Demand For Money Essay

881 words - 4 pages

Quantity theory of money (QTM) – suggests
that the demand for real money balances is

proportional to income.
Quantity eqn.:
where M – money supply;
V – velocity of money: the # of
times a PhP bill changes hands for time, t;
P – price level; and,
T – transactions.



Income (Y) version of the QE:
◦ where V: the # of times a PhP bill enters someone’s
◦ P x Y: nominal GDP.

This version of the QTM is used since it is
difficult to observe transactions.

Money Demand & the Quantity Theory of
 uses real money balances to measure the
purchasing power of the stock of money;
 the money demand function is like the
...view middle of the document...

GDP deflator (price level) – is the ratio of
nominal to real GDP.



Monetary transmission mechanism :

When BSP ↑MS, since V is fixed, there is a
proportionate ↑nominal GDP;

Since factors of production & the
production fn have already determined
real GDP, the ∆ in nominal GDP must
represent a ∆ in the price level;

Thus, the price level is proportionate to

The QTM is ultimately saying that the BSP,
which controls MS, has control of the
inflation rate:
◦ If BSP keeps MS stable, price level will be stable;
◦ If BSP ↑MS rapidly, the price level will ↑ rapidly.

Empirically, there is evidence in the US of
positive correlation between money growth
& inflation.



Q: Why would BSP ↑MS if this is

theoretically inflationary?

A: To finance budget deficits.
Governments monetize deficits and
use seigniorage (revenue earned from
printing money)

Transmission mechanism:
↑MS → ↑ inflation → imposes an inflation tax on
holders of money.
As ↑P → ↓Y/P in pocket, making old money in the
hands of public less valuable.
Empirically, countries who rely heavily on
seigniorage have experienced hyperinflation (i.e.



TLP: the demand for real balances depends
on nominal interest rates (i) & Y. The general
money demand function:



 L(i,Y )

◦ Where i : nominal interest rate
Y: level of income
◦ A higher i → a lower (M/P)d
◦ Higher Y → a greater demand for (M/P)d

Fischer equation: shows the relationship between
inflation & interest rate. It has been used to vary
the TLP:


- where r – real interest rate;
π – inflation rate.

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