appendix 2 to chapter
22 Empirical Evidence on the Demand for Money
Interest Rates
and Money
Demand
Here we examine the empirical evidence on the two primary issues that distinguish the different theories of money demand and affect their conclusions about whether the quantity of money is the primary determinant of aggregate spending: Is the demand for money sensitive to changes in interest rates, and is the demand for money function stable over time?
James Tobin conducted one of the earliest studies on the link between interest rates and money demand using U.S. data.1 Tobin separated out transactions balances from other money balances, which he called Òidle balances,Ó assuming that transactions balances were proportional to income only, and idle balances were related to interest rates only. He then looked at whether his measure of idle balances was inversely related to interest rates in the period 1922Ð1941 by plotting the average level of idle balances each year against the average interest rate on commercial paper that year. When he found a clear-cut inverse relationship between interest rates and idle balances, Tobin concluded that the demand for money is sensitive to interest rates.2
Additional empirical evidence on the demand for money strongly confirms TobinÕs finding.3 Does this sensitivity ever become so high that we approach the case of the liquidity trap in which monetary policy is ineffective? The answer is almost certainly no. Keynes suggested in The General Theory that a liquidity trap might occur when interest rates are extremely low. (However, he did state that he had never yet seen an occurrence of a liquidity trap.)
Typical of the evidence demonstrating that the liquidity trap has never occurred is that of David Laidler, Karl Brunner, and Allan Meltzer, who looked at whether the interest sensitivity of money demand increased in periods when interest rates were
1James Tobin, ÒLiquidity Preference and Monetary Policy,Ó Review of Economics and Statistics 29 (1947): 124Ð131.
2A problem with TobinÕs procedure is that idle balances are not really distinguishable from transactions balances. As the Baumol-Tobin model of transactions demand for money makes clear, transactions balances will be related to both income and interest rates, just like idle balances.
3See David E. W. Laidler, The Demand for Money: Theories and Evidence, 4th ed. (New York: HarperCollins, 1993). Only one major study has found that the demand for money is insensitive to interest rates: Milton Friedman, ÒThe Demand for Money: Some Theoretical and Empirical Results,Ó Journal of Political Economy 67 (1959): 327Ð351. He concluded that the demand for money is not sensitive to interest-rate movements, but as later work by David Laidler (using the same data as Friedman) demonstrated, Friedman used a faulty statistical procedure that biased his results: David E. W. Laidler, ÒThe Rate of Interest and the Demand for Money: Some Empirical Evidence,Ó Journal of Political Economy 74 (1966): 545Ð555. When Laidler employed the correct statistical procedure, he found the usual result that the demand for money is sensitive to interest rates. In later work, Friedman has also concluded that the demand for money is sensitive to interest rates.
3 Appendix 2 to Chapter 22
result of this evidence, the M1 money demand function became the conventional money demand function used by economists.
The Case of the Missing Money. The stability of the demand for money, then, was a well-established fact when, starting in 1974, the conventional M1 money demand function began to severely overpredict the demand for money. Stephen Goldfeld labeled this phenomenon of instability in the demand for money function Òthe case of the missing money.Ó7 It presented a serious challenge to the usefulness of the money demand function as a tool for understanding how monetary policy affects aggregate economic activity. In addition, it had important implications for how monetary policy should be conducted. As a result, the instability of the M1 money demand function stimulated an intense search for a solution to the mystery of the missing money so that a stable money demand function could be resurrected.
The search for a stable money demand function took two directions. The first direction focused on whether an incorrect definition of money could be the reason why the demand for money function had become so unstable. Inflation, high nominal interest rates, and advances in computer technology caused the payments mechanism and cash management techniques to undergo rapid changes after 1974. In addition, many new financial instruments emerged and have grown in importance. This has led some researchers to suspect that the rapid pace of financial innovation since 1974 has meant that the conventional definitions of the money supply no longer apply. They searched for a stable money demand function by actually looking directly for the missing money; that is, they looked for financial instruments that have been incorrectly left out of the definition of money used in the money demand function.
Overnight repurchase agreements (RPs) are one example. These are one-day loans with little default risk because they are structured to provide Treasury bills as collateral. (The appendix to Chapter 2 gives a more detailed discussion of the structure of this type of loan.) Corporations with demand deposit accounts at commercial banks frequently lend out substantial amounts of their account balances overnight with these RPs, lowering the measures of the money supply. However, the amounts lent out are very close substitutes for money, since the corporation can quickly make a decision to decrease these loans if it needs more money in its demand deposit account to pay its bills. Gillian Garcia and Simon Pak, for example, found that including overnight RPs in measures of the money supply substantially reduced the degree to which money demand functions overpredicted the money supply.8 More recent evidence using later data has cast some doubt on whether including overnight RPs and other highly liquid assets in measures of the money supply produces money demand functions that are stable.9
The second direction of search for a stable money demand function was to look for new variables to include in the money demand function that will make it stable.
7Stephen M. Goldfeld, ÒThe Case of the Missing Money,Ó Brookings Papers on Economic Activity 3 (1976): 683Ð730.
8Gillian Garcia and Simon Pak, ÒSome Clues in the Case of the Missing Money,Ó American Economic Review 69 (1979): 330Ð334.
9See the survey in John P. Judd and John L. Scadding, ÒThe Search for a Stable Money Demand Function,Ó Journal of Economic Literature 20 (1982): 993Ð1023.
Empirical Evidence on the Demand for Money 4
Michael Hamburger, for example, found that including the average dividendÐprice ratio on common stocks (average dividends divided by average price) as a measure of their interest rate resulted in a money demand function that is stable.10 Other researchers, such as Heller and Khan, added the entire term structure of interest rates to their money demand function and found that this produces a stable money demand function.11
These attempts to produce a stable money demand function have been criticized on the grounds that these additional variables do not accurately measure the opportunity cost of holding money, and so the theoretical justification for including them in the money demand function is weak.12 Also, later research questions whether these alterations to the money demand function will lead to continuing stability in the future.13
Velocity Slowdown in the 1980s. The woes of conventional money demand functions increased in the 1980s. We have seen that they overpredicted money demand in the middle and late 1970s; that is, they underpredicted velocity (PY/M ), which rose faster than expected. The tables turned beginning in 1982; as can be seen in Figure 1 in Chapter 22, economists now faced a surprising slowdown in M1 velocity, which conventional money demand functions also could not predict. Although researchers have tried to explain this velocity slowdown, they have not been entirely successful.14
M2 to the Rescue? As we saw in Figure 1, M2 velocity remained far more stable than M1 velocity in the 1980s. The relative stability of M2 velocity suggests that money demand functions in which the money supply is defined as M2 might perform substantially better than those in which the money supply is defined as M1. Researchers at the Federal Reserve found that M2 money demand functions performed well in the 1980s, with M2 velocity moving quite closely with the opportunity cost of holding M2 (market interest rates minus an average of the interest paid on deposits and financial instruments that make up M2).15 However, in the early 1990s, M2 growth underwent a dramatic slowdown, which some researchers believe cannot be explained by
10Michael Hamburger, ÒBehavior of the Money Stock: Is There a Puzzle?Ó Journal of Monetary Economics 3 (1977): 265Ð288. The stability of his money demand function also depends on his assumption that the income elasticity of the demand for money is unity. This assumption has been strongly criticized by many critics, including R. W. Hafer and Scott E. Hein, ÒEvidence on the Temporal Stability of the Demand for Money Relationship in the United States,Ó Federal Reserve Bank of St. Louis Review (1979): 3Ð14, who find that this assumption is strongly rejected by the data.
11H. Heller and Moshin S. Khan, ÒThe Demand for Money and the Term Structure of Interest Rates,Ó Journal of Political Economy 87 (1979): 109Ð129.
12Frederic S. Mishkin, ÒDiscussion of Asset Substitutability and the Impact of Federal Deficits,Ó in The Economic Consequences of Government Deficits, ed. Laurence H. Meyer (Boston: Kluwer-Nijhoff, 1983), pp. 117Ð120; Frederic S. Mishkin, ÒDiscussion of Recent Velocity Behavior: The Demand for Money and Monetary Policy,Ó in Monetary Targeting and Velocity (San Francisco: Federal Reserve Bank of San Francisco, 1983), pp. 129Ð132.
13This research is discussed in Judd and Scadding (note 9).
14See, for example, Robert H. Rasche, ÒM1 Velocity and Money-Demand Functions: Do Stable Relationships Exist?Ó Empirical Studies of Velocity, Real Exchange Rates, Unemployment, and Productivity, Carnegie-Rochester Conference Series on Public Policy 17 (Autumn 1987), pp. 9Ð88.
15See David H. Small and Richard D. Porter, ÒUnderstanding the Behavior of M2 and V2,Ó Federal Reserve Bulletin 75 (1989): 244Ð254.
5 Appendix 2 to Chapter 22
traditional money demand functions.16 In the late 1990s, M2 velocity seemed to settle down, suggesting a more normal relationship between M2 demand and macroeconomic variables. However, doubts continue to arise about the stability of money demand.17
Conclusion. The main conclusion from the research on the money demand function seems to be that the most likely cause of its instability is the rapid pace of financial innovation occurring after 1973, which has changed what items can be counted as money. The evidence is still somewhat tentative, however, and a truly stable and satisfactory money demand function has not yet been found. And so the search for a stable money demand function goes on.
The recent instability of the money demand function calls into question whether our theories and empirical analyses are adequate.18 It also has important implications for the way monetary policy should be conducted because it casts doubt on the usefulness of the money demand function as a tool to provide guidance to policymakers. In particular, because the money demand function has become unstable, velocity is now harder to predict, and as discussed in Chapter 21, setting rigid money supply targets in order to control aggregate spending in the economy may not be an effective way to conduct monetary policy.
16See, for example, Bryon Higgins, ÒPolicy Implications of Recent M2 Behavior,Ó Federal Reserve Bank of Kansas City Economic Review (Third Quarter 1992): 21Ð36. For a contrary view, see Robert L. Hetzel, ÒHow Useful Is M2 Today,Ó Federal Reserve Bank of Richmond Economic Review (SeptemberÐOctober 1992): 12Ð26.
17For example, see Kelly Ragan and Bharat Trehan, ÒIs It Time to Look at M2 Again?Ó Federal Reserve Bank of San Francisco Economic Letter #98-07 (March 6, 1998).
18Thomas F. Cooley and Stephen F. Le Roy, ÒIdentification and Estimation of Money Demand,Ó American Economic Review 71 (1981): 825Ð844, is especially critical of the empirical research on the demand for money.
C h a p t e r
23 The Keynesian Framework and the ISLM Model
In the media, you often see forecasts of GDP and interest rates by economists and government agencies. At times, these forecasts seem to come from a crystal ball, but economists actually make their predictions using a variety of economic models. One model widely used by economic forecasters is the ISL M model, which was developed by Sir John Hicks in 1937 and is based on the analysis in John Maynard KeynesÕs influential book The General Theory of Employment, Interest, and Money, published in 1936.1 The ISLM model explains how interest rates and total output produced in the economy (aggregate output or, equivalently, aggregate income) are determined, given a fixed price level.
The ISL M model is valuable not only because it can be used in economic forecasting, but also because it provides a deeper understanding of how government policy can affect aggregate economic activity. In Chapter 24 we use it to evaluate the effects of monetary and fiscal policy on the economy and to learn some lessons about how monetary policy might best be conducted.
In this chapter, we begin by developing the simplest framework for determining aggregate output, in which all economic actors (consumers, firms, and others) except the government play a role. Government fiscal policy (spending and taxes) is then added to the framework to see how it can affect the determination of aggregate output. Finally, we achieve a complete picture of the ISL M model by adding monetary policy variables: the money supply and the interest rate.
Determination of Aggregate Output
http://research.stlouisfed.org /fred/index.html
Information about the macroeconomic variables discussed in this chapter.
Keynes was especially interested in understanding movements of aggregate output because he wanted to explain why the Great Depression had occurred and how government policy could be used to increase employment in a similar economic situation. KeynesÕs analysis started with the recognition that the total quantity demanded of an economyÕs output was the sum of four types of spending: (1) consumer expenditure (C ) , the total demand for consumer goods and services (hamburgers, stereos, rock concerts, visits to the doctor, and so on); (2) planned investment spending ( I ) ,
1John Hicks, ÒMr. Keynes and the Classics: A Suggested Interpretation,Ó Econometrica (1937): 147Ð159.
C H A P T E R 2 3 The Keynesian Framework and the ISLM Model 537
the total planned spending by businesses on new physical capital (machines, computers, factories, raw materials, and the like) plus planned spending on new homes;
(3) government spending (G ) , the spending by all levels of government on goods and services (aircraft carriers, government workers, red tape, and so forth); and (4) net exports ( N X ) , the net foreign spending on domestic goods and services, equal to exports minus imports.2 The total quantity demanded of an economyÕs output, called aggregate demand (Y ad ) , can be written as:
Using the common-sense concept from supply and demand analysis, Keynes recognized that equilibrium would occur in the economy when total quantity of output supplied (aggregate output produced) Y equals quantity of output demanded Y ad , that is, when:
When this equilibrium condition is satisfied, producers are able to sell all of their output and have no reason to change their production. KeynesÕs analysis explains two things: (1) why aggregate output is at a certain level (which involves understanding what factors affect each component of aggregate demand) and (2) how the sum of these components can add up to an output smaller than the economy is capable of producing, resulting in less than full employment of resources.
Keynes was especially concerned with explaining the low level of output and employment during the Great Depression. Because inflation was not a serious problem during this period, he assumed that output could change without causing a change in prices. KeynesÕs analysis assumes that the price level is fixed; that is, dollar amounts for variables such as consumer expenditure, investment, and aggregate output do not have to be adjusted for changes in the price level to tell us how much the real quantities of these variables change. Because the price level is assumed to be fixed, when we talk in this chapter about changes in nominal quantities, we are talking about changes in real quantities as well.
Our discussion of KeynesÕs analysis begins with a simple framework of aggregate output determination in which the role of government, net exports, and the possible effects of money and interest rates are ignored. Because we are assuming that government spending and net exports are zero (G 0 and NX 0), we need only examine consumer expenditure and investment spending to explain how aggregate output is determined. This simple framework is unrealistic, because both government and monetary policy are left out of the picture, and because it makes other simplifying assumptions, such as a fixed price level. Still, the model is worth studying, because its simplified view helps us understand the key factors that explain how the economy works. It also clearly illustrates the Keynesian idea that the economy can come to rest at a level of aggregate output below the full employment level. Once you understand this simple framework, we can proceed to more complex and more realistic models.
2 Imports are subtracted from exports in arriving at the net exports component of the total quantity demanded of an economyÕs output because imports are already counted in C, I, and G but do not add to the demand for the economyÕs output.
538 P A R T V I |
Monetary Theory |
|
Consumer |
Ask yourself what determines how much you spend on consumer goods and services. |
Expenditure and |
Your likely response is that your income is the most important factor, because if your |
the Consumption |
income rises, you will be willing to spend more. Keynes reasoned similarly that con- |
Function |
sumer expenditure is related to disposable income, the total income available for |
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spending, equal to aggregate income (which is equivalent to aggregate output) minus |
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taxes (Y T ) . He called this relationship between disposable income YD and con- |
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sumer expenditure C the consumption function and expressed it as: |
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C a (mpc YD ) |
(3) |
The term mpc, the marginal propensity to consume, is the slope of the consumption function line ( C/ YD ) and reflects the change in consumer expenditure that results from an additional dollar of disposable income. Keynes assumed that mpc was a constant between the values of 0 and 1. If, for example, a $1.00 increase in disposable income leads to an increase in consumer expenditure of $0.50, then mpc 0.5.
The term a stands for autonomous consumer expenditure, the amount of consumer expenditure that is independent of disposable income. It tells us how much consumers will spend when disposable income is 0 (they still must have food, clothing, and shelter). If a is $200 billion when disposable income is 0, consumer expenditure will equal $200 billion.3
A numerical example of a consumption function using the values of mpc 0.5 and a 200 will clarify the preceding concept. The $200 billion of consumer expenditure at a disposable income of 0 is listed in the first row of Table 1 and is plotted as point E in Figure 1. (Remember that throughout this chapter, dollar amounts for all variables in the figures correspond to real quantities, because Keynes assumed that the price level is fixed.) Because mpc 0.5, when disposable income increases by $400 billion, the change in consumer expenditureÑ C in column 3 of Table 1Ñis $200 billion (0.5 $400 billion). Thus when disposable income is $400 billion, consumer expenditure is $400 billion (initial value of $200 billion when income is 0 plus the $200 billion change in consumer expenditure). This combination of consumer expenditure and disposable income is listed in the second row of Table 1 and is plotted as point F in Figure 1. Similarly, at point G, where disposable income has increased by another $400 billion to $800 billion, consumer expenditure will rise by another $200 billion to $600 billion. By the same reasoning, at point H, at which disposable income is $1,200 billion, consumer expenditure will be $800 billion. The line connecting these points in Figure 1 graphs the consumption function.
Study Guide |
The consumption function is an intuitive concept that you can readily understand if |
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you think about how your own spending behavior changes as you receive more dis- |
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posable income. One way to make yourself more comfortable with this concept is to |
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estimate your marginal propensity to consume (for example, it might be 0.8) and your |
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level of consumer expenditure when your disposable income is 0 (it might be $2,000) |
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and then construct a consumption function similar to that in Table 1. |
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3Consumer expenditure can exceed income if people have accumulated savings to tide them over bad times. An alternative is to have parents who will give you money for food (or to pay for school) when you have no income. The situation in which consumer expenditure is greater than disposable income is called dissaving.
C H A P T E R 2 3 The Keynesian Framework and the ISLM Model 539
Table 1 Consumption Function: Schedule of Consumer Expenditure C When mpc = 0.5 and a = 200 ($ billions)
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Change in |
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Change in |
Consumer |
|
Point in |
Disposable |
Disposable |
Expenditure C |
Consumer |
Figure 1 |
income YD |
Income YD |
(0.5 YD) |
Expenditure C |
|
(1) |
(2) |
(3) |
(4) |
E |
0 |
Ñ |
Ñ |
200 ( a) |
F |
400 |
400 |
200 |
400 |
G |
800 |
400 |
200 |
600 |
H |
1,200 |
400 |
200 |
800 |
F I G U R E 1 Consumption
Function
The consumption function plotted here is from Table 1; mpc 0.5 and a 200.
http://nova.umuc.edu/~black /consf1000.html
A dynamic interactive demonstration of how changing the inputs to the consumption function alters the results.
Consumer
Expenditure, C
($ billions)
1,200
C = 200 + 0.5YD
1000
800
H
600
G
400
F
200
a = 200 E
0 200 400 600 800 1,000 1,200 1,400 1,600
Disposable Income, YD ($ billions)
It is important to understand that there are two types of investment. The first type, fixed investment, is the spending by firms on equipment (machines, computers, airplanes) and structures (factories, office buildings, shopping centers) and planned spending on residential housing. The second type, inventory investment, is spending by firms on additional holdings of raw materials, parts, and finished goods, calculated as the change in holdings of these items in a given time periodÑsay a year. (Box 1 explains how economistsÕ use of the word investment differs from everyday use of the term.)
Suppose that Compaq, a company that produces personal computers, has 100,000 computers sitting in its warehouses on December 31, 2003, ready to be shipped to
540 P A R T V I Monetary Theory
Box 1
Meaning of the Word Investment
Economists use the word investment somewhat differ- |
duced goods and services. But when economists |
ently than other people do. When people say that they |
speak of investment spending, they are referring to |
are making an investment, they are normally refer- |
the purchase of new physical assets such as new |
ring to the purchase of common stocks or bonds, |
machines or new housesÑpurchases that add to |
purchases that do not necessarily involve newly pro- |
aggregate demand. |
Equilibrium and
the Keynesian
Cross Diagram
dealers. If each computer has a wholesale price of $1,000, Compaq has an inventory worth $100 million. If by December 31, 2004, its inventory of personal computers has risen to $150 million, its inventory investment in 2004 is $50 million, the change in the level of its inventory over the course of the year ($150 million minus $100 million). Now suppose that there is a drop in the level of inventories; inventory investment will then be negative.
Compaq may also have additional inventory investment if the level of raw materials and parts that it is holding to produce these computers increases over the course of the year. If on December 31, 2003, it holds $20 million of computer chips used to produce its computers and on December 31, 2004, it holds $30 million, it has an additional $10 million of inventory investment in 2001.
An important feature of inventory investment is thatÑin contrast to fixed investment, which is always plannedÑsome inventory investment can be unplanned. Suppose that the reason Compaq finds itself with an additional $50 million of computers on December 31, 2004 is that $50 million less of its computers were sold in 2004 than expected. This $50 million of inventory investment in 2004 was unplanned. In this situation, Compaq is producing more computers than it can sell and will cut production.
Planned investment spending, a component of aggregate demand Y ad, is equal to planned fixed investment plus the amount of inventory investment planned by firms. Keynes mentioned two factors that influence planned investment spending: interest rates and businessesÕ expectations about the future. How these factors affect investment spending is discussed later in this chapter. For now, planned investment spending will be treated as a known value. At this stage, we want to explain how aggregate output is determined for a given level of planned investment spending; we can then examine how interest rates and business expectations influence aggregate output by affecting planned investment spending.
We have now assembled the building blocks (consumer expenditure and planned investment spending) that will enable us to see how aggregate output is determined when we ignore the government. Although unrealistic, this stripped-down analysis clarifies the basic principles of output determination. In the next section, government enters the picture and makes our model more realistic.
The diagram in Figure 2, known as the Keynesian cross diagram, shows how aggregate output is determined. The vertical axis measures aggregate demand, and the horizontal axis measures the level of aggregate output. The 45¡ line shows all the points
