The demand for money is a demand for real balances. It is the purchasing power,
not the number of dollar bills, that matters to holders of money.
The money supply, M1, is made up of currency and checkable deposits. A broader
measure, M2, also includes savings and time deposits at depository institutions as
well as some other interest-bearing assets.
The chief characteristic of money is that it serves as a means of payment. The three
classic reasons to hold money are for transactions purposes (M1) and for
precautionary (M1 and M2) and speculative reasons (M2).
Decisions to hold money are based on a tradeoff between the liquidity of money
and the opportunity cost of holding it when other assets have a higher yield.
The inventory-theoretic approach shows that an individual will hold a stock of real
balances that varies inversely with the interest rate but increases with the level of
real income and the cost of transactions. According to the inventory approach, the
income elasticity of money demand is less than unity, implying that there are
economies of scale.
Uncertainty about payments and receipts in combination with transactions costs
gives rise to a precautionary demand for money. Precautionary money holdings are
higher the greater the variability of net disbursements, the higher the cost of
illiquidity, and the lower the interest rate.
Some assets that are in M2 form part of an optimal portfolio because they are less
risky than other assets—their nominal value is constant. Because they earn interest,
assets such as savings or time deposits and MMMF shares dominate currency and
demand deposits for portfolio diversification purposes.
The empirical evidence provides support for a negative interest elasticity of money
demand and a positive income elasticity. Because of lags, short-run elasticities are
much smaller than long-run elasticities.
The demand function for M1 started showing instability in the mid-1970s. The
demand function for M2 appears to be somewhat more stable, showing a unit
income elasticity, a positive elasticity with respect to the own rate, and a negative
elasticity with respect to the commercial paper rate.
The income velocity of money is defined as the ratio of income to money or the
rate of turnover of money. The behavior of velocity is closely tied to the demand
for money, so an increase in the opportunity cost of holding money leads to an
increase in velocity.
The velocity of M2 was roughly constant for many years. The constancy is a reflection
of small changes in the opportunity cost of holding money and of a unit income
elasticity of demand for M2. In recent years, M2 velocity has varied considerably.
Inflation implies that money loses purchasing power, and inflation thus creates a
cost of holding money. The higher the rate of inflation, the lower the amount of
real balances that will be held. Hyperinflations provide striking support for this
prediction. Under conditions of very high expected inflation, money demand falls
dramatically relative to income. Velocity rises as people use less money in relation
to income.
