medium of exchange
store of value
unit of account
standard of deferred payment
Click here to view the Federal Reserve's most recent estimates of the monetary aggregates.
M1
M1 = currency + traveler's checks + demand deposits + other checkable deposits
M2
M2 = M1 + overnight RP's + overnight Eurodollars + money market mutual funds + money market deposit accounts + savings deposits + small time depositsÂ
M3
M3 = M2 + large time deposits + term RP's + term Eurodollars + institutional money market mutual funds
The transactions demand is for use as a medium of exchange. The demand for money should depend on the value of transactions. As prices rise, you need more money to buy the same quantity of goods and services. So, changes in nominal money holdings are proportional to changes in the price level. So, we focus on the demand for real money balances.
The quantity theory of money argues that the velocity of money (the average number of times a dollar is spent each year to purchase goods and services) is constant. Then, the demand for real money balances is proportional to aggregate output. So, as income rises, the demand for money rises because more transactions are carried out.
the velocity of money depends on
frequency of paychecks
use of credit
transportation speed
communications speed
habits
population density
Velocity fluctuates too much even in the short run to be viewed as a constant.
The quantity theory assumes that interest rates do not affect the transactions demand for money.
The funds that people hold for transactions can be held in either cash or savings deposits. There is a tradeoff between the convenience of cash (since you don't have to make a trip to the bank) and the interest you can earn on your savings account. The higher the interest rate, the less cash you will hold and the more transactions balances you place in your savings account.
A second motive for holding money is to avoid being illiquid. Money is the most liquid of all assets. So, you want to hold some money for emergency purposes.
The speculative motive looks at the demand for money as an asset. People are viewed as switching their asset holdings back and forth between money and bonds.
The expected return on money is assumed to be zero. The expected return on a bond consists of the interest payment plus expected capital gains. When interest rates rise, bond prices fall. So, bondholders suffer a capital loss. Bondholders receive a capital gain when interest rates fall.
People are assumed to hold in mind some "normal" interest rate. When interest rates are above "normal", they will be expected to fall. Wishing to earn a capital gain, investors will hold all bonds and no money. If interest rates are below "normal", bondholders will suffer a capital loss when interest rates rise to return to "normal", so investors will sell their bonds and hold all their wealth in money. So, the demand for money is negatively related to the interest rate.
Every study has found that the demand for money is sensitive to interest rates.
Until the early 1970's, the demand for money could be quite reliably predicted if one knew only (1) the value of real GNP, (2) the interest rate on Treasury bills, and (3) the interest rate on savings deposits. However, starting in 1974, the conventional money demand function began to seriously overpredict money demand. The money demand curve began shifting around. In other words, money demand is unstable.
possible explanations:
financial innovation
financial deregulation
A truly stable money demand function has not yet been found.