Estimating the Demand for Money Essay Example for Free

Estimating the Demand for Money Essay We all know that money employed in consumption sustains life and gives pleasure, but it does not lead to economic growth. Money employed for investment increases productive capacity, thereby increasing wealth available for consumption investment in the future. Use of money for both consumption investment leads to employment but later reaps future benefits. The quantity theory of money posits that the value of money is equal to the collective supply of goods and services in an economy. The value of money could be called the aggregate clearing price for the aggregate supply aggregate demand in an economy. A condition in which the aggregate clearing price is below the aggregate costs of production would be symptomatic of gross misallocations of resources in an economy but this kind of condition is not theoretically impossible. Ending of wars that includes cold wars are often associated with massive reallocations of productive resources and these reallocations can involve painful periods of readjustment. â€Å"Artificial bubbles† resulting from central banker manipulation of money and interest cause boom bust misallocations. Regarded money as nothing but a means to facilitate barter, the aggregate supply of goods and services represents the wealth of society. If everyone woke up one morning to find every dollar replaced by one hundred dollars, no one would be wealthier or poorer because wages and prices had two additional zeroes. Nor would there be any change in either aggregate supply or demand. The concept of aggregate supply to represent the wealth of society can be misleading. Most homeowners would sell their house if offered an outrageously high price for it. In that sense, nearly all existing homes are part of the aggregate supply. But in the normal course of events, homeowners are slowly consuming their houses by living in them and are not considering an immediate sale although the thought of eventual re-sale is usually in their minds. Similarly, most capitalists would sell their factories if offered a high price, but are primarily focused on increasing the productivity of those factories and ensuring that the factories produce goods for which demand is high. Money works magic in the minds of many economists which transform simple relationships into complex conceptual nightmares. Say’s Law one monetary interpretation holds that the costs of production (paid for labor, land and capital goods) results in the incomes essential for purchasing output. Moving this argument further, critics of Says Law express concern that all the income will not be spent concerning that some money will be saved or even hoarded. Thinking that it is better to save the money than to spend it that result to manufacturing decline, unemployment and recession. But the confident consumer who saves and invests actually benefits the economy more than the consumer who spends. Invested capital provides the means to hire labor and other factors of production that increase employment and wealth. Vision of economic activity as a circular flow of money between spenders earners blinded him to the nature of wealth-creation, productive incentives, productivity increase and economic growth. The economic benefits of savings should not be justified on the grounds that savings is another form of spending. On the contrary, savings is the source of capital accumulation. Capital technological progress is the source of economic growth. Capital means plant, equipment, technology, research and employees to make new products. Consumers can only keep an economy from recession if they are employed in productive activity. If unemployment is low and those employed are producing useful goods services, then an economy can remain healthy. High consumer spending is more an effect than a cause of the economic well-being associated with low unemployment. Consumer confidence is expected to be high if unemployment is low. Recession is not just a national bad mood. Unemployed consumers who spend money received from government destroy consume wealth without producing wealth. Economic growth occurs only if the consumer is also a producer. In empirical method it determines the relationships between economic variables through observation or experiment. The Baumol-Tobin model provides the foundation for most empirical studies of money demand. The Capital Asset Pricing Model, while important in financial economics, is viewed to be much less important in determining money demand. Most wealth is shifted under the speculative motive from long-term to short-term securities rather than money. The prices of short-term bonds do not change as much as long-term bonds and there is a default risk with money because of the limit to federal insurance on deposits. One of the difficulties in empirical work on money demand is that money demand adjusts to changes in income and interest rates with a lag. In other words, a change in income leads to a delayed change in money demand. Money demand may be slow to change because of adjustment costs, expectations may be slow to adjust or may hold that a change in income or interest rates is in part temporary. Consequently, empirical studies of money demand look at both short-term and long-term responses to changes in macroeconomic conditions. An increase in the interest rate reduces the demand for M1 money as expected, but the effect is small. An increase in the interest rate from 4 to 5 percent (a 25 percent increase) reduces money demand in the short run by 0. 5 percent (= 0. 02 x 25%). The long run response is about a 1. 25 percent reduction in money demand. An increase in the interest rate from 10 to 11 percent produces even smaller money demand responses. There is an extensive literature on the theory of money demand and the influencing factors. In general, the real money balances are related to some scale measure, such as income or wealth, and some opportunity cost measures, such as inflation, interest and exchange rates. There are various discussions on the form of the money demand function and the selection of the variables entering in the equation. Thus the choice of economic indicators varies in different country experiences due to the distinction in different financial systems. The choice of an appropriate monetary aggregate for the estimation of a meaningful money demand function is complicated. Either a broad or a narrow definition of money can be used as the monetary variable depending on the issue of the monetary authorities. Generally it may be thought that a narrow definition of money like monetary base or M1 tends to be more flexible and reactive to market operations and thus to interest rate policies. Narrow money can have a close relationship with prices since it can easily be influenced by economic variables, however it cannot always be adequate to capture all the information related to the financial system. Although narrowly defined aggregates are easy to control, their relationship with income appears subject to considerable variability. One main cause of this insufficiency is due to banking habits of money holders, as they wish to hold their savings not only in demand deposits, but also in time deposits or other different financial instruments. For that reason, a broader definition of money, such as M2 or M2X, can comprise a wider range of the financial system; however it may be less sensitive to the changes in the economy. The scale variable measuring the level of economic activity is the first determinant of the money demand function. The holding of money and thus the demand for money are related to the volume of the transactions, using the fact that the amount of the transactions is proportional to the level of income. Either a wealth variable or an income variable can be used as a scale variable. Generally, when wealth data is not available, an income variable like the Gross National Product or Gross Domestic Product can be taken into consideration. Money demand is directly proportional to income, but inversely related to market interest rates and yields on different financial assets. The interest rate concerning time deposits is thought to be the nominal return of holding money if the broad definition of money is considered, hence has a positive sign in the money demand equation. Another important variable which measures the rate of return of an opportunity cost is the interest rate on government securities. As currency substitution can occur either by switching into foreign denominated deposits or by switching to bonds or securities, the rate of interest on government securities is a measure of the rate of return of an opportunity cost, and its expected sign in the equation is therefore negative. The relationship between inflation and the demand for money has been studied widely. If there are high fluctuations in prices, the rate of inflation becomes an important determinant of the money demand function. Money demand is inversely related to predictable inflation rate since an increase in inflation increases the cost of holding money. Especially, in developing countries, the long run inflation elasticity is generally expected to be high as the range of financial instruments outside money is limited and real assets represent a substantial part of the public’s portfolio (Nachega, 2001). Like in Turkish economy that is subject to not only a high degree of price level but also a high variability in the prices, the price level has a considerable impact on the return of financial assets; as money holders will have difficulties in predicting the prices, the risk in saving money will raise and consequently the holding of money will tend to decrease. Since foreign exchange rate measures the rate of return on holding foreign currency, it is also an important determinant in the demand equation on holding foreign currency. The sign of exchange rate is negative since when the deposit holders increase their demand for foreign currencies, the domestic currency will depreciate. In an open economy, the return of foreign assets is usually denoted by some exchange rate variable, which may have an increasing role due to the high level of financial globalization. (Central Bank Review, 2002 pp. 55-65). Boughton (1992) presents the sources of disturbances that can affect the elasticities of variables in the long run equation. Inflation expectations varying over time is the first important factor that may affect real return of assets which is a vital element of the money demand equation. An inflationary expectation is generally proxied by the inflation rate, thus it is essential to examine the inflation data before inserting in the money demand equation. The change in exchange rate is the second important source of variability. Therefore the relationship between the exchange rate mechanism and the dynamics of real money balances is important, justifying the addition of the real effective exchange rate into the model.