade#off between risk and yields affect the degree to which they hold their wealth as money. Heightened concerns about risk in the last half of E<<I led many households to increase their demand for money. ,elow $igure, An %ncrease in -oney +emand" shows an increase in the demand for money. Such an increase could result from a higher real G+0, a higher price
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level, a change in expectations, an increase in transfer costs, or a change in preferences. An (ncrea#e in Money Demand

An increase in real G+0, the price level, or transfer costs, for example, will increase the .uantity of money demanded at any interest rate r, increasing the demand for money from *; to *E. 'he .uantity of money demanded at interest rate r rises from M to MW. 'he reverse of any such events would reduce the .uantity of money demanded at every interest rate, shifting the demand curve to the left. $he *u&&ly of Money 'he supply curve of money shows the relationship between the .uantity of money supplied and the market interest rate, all other determinants of supply unchanged. We have learned that ,,, through its open#market operations, determines the total .uantity of reserves in the banking system. We shall assume that banks increase the money supply in fixed proportion to their reserves. ,ecause the .uantity of reserves is determined by *entral ,ank 6eserve policy, we draw the supply curve of money in the below $igure, 'he Supply *urve of -oney" as a vertical line, determined by
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the ,angladesh ,ank&s monetary policies. %n drawing the supply curve of money as a vertical line, we are assuming the money supply does not depend on the interest rate. *hanging the .uantity of reserves and hence the money supply is an example of monetary policy. $he *u&&ly %ur,e of Money

We assume that the .uantity of money supplied in the economy is determined as a fixed multiple of the .uantity of bank reserves, which is determined by ,,. 'he supply curve of money is a vertical line at that .uantity. 0quilibrium in the Market for Money 'he money market is the interaction among institutions through which money is supplied to individuals, firms, and other institutions that demand money. -oney market e.uilibrium occurs at the interest rate at which the .uantity of money
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demanded is e.ual to the .uantity of money supplied. ,elow $igure, -oney -arket /.uilibrium" combines demand and supply curves for money to illustrate e.uilibrium in the market for money. With a stock of money F MG, the e.uilibrium interest rate is r. Money Market 0quilibrium

'he market for money is in e.uilibrium if the .uantity of money demanded is e.ual to the .uantity of money supplied. Here, e.uilibrium occurs at interest rate r. 0ffect# of %han"e# in the Money Market A shift in money demand or supply will lead to a change in the e.uilibrium interest rate. :et&s look at the effects of such changes on the economy. %han"e# in Money Demand Suppose that the money market is initially in e.uilibrium at r; with supply curve ) and a demand curve *; as shown in 0anel FaG of below $igure, A +ecrease in the +emand for -oney". Jow suppose that there is a decrease in money demand, all
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other things unchanged. A decrease in money demand could result from a decrease in the cost of transferring between money and non money deposits, from a change in expectations, or from a change in preferences. 0anel FaG shows that the money demand curve shifts to the left to *E. We can see that the interest rate will fall to rE. 'o see why the interest rate falls, we recall that if people want to hold less money, then they will want to hold more bonds. 'hus, 0anel FbG shows that the demand for bonds increases. 'he higher price of bonds means lower interest rates4 lower interest rates restore e.uilibrium in the money market. A Decrea#e in the Demand for Money

A decrease in the demand for money due to a change in transactions costs, preferences, or expectations, as shown in 0anel FaG, will be accompanied by an increase in the demand for bonds as shown in 0anel FbG, and a fall in the interest rate. 'he fall in the interest rate will cause a rightward shift in the aggregate demand curve from &*; to &*E, as shown in 0anel FcG. As a result, real G+0 and the price level rise. :ower interest rates in turn increase the .uantity of investment. 'hey also stimulate net exports, as lower interest rates lead to a lower exchange rate. 'he aggregate demand curve shifts to the right as shown in 0anel FcG from &*; to &*E. Given the short#run aggregate supply curve )!&), the economy moves to a higher real G+0 and a higher price level. An increase in money demand due to a change in expectations, preferences, or transactions costs that make people want to hold more money at each interest rate will have the opposite effect. 'he money demand curve will shift to the right and the demand for bonds will shift to the left. 'he resulting higher interest rate will lead to
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a lower .uantity of investment. Also, higher interest rates will lead to a higher exchange rate and depress net exports. 'hus, the aggregate demand curve will shift to the left. All other things unchanged, real G+0 and the price level will fall. %han"e# in the Money *u&&ly Jow suppose the market for money is in e.uilibrium and the $ed changes the money supply. All other things unchanged, how will this change in the money supply affect the e.uilibrium interest rate and aggregate demand, real G+0, and the price levelU Suppose the $ed conducts open#market operations in which it buys bonds. 'his is an example of expansionary monetary policy. 'he impact of ,angladesh ,ank bond purchases is illustrated in 0anel FaG of below $igure , An %ncrease in the -oney Supply". 'he ,,&s purchase of bonds shifts the demand curve for bonds to the right, raising bond prices to PbE. As we learned, when the $ed buys bonds, the supply of money increases. 0anel FbG of below $igure, An %ncrease in the -oney Supply" shows an economy with a money supply of M, which is in e.uilibrium at an interest rate of r;. Jow suppose the bond purchases by the *entral ,ank as shown in 0anel FaG result in an increase in the money supply to MW4 that policy change shifts the supply curve for money to the right to )E. At the original interest rate r;, people do not wish to hold the newly supplied money4 they would prefer to hold non money assets. 'o reestablish e.uilibrium in the money market, the interest rate must fall to increase the .uantity of money demanded. %n the economy shown, the interest rate must fall to rE to increase the .uantity of money demanded to MW. An (ncrea#e in the Money *u&&ly

,, increases the money supply by buying bonds, increasing the demand for bonds in 0anel FaG from *; to *E and the price of bonds to PbE. 'his corresponds to an
33

increase in the money supply to MW in 0anel FbG. 'he interest rate must fall to rE to achieve e.uilibrium. 'he lower interest rate leads to an increase in investment and net exports, which shifts the aggregate demand curve from &*; to &*E in 0anel FcG. 6eal G+0 and the price level rise. 'he reduction in interest rates re.uired to restore e.uilibrium to the market for money after an increase in the money supply is achieved in the bond market. 'he increase in bond prices lowers interest rates, which will increase the .uantity of money people demand. :ower interest rates will stimulate investment and net exports, via changes in the foreign exchange market, and cause the aggregate demand curve to shift to the right, as shown in 0anel FcG, from &*; to &*E. Given the short#run aggregate supply curve )!&), the economy moves to a higher real G+0 and a higher price level. Cpen#market operations in which the *entral ,ank sells bondsNthat is, a contractionary monetary policyNwill have the opposite effect. When the ,, sells bonds, the supply curve of bonds shifts to the right and the price of bonds falls. 'he bond sales lead to a reduction in the money supply, causing the money supply curve to shift to the left and raising the e.uilibrium interest rate. Higher interest rates lead to a shift in the aggregate demand curve to the left. As we have seen in looking at both changes in demand for and in supply of money, the process of achieving e.uilibrium in the money market works in tandem with the achievement of e.uilibrium in the bond market. 'he interest rate determined by money market e.uilibrium is consistent with the interest rate achieved in the bond market. %onclu#ion 0eople hold money in order to buy goods and services Ftransactions demandG, to have it available for contingencies Fprecautionary demandG, and in order to avoid possible drops in the value of other assets such as bonds Fspeculative demandG. 'he higher the interest rate, the lower the .uantities of money demanded for transactions, for precautionary, and for speculative purposes. 'he lower the interest rate, the higher the .uantities of money demanded for these purposes. 'he demand for money will change as a result of a change in real G+0, the price level, transfer costs, expectations, or preferences. We assume that the supply of money is determined by the *entral ,ank. 'he supply curve for money is thus a vertical line. -oney market e.uilibrium occurs at the interest rate at which the .uantity of money demanded e.uals the .uantity of money supplied. All other things unchanged, a shift in money
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demand or supply will lead to a change in the e.uilibrium interest rate and therefore to changes in the level of real G+0 and the price level.

5iblio"ra&hy

A= 5ook# '.'. S/'H%, +Money ,an-ing . /nternational Trade0 page =<#?E, E<<; $rederic S. -ishkin, -arkets", @th edition, 5= >ournal# and Ma"a9ine# -endr(, Andrew3 'raditional /conomies" E<;< 6avi, 6amon3 +The cutting edge of money demand01 'he +aily Star, 0age ;H, Cctober E<<?. 0rimer, 'homas3 +2verflo3 of Monetary policy0 6eaders +igest maga(ine, page H?, -ay E<<?. ,etter Humans3 +'oney Tastes )3eet1 Money *emand in an open Economy01 E<<= Watson3 /SM/S /conometrics System", E<;; 8ohnson3 -odern Society Accelerates, %mportance of -oney +emand", ;DDH
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'he /conomics of -oney, ,anking, and $inancial

%= 8n&ubli#hed Material# ?$he#e#@ 6afi.ul, Bhan3 +&utomation of demand for Money0, 8agannath 9niversity, +haka, -arch E<;=. /conometrics 0rocess3 Money demand !ecord )ystem01 *hittagong 9niversity, *hittagong, August E<;=.

Cvic Alam3 Money in the hands of the pu4lic01 8agannath 9iversity, +haka, -arch E<;=. D= 0lectronic *ource# http322www.scribd.com2doc2H?E!EIEE2'hesis#;#H#ted Wikipedia3 'erminologies Http322Wikipedia.org

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