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FEDERAL RESERVE BANK OF RICHMOND

MONTHLY
REVIEW
The Role o f the M oney Supply in the
Conduct o f M onetary Policy
Evolution o f the Concept of the
Demand fo r M oney

Volume 59
Number 12



DECEMBER

1973

The Role of the Money Supply in the
Conduct of Monetary Policy
The following letter, dated N ovem ber 6, 1973, by Arthur F. Burns, Chairman o f the
Board o f Governors o f the Federal Reserve System, was written in response to
inquiries by Senator P roxm ire regarding criticisms of
m onetary policy during the past year.

T he H onorable W illiam P roxm ire

M any observers have blamed these difficulties on

United States Senate
W ashington, D. C.

the management o f public econom ic policies.

C er­

tainly, the Federal budget— despite vigorou s efforts
to hold expenditures dow n— continued in substantial

Dear Senator P r o x m ir e :

deficit.

I am w riting in further response to your letter of
September 17, 1973, which requested comm ents on
certain criticisms of monetary policy over the past
year.

T here has also been an enorm ous grow th in

the activities of Federally-sponsored agencies which,
although technically outside the budget, must still be
financed.

T he results of efforts to control wages and

prices during the past year have been disappointing.

A s stated in your letter, the criticisms a r e : ( 1 )

Partial decontrol in early 1973 and the subsequent

“ that there was too much variation from time to time

freeze failed to bring the results that were hoped for.

in the rate of increase in the money supply, that

M onetary policy has been criticized on somewhat

monetary policy was too erratic, too much character­

contradictory counts— for being inflationary, or for

ized by stops and starts’ ’ ; and (2 ) “ that the money

permitting too high a level of interest rates, or for

supply had increased much too much last year, in

failing to bring the econom y back to full employment,

fact that the increase would have been too much even
if we had been in the depths o f a recession instead of

or for permitting excessive short-term variations in

enjoyin g a fairly vigorous econom ic expansion.”
These criticisms involve basic issues with regard
to the role of money in the econom y, and the role
that the m oney supply should play in the form ula­
tion and execution of monetary policy. These issues,
along with the specific points you raise, require
careful examination.

the grow th o f the money supply, and so on.
One indication o f dissatisfaction with our public
policies was provided by a report, to which you refer
in your letter, on a questionnaire survey conducted by
the National A ssociation o f Business Econom ists.
O f the respondents, 38 per cent rated fiscal policy
“ over the past year” as “ p o o r ” ; 41 per cent rated
monetary policy “ over the past year” as “ p o o r” ; only
14 per cent felt that the w age-price controls under

Criticism of Our Public Policies

Phase I V were “ about right.”

D uring the past tw o years the A m erican econom y

If this sampling is at

all indicative, the public policies on which we have

has experienced a substantial measure o f prosperity.

relied are being widely questioned.

Real output has increased sharply, job s have been

o f the above group, in fact, went on record for a

created for millions of additional workers, and total

significant change in fiscal policy.

personal income-—both in dollars and in terms of

question whether they favored a variable investment

real purchasing pow er— has risen to the highest levels

tax credit, 46.5 per cent said “ yes,” 40 per cent said

ever reached.
Y et the prosperity has been a troubled one.

“ n o,” and 13.5 per cent expressed “ no opin ion .”

increases have been large and widespread.

M any members
In response to a

Price

Let me turn now to the questions raised in your

F or a

letter and in some other recent discussions about

time, the unemployment rate remained unduly high.

monetary policy.

Interest rates have risen sharply since the spring of

role of money supply in the conduct o f monetary

1972. M ortgage money has recently becom e difficult
to obtain in many comm unities. A n d confidence in

p o lic y ; the extent and significance of variability in

the dollar at home and abroad has at times wavered.

havior of the money supply during 1972-73.


2


I shall discuss, in particular, the

the grow th o f the m oney su p p ly ; and the actual be­

M ONTHLY REVIEW, DECEMBER 1973

Role of M oney Supply
F or many years economists have debated the role
o f the m oney supply in the perform ance of econom ic
systems. O ne school of thought, often termed “ m one­
tarist,” claims that changes in the money supply in­
fluence very importantly, perhaps even decisively, the
pace o f econom ic activity and the level of prices.
M onetarists contend that the m onetary authorities
should pay principal attention to the money supply,
rather than to other financial variables such as inter­
est rates, in the conduct of monetary policy. T hey
also contend that fiscal policy has only a small inde­
pendent impact on the econom y.

econom ic disturbances tend to be self-correcting, and
they therefore argue that a constant or nearly co n ­
stant rate o f grow th of the m oney supply w ould result
in reasonably satisfactory econom ic performance.
But neither historical evidence, nor the thrust of
explorations in business-cycle theory over a long
century, give support to the notion that our econom y
is inherently stable. O n the contrary, experience has
demonstrated repeatedly that blind reliance on the
self-correcting properties of our econom ic system can
lead to serious trouble. D iscretionary econom ic p oli­
cy, while it has at times led to mistakes, has m ore
often proved reasonably successful. T he disappear­
ance of business depressions, which in earlier times

A nother school of thought places less emphasis on

spelled mass unem ployment for w orkers and mass

the m oney supply and assigns m ore im portance to

bankruptcies fo r businessmen, is largely attributable

the expenditure and tax policies of the Federal G ov ­
ernment as factors influencing real econom ic activity

to the stabilization policies of the last thirty years.

and the level of prices. T his school emphasizes the
need for monetary policy to be concerned with interest

econom y tend of themselves to generate business

rates and with conditions in the m oney and capital
markets. Som e econom ic activities, particularly resi­
dential building and State and local governm ent co n ­
struction, depend heavily on borrow ed funds, and are
therefore influenced greatly by changes in the cost
and availability of credit.
In other categories o f
spending— such as business investment in fixed capi­
tal and inventories, and consum er purchases o f dur­
able good s— credit conditions play a less decisive
role, but they are nonetheless important.
M onetarists recognize that monetary policy affects
private spending in part through its impact on interest

T he fact is that the internal w orkings of a market
fluctuations, and m ost m odern economists recognize
this.

F or example, im proved prospects fo r profits

often spur unsustainable bursts o f investment spend­
ing. T he flow of personal incom e in an age of afflu­
ence allows ample latitude fo r changes in discretion­
ary expenditures and in savings rates.

D uring a

business-cycle expansion various imbalances tend to
develop within the econom y— between aggregate in­
ventories and sales, or between aggregate business
investment in fixed capital and consum er outlays, or
between average unit costs of production and prices.
Such imbalances give rise to cyclical m ovements in
the econom y.

F lexible fiscal and monetary policies,

rates and other credit terms. But they believe that
prim ary attention to the grow th o f the m oney supply

therefore, are often needed to cope with undesirable

will result in a m ore appropriate monetary policy
than w ould attention to conditions in the credit

ished by the fact that our available tools o f econom ic
stabilization leave something to be desired.

markets.

T here is general agreement am ong econom ists that,
as a rule, the effects o f stabilization policies occur

Needless to say, monetary policy is— and has long
been— a controversial subject. Even the monetarists

econom ic developments, and this need is not dim in­

do not speak with one voice on monetary policy.

gradually over time, and that econom ic forecasts are
an essential tool o f policy making.
H ow ever, no

Som e influential monetarists believe that monetary
policy should aim strictly at maintaining a constant

econom ist— or school o f econom ics— has a m onopoly
on accurate forecasting. A t times, forecasts based

rate of grow th of the m oney supply. H ow ever, what

largely on the m oney supply have turned out to be

that constant should be, or how broadly the money

satisfactory. A t other times, such forecasts have been

supply should be defined, are matters on which m one­

quite poor, mainly because o f unanticipated changes

tarists still differ.

in the intensity with which the existing m oney stock

A n d there are also monetarists

w ho w ould allow some— but infrequent— changes in
the rate of grow th of the m oney supply, in accordance
with changing econom ic conditions.

is used by business firm s and consumers.
Changes in the rate of turnover o f m oney have
historically played a large role in econom ic fluctu­

It seems self-evident that adherence to a rigid

ations, and they continue to do so.

F or example, the

grow th rate rule, or even one that is changed infre­

narrow ly-defined m oney stock— that is, demand d e­

quently, w ould practically prevent m onetary policy

posits plus currency in public circulation— grew by

from playing an active role in econom ic stabilization.

5.7 per cent between the fourth quarter o f 1969 and

M onetarists recognize this.

the fourth quarter o f 1970.




T hey believe that most

FEDERAL RESERVE BA N K OF RIC H M O N D

But the turnover o f
3

m oney declined during that year, and the dollar value
of G N P rose only 4.5 per cent. In the follow in g
year, the grow th rate o f the m oney supply increased

I recognize that one advantage o f maintaining a
relatively stable grow th rate of the m oney supply is
that a partial offset is thereby provided to unexpected

to 6.9 per cent, but the turnover of m oney picked up
briskly and the dollar value of G N P accelerated to

and undesired shifts in the aggregate demand for

9.3 per cent. T h e m ovem ent out of recession in 1970

as to the em erging strength o f aggregate demand.

into recovery in 1971 was thus closely related to the

m oney grow th is maintained at a rather stable rate,

greater intensity in the use o f money.

good s and services. T here is always some uncertainty
If

O ccurrences

and aggregate demand turns out to be weaker than

such as this are very com m on because the willingness

is consistent with the nation’s econom ic objectives,

to use the existing stock of money, expressed in its

interest rates will tend to decline and the easing o f

rate of turnover, is a highly dynamic force in e co ­

credit markets should help to m oderate the undesired
weakness in demand. Similarly, if the demand fo r

nom ic life.
F or this as well as other reasons, the Federal
Reserve uses a blend of forecasting techniques. T he

goods and services threatens to outrun productive

behavior of the m oney supply and other financial

provide a restraining influence on the supply o f credit
and thus tend to restrain excessive spending.

variables is accorded careful attention.

So also are

the results o f the m ost recent surveys on plant and
equipment spending, consumer attitudes, and inven­

capacity, a rather stable rate of m onetary grow th will

H ow ever, it w ould be unwise for m onetary policy

Recent trends in key producing and

to aim at all times at a constant or nearly constant
rate of grow th of m oney balances. T he m oney grow th

spending sectors are analyzed. T he opinions o f busi­

rate that can contribute m ost to national objectives

nessmen and outside econom ic analysts are canvassed,
in part through the nationwide contacts o f Federal

will vary with econom ic conditions.

Reserve Banks. A n d an assessment is made of the
probable course of fiscal policy, also o f labor-market

usually weak, or if the demand fo r liquidity is unusu­

and agricultural policies, and their effects on the

well above the desirable long-term

econom y.

needed for a time.

tory plans.

E vidence from all these sources is weighed. E fforts

F o r exam ple, if

the aggregate demand fo r good s and services is un­
ally strong, a rate of increase in the m oney supply
trend m ay be

A gain, when the econom y is

experiencing severe cost-push inflation, a m onetary

developments

grow th rate that is relatively high by a historical

through the use of large-scale econom etric models.
A n eclectic approach is thus taken by the Federal

yardstick may have to be tolerated fo r a time. If
m oney grow th were severely constrained in order to

R eserve, in recognition of the fact that the state of

combat the element o f inflation resulting from such a

econom ic know ledge does not justify reliance on any
single forecasting technique. A s econom ic research

cause, it might well have seriously adverse effects on
production and employment. In short, what grow th
rate of the m oney supply is appropriate at any given
time cannot be determined simply by extrapolating

are

also

made

to

assess

econom ic

has cumulated, it has becom e increasingly clear that
money does indeed matter.

But other financial vari­

ables also matter.
In recent years, the Federal Reserve has placed
somewhat m ore emphasis on achieving desired
grow th rates of the monetary aggregates, including

past trends or by som e preconceived arithmetical
standard.
M oreover, for purposes o f conducting monetary
policy, it is never safe to rely on just one concept of

the narrow ly-defined m oney supply, in its conduct

m oney— even if that concept happens to be fashion­

o f monetary policy.

able.

But we have continued to give

A variety o f plausible concepts merit careful

careful attention to other financial indicators, am ong

attention, because a number o f financial assets serve

them the level o f interest rates on m ortgages and

as a convenient, safe, and liquid store o f purchasing

other loans and the liquidity position o f financial
institutions and the general public.

T his is neces­

sary because the econom ic implications of any given
m onetary grow th rate depend on the state of liquidity,
the attitudes of businessmen, investors, and co n ­

power.
T he Federal R eserve publishes data corresponding
to three definitions of m oney, and takes all o f them
into account in determining policy.

T h e three m ea­

sures a re: ( a ) the narrow ly-defined m oney stock
( M i ) , which encompasses currency and demand de­

sumers tow ard liquidity, the cost and availability o f

posits held by the nonbank p u b lic;

borrow ed funds, and other factors.

A lso , as the

broadly-defined money stock ( M 2) , which also in­

nation’s central bank, the Federal R eserve can never

cludes time and savings deposits at com m ercial banks

(b )

a m ore

lose sight of its role as a lender of last resort, so that

(other than large negotiable time certificates o f de­

financial crises and panics will be averted.

posits) ; ( c ) a still broader definition ( M 3) , which


4


M ONTHLY REVIEW, DECEMBER 1973

includes savings deposits at mutual savings banks and
savings and loan associations. A definition em brac­
ing other liquid assets could also be justified— for
example, one that would include large-denomination
negotiable time certificates o f deposit, U . S. savings
bonds and Treasury bills, com m ercial paper, and
other short-term m oney market instruments.

requirements set by the Federal Reserve. A s a result
there is some slippage in monetary control. F urther­
m ore, since deposits at nonm em ber banks have been
reported for only tw o to four days in a year, in co n ­
trast to daily statistics for member banks, the data
on the money supply— which we regularly present
on a weekly, monthly, and quarterly basis— are esti­

There are many assets closely related to cash, and
the public can switch readily am ong these assets.

mates rather than precise measurements. W h en the
infrequent reports from nonm ember banks becom e

H ow ever m oney may be defined, the task of deter­

available, they often necessitate considerable revisions
of the money supply figures. In the past tw o years,

mining the amount of m oney needed to maintain high
employment and reasonable stability o f the general
price level is com plicated by shifting preferences o f
the public for cash and other financial assets.

the revisions were upward, and this may happen
again this year.
Som e indication of the extent of short-term vari­
ations in the recorded money supply is provided be­

Variability of M oney Supply Growth

low.

Table I shows the average and m axim um devi­

In the short-run, the rate o f change in the observed

ations (w ithout regard to sign) o f M i from its aver­

m oney supply is quite erratic, and cannot be trusted
as an indicator of the course of monetary policy.

age annual grow th rate over a three and a half year

This w ould be so even if there were no errors o f
measurement.

ation diminishes as the time unit lengthens; it is
much larger for monthly than for quarterly data, and
is also larger for quarterly than for semi-annual data.

The record of hearings held by the Joint E conom ic
Committee on June 27, 1973 includes a memorandum

period.

A s w ould be expected, the degree o f vari­

which I submitted on problem s encountered in co n ­

Table I

trolling the m oney supply. A s indicated there, weekto-week, m onth-to-m onth, and even quarter-to-

DEVIATIONS IN M, FROM ITS AVERAGE RATE

quarter fluctuations in the rate of change o f money

OF GROWTH, 1970 THRU MID-1973

balances are frequently influenced by international
Annual Rates of Change in per cent

flow s o f funds, changes in the level of U. S. G overn­

A verage
Deviation

M axim um
Deviation

M onthly

3.8

8.8

Q uarterly

2.4

5.5

Because the demands of the public for money are
subject to rather wide short-term variations, efforts

Sem i-annual

1.8

4.1

by the Federal R eserve to maintain a constant grow th

In our judgm ent, there need be little reason for
concern about the short-run variations that occur in
the rate of change in the m oney stock. Such vari­

ment deposits, and sudden changes in the public’s
attitude towards liquidity. Som e of these variations
appear to be essentially random— a product o f the
enorm ous ebb and flow o f funds in our modern econ ­
omy.

rate of the money supply could lead to sharp shortrun swings in interest rates and risk damage to finan­
cial markets and the econom y.

Uncertainties about

financing costs could reduce the fluidity of markets

Form of Data

ations have minimal effects on the real econom y. F or
one thing, the outstanding supply of m oney is very

and increase the costs of financing to borow ers. In
addition, wide and erratic movements o f interest

large. It is also quite stable, even when the short-run

rates and financial conditions could have undesirable

outstanding supply of M i, seasonally adjusted, was

effects on business and consum er spending.

about $264 billion.

These

rate o f change is unstable.

This O ctober the average

O n this base, a monthly rise or

adverse effects may not be o f m ajor dimensions, but

fall in the money stock of even %2y2 billion would

it is better to avoid them.

amount to only a 1 per cent change.

But when such

In any event, for a variety o f reasons explained in

a tem porary change is expressed as an annual rate,

the mem orandum for the Joint E conom ic Committee,

as is now com m only done, it com es out as about 12

to which I have previously referred, the Federal R e ­

per cent and attracts attention far beyond its real

serve does not have precise control over the money

significance.

supply. T o give one example, a significant part of
the money supply consists o f deposits lodged in

carefully the econom ic implications of variability in

nonm ember banks that are not subject to the reserve

M i grow th.




T he Federal R eserve research staff has investigated
T he experience of the past tw o decades

FEDERAL RESERVE BANK OF RIC H M O N D

5

suggests that even an abnormally large or abnormally
small rate of growth of the money stock over a period
up to six months or so has a negligible influence on
the course of the econom y— provided it is subse­
quently offset.

Such short-run variations in the rate

of change in the money supply may not at all reflect

o f 1972. A lso, the grow th of M i, which on a m onthend basis appears very erratic in the first three quar­
ters of 1973, is much m ore stable on a quarterly
average basis. F or example, while the level o f M i
did not expand significantly between June and Sep­
tember, the quarterly average figures indicate further

Federal Reserve policy, and they do not justify the
attention they often receive from financial analysts.

sizable grow th in the third quarter.

T he thrust of monetary policy and its probable
effects on econom ic activity can only be determined

that the m oney available for use wras appreciably

by observing the course o f the money supply and of
other monetary aggregates over periods lasting six
months or so.
Even then, care must be taken to
measure the grow th of money balances in ways that
temper the influence of short-term variations.

F or

F or purposes o f

econom ic analysis, it is an advantage to recognize
larger in the third quarter than in the second quarter.
Experience of 1972-73
D uring 1972, it was the responsibility o f the F ed ­
eral Reserve to encourage a rate of econom ic expan­
sion adequate to reduce unemployment to acceptable

example, the grow th of m oney balances over a quarter

levels.

can be measured from the amount outstanding in the
last month of the preceding quarter to the last month
of the curent quarter, or from the average amount
outstanding during the preceding quarter to the aver­

effects of the w age-price control program , inflationary

age in the current quarter.

The first measure cap­

These objectives were to some extent conflicting, and

tures the latest tendencies in the m oney supply, but
may be distorted by random changes that have no
lasting significance. T he second measure tends to

monetary policy alone could not be expected to cope
with both problem s.
Continuation of an effective

average out tem porary fluctuations and is comparable

straint were urgently needed.
The narrow ly-defined money stock increased 7.4

to the data provided on a wide range o f non-m onetarv
econom ic variables, such as the gross national product
and related measures.
A com parison o f these tw o ways of measuring the

A t the same time, despite the dampening

pressures were gathering. M onetary policy, therefore,
had to balance the twin objectives of containing infla­
tionary pressures and encouraging econom ic growth.

w age-price program and a firm er policy o f fiscal re­

per cent during 1972 (m easured from the fourth
quarter of 1971 to the fourth quarter of 1972). B e­
tween the third quarter of 1972 and the third quarter

rate of grow th in M i is shown in Table II for succes­
sive quarters in 1972 and 1973. T he first colum n,

of 1973, the grow th rate was 6.1 per cent.

labeled M , shows annual rates calculated from endrnonths of quarters; the second colum n, labeled O .
shows annual rates calculated from quarterly aver­

clined to 5.8 per cent, and a further slow ing occurred
in the third quarter.

ages.

rates would require full analysis of the econom ic and
financial objectives, conditions, and policies during
the past tw o years, if not longer. Such an analysis

Table II

B y the

first half of 1973, the annual grow th rate had d e­

Evaluation of the appropriateness of these growth

GROWTH RATES OF MONEY SUPPLY

cannot be undertaken here.
Som e perspective on
m onetary developments during 1972-73 may be

O N TWO BASES

gained, however, from com parisons with the exp eri­

Annual Rate of Change, in per cent
M
1

9 .2

5 .3

1
1

1972

Q

6.1

8 .4

III

8 .2

8 .0

IV

8 .6

7 .1

ence of other industrial countries, and by recalling
briefly how domestic econom ic conditions evolved
during this period.
Table III com pares the grow th of M i in the United
States with that of other industrial countries in 1972
and the first half of 1973.

T he definitions of M i

differ somewhat from country to country, but are as

1

1 .7

4 .7

nearly com parable as statistical sources permit.

I
I

1 0 .3

6 .9

goes without saying that each country faced its own

III

1973

0 .3

5.1

set of econom ic conditions and problems.

It

Y et it is

useful to note that m onetary grow th in the United
A s may be seen, the quarterly averages disclose

States was much low er than in other m ajor industrial

much m ore clearly the developing trend of monetary

countries, and that it also was steadier than in the

restraint— which, in fact, began in the second quarter

other countries.


6


MONTHLY REVIEW, DECEMBER 1973

Table III

ANNUAL PER CENT RATES OF GROWTH
IN M O NEY SUPPLY
4tn Q uarter 1971 to
4th Q uarter 1972

United States

4th Quarter 1972 to
2nd Q uarter 1973

7.4
14.1

United K ingdom
G e rm an y
France
Japan

until Novem ber that the unem ployment rate dropped
below Sl 2 per cent. F o r the year as a whole, the
/
unemployment rate averaged 5.6 per cent. It may
be o f interest to recall that unem ployment averaged
5.5 per cent in 1954 and 1960, w hich are com m only
regarded as recession years.

5.8

14.3
15.4
23.1

Since the expansion of M i in 1972 was low rela­

10.0
4.2
8.7
28.2

tive to the demands for m oney and credit, it was
accompanied

by

rising

short-term

interest

rates.

L ong-term interest rates showed little net change
last year, as credit demands were satisfied mainly in
the short-term markets.

T he next table shows, in summary fashion, the
rates of change in the money supply of the United
States, in its total production, and in the consum er
price level during 1972 and 1973. The table is based

In 1973, the grow th o f M x moderated while the
transactions demands for cash and the turnover of
money accelerated. G N P in current dollars rose at a

It may be noted, in passing, that,

12 per cent annual rate as prices rose m ore rapidly.
In credit markets, short-term interest rates rose

according to data available as late as January 1973,

sharply further, while long-term interest rates also

the rate of grow th of M i during 1972 was 7 .2 % ,

m oved up, though by substantially less than short­
term rates.

on the latest data.

not 7 .4 % ; and that the rate of increase in real G N P
was 7 .7 % , not 7 .0 % .

In other words, on the basis

of the data available during 1972, the rate of growth
of M i was below the rate of grow th o f the physical
volume of over-all production.

T he extraordinary upsurge of the price level this
year reflects a variety o f special influences. First,
there has been a w orld-w ide econom ic boom super­
im posed on the boom in the United States. Second,
we have encountered critical shortages o f basic m a­
terials. T he expansion in industrial capacity needed

Table IV

MONEY SUPPLY, GNP, AND PRICES IN THE U. S.
(Per cent change at annual rates)

to produce these materials had not been put in place
earlier because of the abnormally low level of profits
between 1966 and 1971 and also because of num erous
impediments to new investment on ecological grounds.

4th Quarter
1971 to
4th Q uarter
1972

M o n e y sup ply (M i)

7.4

4th Quarter 1972 to
2nd Quarter
of 1973

3rd Quarter
of 1973

5.8

5.6

11.7
4.8

12.1

5.4

Prices
Consum er price
index (CPI)
CPI excluding
food

result of crop failures in many countries last year.
Fourth, fuel prices spurted upward, reflecting the
developing shortages in the energy field. A n d fifth,
the depreciation of the dollar in foreign exchange

G ross N atio n al Product
Current dollars 10.6
Constant dollars 7.0

T hird, farm product prices escalated sharply as a

markets has served to boost prices o f im ported goods
and to add to the demands pressing on our prod u c­
tive resources.
In view of these pow erful special factors, and the
cyclical expansion of our econom y, a sharp advance in

3.4

7.1

7.8

our price level w ould have been practically inevitable
in 1973. The upsurge o f the price level this year

3.0

4.0

4.1

hardly represents either the basic trend of prices or
the response of prices to previous monetary or fiscal

T he table indicates that grow th in M i during 1972

policies— whatever their shortcom ings may have been.

and 1973 approxim ately matched the grow th o f real

In particular, as the above table shows, the explosion

output, but was far below the expansion in the dollar

o f food prices that occurred this year is in large part

value of the nation’s output.

responsible for the accelerated rise in the over-all

A lthough monetary

policy limited the availability of money relative to

consumer price level.

the grow th of transactions demands, it still encour­

T he severe rate of inflation that we have exp eri­

aged a substantial expansion in econom ic a ctiv ity ;

enced in 1973 cannot responsibly be attributed to

real output rose by about 7 per cent in 1972.

monetary management or to public policies m ore gen ­

so,

unemployment

remained

unsatisfactorily

throughout the greater part of the year.



Even
high

It was not

erally.

In retrospect, it may well be that monetary

policy should have been a little less expansive in

FEDERAL RESERVE BA N K OF RIC H M O N D

7

1972. But a markedly more restrictive policy w ould
have led to a still sharper rise in interest rates and
risked a premature ending of the business expansion,

demand deposits at com m ercial banks on a uniform

without limiting to any significant degree this year’s

It is important for the Congress to put an end to

upsurge of the price level.

basis from the standpoint o f reserve requirements.
Im provem ents in our fiscal policies are also needed.
fragmented consideration of expenditures, to place a
firm ceiling on total Federal expenditures, and to

Concluding Observations

relate these expenditures to prospective revenues and

T he present inflation is the most serious econom ic
problem facing our country, and it poses great d iffi­
culties for econom ic stabilization policies. W e must

the nation’s econom ic needs.

recognize, I believe, that it will take some time for
the forces of inflation, which now engulf our econom y
and others around the w orld, to burn themselves out.
In today’s environment, controls on wages and prices
cannot be expected to yield the benefits they did in
1971 and 1972, when econom ic conditions were much
different. Prim ary reliance in dealing with inflation
— both in the near future and over the longer t e r m wili have to be placed on fiscal and monetary policies.
T he prospects for regaining price stability would
be enhanced by improvements in our m onetary and

Fortunately, there is

now widespread recognition by members of Congress
of the need to reform budgetary procedures along
these broad lines.
It also is high time for fiscal policy to becom e a
more versatile tool of econom ic stabilization. P a r­
ticularly appropriate would be fiscal instruments that
could be adapted quickly, under special legislative
rules, to changing econom ic conditions— such as a
variable tax credit for business investment in fixed
capital. O nce again I w ould urge the Congress to
give serious consideration to this urgently needed
reform .
W e must strive also fo r better understanding o f the

fiscal instruments. T h e conduct of monetary policy
could be im proved if steps were taken to increase

effects of econom ic stabilization policies on econom ic
activity and prices. O u r knowledge in this area is

the precision with which the money supply can be

greater now than it was five or ten years ago, thanks
to extensive research undertaken by econom ists in

controlled by the Federal Reserve.

Part o f the

present control problem stems from statistical inade­
quacies— chiefly the paucity of data on deposits at
nonm ember banks.

A lso, however, control over the

academic institutions, at the Federal Reserve, and
elsewhere. T he keen interest of the Joint E conom ic

m oney supply and other monetary aggregates is less

Committee in im proving econom ic stabilization p oli­
cies has, I believe, been an influence of great im por­

precise than it can or should be because nonm ember

tance in stimulating this widespread research effort.

banks are not subject to the same reserve require­
ments as are Federal R eserve members.
I hope that the Congress will support efforts to

Committee in an effort to achieve the kind o f e co ­
nom ic perform ance our citizens expect and deserve.

I look forw ard to continued cooperation with the

rectify these deficiencies. F or its part, the Federal
R eserve Board is even now carrying on discussions
with

the

Federal

Deposit

Insurance

Sincerely yours,

Corporation

about the need for better statistics on the nation’ s
m oney supply. T h e B oard also expects shortly to
recom m end to the Congress legislation that will put


8


M ONTHLY REVIEW, DECEMBER 1973

A rth ur F . Burns

Evolution of the Concept of the
Demand for Money
T he concept of the demand fo r m oney is one o f
the

m ore

fundamental

elements

of

supply.

An

erratically

shifting

demand

function

contem porary

might offset the effect o f a controlled shift in the

m acroeconom ic analysis. T his concept refers to the
functional relationship, often expressed as a mathe­

m oney supply at one time yet accentuate it at another.
H aving no firm grasp on the demand function, p olicy­

matical equation, between the quantity of m oney that
people demand to hold and the variables (e.g., inter­

makers could not hope to assess correctly the m agni­

est rates, income, wealth, etc.) on which that quantity

O ver the past tw o decades the demand fo r m oney
has been the subject of many ingenious and com plex

depends. D em and-for-m oney equations are key co m ­
ponents of current theoretical and empirical models
of the aggregate econom y.

F or example, such equa­

tude or direction of the effects o f their policy actions.

theoretical and empirical studies.
thus, however.

It was not always

O w in g to the strategic im portance o f

tions are used to represent the behavior o f the d e­

the m oney demand function, one might assume that

mand side o f the so-called “ m oney-market sector” in

there had been an early emergence o f a sophisticated

large-scale econom etric models em ployed in simulat­
ing the influence of policy actions and other changes
on the econom ic system. In these models, m oney de­

analysis of it. It seems reasonable to expect that the
techniques

and

standards

applied

in

dem and-for-

m oney constructions at least w ould have matched

mand equations help to determine the solution (eq u i­

those em ployed in ordinary com m odity demand anal­

librium ) values of national income, interest rates, the

ysis.

price level, and other measures of aggregate econom ic

the methods o f monetary demand analysis differed
from those o f traditional demand theory.

activity.

Such was not the case, however, and fo r years

T h e chief reason for econom ists’ interest in the

B y the turn of the century, com m odity demand

dem and-for-m oney relationship, however, is its prac­

analysis was firm ly anchored in the theory o f utility-

tical policy implications.
M acroeconom ic analysis
suggests that certain properties of the m oney demand

m axim izing behavior— part o f the general theory of
rational choice.
T he utility-m axim ization analysis

function may critically influence the degree o f effec­

provided economists with a set of pow erful analytical
techniques that were em ployed systematically in iden­

tiveness o f monetary policy.
Especially im portant
are ( 1 ) the interest rate elasticity of the demand for
money, i.e., the responsiveness or sensitivity o f the
quantity of money demanded to changes in market in­
terest rates and ( 2 ) the stability of the functional
relationship between m oney balances demanded and

tifying both the general form and the principal inde­
pendent variables o f com m odity demand functions.
B y contrast, techniques o f m icroeconom ic value
theory were not introduced into monetary analysis
until the m id-1930’s, and even then their application

the independent variables (interest rates, income,
etc.) of the equation. F or example, if the amount of
money demanded is extrem ely interest elastic, m one­

was incomplete.

tary policy may be powerless to stimulate the econ ­

ysis. One unfortunate consequence of this delay was
that for years monetary theorists virtually ignored,

om y because, in this case, the slightest fall in the rate

N ot until the 1950’s was money

demand analysis fully integrated into the rational
choice fram ew ork em ployed in ordinary demand anal­

of interest, resulting from a policy engineered expan­

or at least did not exam ine systematically, the influ­

sion of the m oney stock, would simply induce cash

ence o f cost and yield considerations on m oney-

holders to absorb all the new m oney into idle hoards.

holding decisions.

Consequently, no increase in expenditure w ould en­

W h y were econom ists so slow

in applying the

sue. Even if the demand for money is not excessively

methods and procedures

responsive to interest rate changes, however, policy­

ysis to m oney?

makers may still be confronted with the problem of

cedures consist of and how did m oney demand theory

an unstable demand relationship. Instability o f the
m oney demand function w ould hinder monetary p oli­

depart from them ?

cy by making it difficult for the authorities to predict

counterparts?

the impact of policy-induced changes in the money

sition from the older approaches to the current ones,




of traditional demand anal­

W h at did these methods and p ro ­
H o w did the older approaches

to the demand for m oney differ from their current

FEDERAL RESERVE BA N K OF RIC H M O N D

W h at were the main stages o f tran­

9

and how did this development manifest itself in suc­
cessive form ulations o f the m oney demand fu n ction ?
W h a t explanatory variables were stressed in each
form ulation? M ost important, what were the chief

these variables are the substitution and incom e effects,
the tw o main forces influencing the amount o f any
good demanded by an individual. T he substitution

policy implications of the alternative v iew s?
This
article seeks to answer these questions by tracing
against the backdrop o f orth od ox demand analysis

follow ing a change in relative prices, which, by alter­
the substitution of relatively cheaper fo r relatively

the main lines of development of the theory o f the
demand for m oney from the early decades of the

dearer good s in the consum er’s budget. T he incom e
effect refers to the demand impact of a price-induced

century to the present. T h e basic m ethod em ployed
in ordinary demand analysis is outlined in the fo l­
low ing section, which then serves as a point o f refer­

change in the real purchasing pow er o f the individ­

ence for the remainder o f the article dealing with the

of a single g oo d has the effect of increasing the co n ­

effect refers to the shift in expenditure patterns
ing the rates of exchange am ong com m odities, induces

ual’s total budget, which alters his entire range o f
alternatives.

F o r example, the low ering o f the price

study o f dem and-for-m oney relationships.

sumer’s effective budget, thereby expanding his field

Conventional Demand Analysis

o f choice and thus influencing his demand fo r all
com m odities including the particular g ood in question.

C o m m o d ity d e ­

mand analysis is founded on the theory o f rational
choice, or optim izing (i.e., constrained utility-m axi­
m izing) behavior.

T he analysis begins at the level

of the individual consum er and seeks to deduce how
he will allocate his limited m oney resources— the socalled budget constraint— am ong the various goods
available to him at given market prices in such a way
as to m axim ize his total satisfaction or utility. T he
conclusion is that he will apportion his budget in such
a w ay that the rate at which he can substitute one
good for another via market exchanges is just equal
to the rate at which he is willing to d o so (h is sub­
jective tra d e -o ff).

T he next stage o f the analysis is to derive the
market demand function by aggregating over all the
individual demand functions.
In general, relative
prices and incom e will also be the chief arguments in
the market demand functions.

T h e im portant point,

however, is that the analysis proceeds from the level
o f the individual decision-m aking unit to the m a rk et;
market demand functions follow from individual d e­
mand functions.
Finally, in the last stage o f the
analysis, the market demand and market supply equa­
tions are solved simultaneously to determine the
market clearing levels of price and output.
T o summarize, traditional demand analysis: ( 1 ) is

In principle, the individual’ s demand function for
any com m odity can be derived from this analysis of
budget-constrained utility-maxim ization. T he result­
ing demand functions indicate the relationships be­
tween the quantities demanded o f the g ood s and the
variables on which those quantities depend.

W ith

tastes and preferences given, the individual’ s demand
for any com m odity will depend chiefly on tw o sets of
variables: ( 1 ) relative prices (the price o f the good

based on the principle of optimization or rational
choice, ( 2 ) starts at the level o f the individual deci­
sion-m aking agent and then proceeds, via aggrega­
tion, to the market level, and ( 3 ) predicts that d e­
mands will be largely determined by relative prices
and incom e constraints.
The Demand for M oney— Transactions Velocity

in question in com parison with the prices o f all other

Approach
T o the m od ern e co n o m ist, it seem s
natural to construct dem and-for-m oney equations in

goods that com pete for the consum er’ s expenditure)

exactly the same way that com m odity demand equa­

and

T he relative price variables represent the

tions are formulated. T h e analysis begins at the level
of the individual m oney holder, determines the appro­

terms in which one g ood can be substituted for

priate budget constraint and the relevant opportunity

(transform ed

ex­

cost or relative price variables that enter his demand-

T hese variables also measure the op p or­

for-m oney function, and derives via aggregation the

tunity costs of obtaining one g ood in terms of the

total market dem and-for-m oney function. T h e analy­

(2 )

straint).

changes.

the consum er’s incom e

in to)

other

(his budget co n ­

goods

via

market

amounts of other good s w hose purchase must be

sis then proceeds to investigate both the substitution

sacrificed or foregone.

T he remaining variable, in­

effects between m oney and com peting assets stem­

come, indicates the individual’s com m and over all

m ing from changes in relative (com parative) rates o f

goods

and

return and the incom e (o r w ealth) effects on the

thus serves to fix an upper limit on the amount of

demand fo r m oney stemming from changes in na­

the com m odity he can purchase.

tional income.

(the purchasing pow er of his budget)

Relative price and

incom e variables play stra­

tegic roles in demand analysis.

10


O perating through

T his conventional approach is of relatively recent
origin, how ever.

M ONTHLY REVIEW, DECEMBER 1973

U p through the early decades of

the twentieth century, econom ists as a rule did not
examine the demand for m oney along the lines o f
orth od ox demand theory. Rational choice principles,
or utility-maxim ization analysis, it was argued, could
not explain w hy any individual would want to hold
money, because cash holdings as such were believed
to produce no direct satisfaction.

In short, money

the product of the average stock o f m oney, M , and
the average number o f times each unit o f m oney turns
over in financing exchanges (v e lo c ity ), V — must
equal the aggregate value of transactions, P T — the
product of the total number of transactions, T , and
the average price per transaction, P.

was view ed as just a mechanical medium o f exch ange,

Fisher argued that the transactions velocity o f
m oney was determined by slow ly changing techno­

i.e., something used to facilitate market transactions
and to circulate goods, but not in itself a utility-

logical and institutional factors, e.g., state o f develop­
ment o f the banking system, frequency o f receipts and

yielding asset.
T he distinguishing feature of a medium o f e x ­

disbursements, length of the payment period, degree
o f synchronization o f cash inflows and outflows,

change is that it is transferred or circulated, not that
it is held. A ccordin gly, theories that focus exclu ­

rapidity o f transportation and comm unication, etc.

sively on the m edium -of-exchange function o f m oney
tend to ignore the demand fo r m oney p er se and
instead concentrate on how fast money circulates from
hand to hand. T his interest in the circidation v elocity,
or rate of use, o f m oney was particularly character­
istic of most nineteenth and early twentieth century
monetary theorists.
T hese analysts pointed out that the efficiency with

Since these factors were subject to only gradual,
evolutionary change, velocity could be considered a
virtual constant in the equation o f exchange.
T he constancy of velocity implies the com plete
stability o f the demand fo r m oney. A n d with the
latter absolutely stable, monetary policy could be
expected to exert a pow erful, predictable influence
on prices and nominal income. U sing the equation o f
exchange, Fisher demonstrated the potential potency

which m oney facilitates exchanges depends on how

o f monetary policy in this stable demand case.

rapidly it circulates in market transactions.

velocity, V , a constant, and transactions, T , also
assumed to be a constant determined by the full-

In the

limit, the turnover velocity of a perfectly efficient
medium o f exchange w ould approach infinity; and
the demand for cash balances correspondingly w ould
approach zero. It was, of course, recognized that
perfect efficiency in circulation is never achieved,
that velocity is necessarily finite, and that people often'

W ith

capacity utilization o f the econ om y’s productive re­
sources, the equation could be expressed in a form ,
P = ( V / T ) M — (con stan t) M , showing a constant
proportional relationship between average prices and
the m oney stock.

T his expression implied that a

maintain inventories of idle cash fo r sustained inter­

given percentage change in the m oney stock w ould

vals of time. T he existence of positive cash balances,

cause the same percentage change in the price level.

however, was attributed not to rational choices and
utility-m axim izing decisions but rather to institu­

The Cambridge Cash Balance Approach

tional “ frictions” in the econom ic system.

In sum,

initial step in m oving the theory of the demand for

the rate of circulation of m oney— and by implication

money in the direction o f ordinary demand analysis
was taken simultaneously by several Continental and

the dem and-for-m oney balances— was thought to be
determined by technological and institutional factors
associated with the aggregate payments mechanism
rather than by the subjective processes of individual
decision-making.
Consequently, analysis tended to
center on statistical measures of the aggregate trans­
actions velocity o f m oney, rather than on cost and
yield considerations affecting the m oney-holding
choices of individual optimizers.

The

British economists. A m on g the m ore influential o f
these analysts was the small grou p associated with
Cam bridge U niversity in England. In a series o f
writings spanning the period 1917-1930, econom ists
o f the Cam bridge school contributed at least four
innovations to m onetary analysis, thereby advancing
it beyond F isher’s transactions velocity form ulation.
T h e first innovation was to concentrate on m oney

T he leading exponent of the transactions velocity

in relation to final output, or national income, rather

approach was the A m erican economist, Irving Fisher,

than on the much broader and m ore inclusive aggre^

whose principal w riting in the field of monetary

gate, total transactions.

theory, T he Purchasing P o w e r of M o n ey , appeared

attention to the properties that make m oney a desir­

T his innovation directed

in 1911. Fisher did not write out an explicit demand-

able ob ject to hold as distinct from an object to spend.

for-m oney function.

Instead, he examined the be­

A s long as one associates m oney with gross trans­

havior o f velocity within the fram ework of his cele­

actions, one necesarily tends to think o f m oney e x ­

brated equation of exchange, M V =

PT.

This fo r ­

mula is an identity stating that total spending, M V —



clusively as a means o f exchange.

B y recasting the

analysis in terms of income, rather than transactions,

FEDERAL RESERVE B A N K OF R IC H M O N D

11

however, the Cam bridge school opened up the possi­
bility of interpreting m oney as something m ore than
just a medium o f exchange.

equal m oney demand, M s = M d, resulting in the
cash balance equation, M = kP y.

W ith emphasis shifting from transactions to in ­

plicitly stated a rudimentary m oney demand function
and drew the demand curve corresponding to it.

com e, F isher’s equation of exchange was eventually
restated as M V y = P y = Y , where M is the stock
of m oney in circulation, Y is nominal national income,
y is real income or the national product valued at
constant prices, P is the price level of the national
product, and V y is the incom e velocity o f money, i.e.,

A s a fourth innovation, Cam bridge econom ists e x ­

F rom the assumption that the com m unity w ould
wish to hold a constant quantity o f real (p rice deflated) cash balances at the full-capacity level o f
real output, an expression was derived showing the

the ratio of nominal national incom e to the money

quantity of nominal balances demanded, M , as a
function of the exchange value of the monetary

stock or, alternatively, the rate of turnover o f money
as it circulates against the national product. A few

unit (i.e., the reciprocal o f the price level, 1 / P ) .
A dm ittedly an artificial construct, this particular d e­

analysts, particularly in the United States, began to
use this equation to investigate the behavior of incom e

mand equation expressed the product of the tw o
variables M and 1 /P as a fixed constant. Real in­

velocity. T he Cam bridge school, however, fo r the
most part generally eschewed analysis of m oney’ s

com e and the m on ey /in com e ratio— the other factors
that conceivably could m fluence the demand for

circulation velocity and instead focused on the famous

m oney— w ere interpreted as fix ed parameters in the

“ Cam bridge k ,” i.e., the desired ratio, k, o f money

function.

balances to income.

graphed in the Cartesian plane, with nominal m oney
balances demanded, M , measured along the horizontal

In other w ords, the Cambridge

school sought to explain the proportion of annual
incom e that the com m unity of decision makers wished
to hold in the form of m oney, not how rapidly m oney

T he function was of a special fo r m : when

axis and the exchange value o f m oney, 1/ P , along the
vertical axis, the equation described a dow nw ard-

turns over in buying the national product.

sloping rectangular hyperbola.

This focus on the cash balance ratio was the second
novelty of the Cam bridge approach that ultimately

coordinates of each point on this demand curve would

led to a m ore conventional interpretation o f the de­

T he product o f the

be the same and equal to the constant quantity o f real

1/V y.

balances demanded, M /P . T his special demand curve
was used by the Cam bridge school to demonstrate the
validity o f the quantity theory o f m oney. T he quan­

But the k ratio implies a desired holding o f m oney

tity theory asserts that, because people look to the

balances, and is thus m ore suggestive o f conventional

purchasing pow er rather than to the mere money

demand theory than is V y, the rate of spending o f
money. T he Cam bridge emphasis on cash holdings

value of their cash balances, the price level w ould
have to vary in direct proportion to the nominal

suggested that m oney might be a utility-yielding as­

m oney supply to maintain real balances intact.

set, and also that the demand for money, like the
demand for any com m odity, is a matter o f individual

bridge form ulation, however.

mand for money. Form ally, k is just the reciprocal of
the incom e velocity o f circulation, i.e., k =

choices and decisions.

O ne crucial element was m issing from the Cam ­
T here was nothing in

A s a third innovation, the Cambridge school re­

the m oney demand equations analogous to the rela­
tive price arguments that appear in ordinary demand

form ulated the equation o f exchange in a manner

functions. N o variables entered the Cambridge equa­

more consistent with orth od ox demand and supply

tions to represent the opportunity costs of cash hold­

analysis.

T his step involved replacing the symbol

ings, i.e., the yields on alternative non-m onetary

for the incom e velocity of money with its reciprocal,

assets.

the Cam bridge k, and then incorporating the latter

for m oney to respond to changes in these costs or

into the Cam bridge cash balance equation M =

yields.

kP y.

Y et one norm ally w ould expect the demand
F or example, if cash holders behaved ratio­

T h e cash balance equation was interpreted as the

nally, a rise in interest rates w ould probably induce a

equilibrium solution o f a three-equation dem an d /

fall in k (the cash balance ratio) as people sought to

supply system, rather than as a simple identity as had

econom ize on cash holdings and to substitute interest

been the equation of exchange.

earning assets for m oney balances in their asset p ort­

Specifically, the

Cam bridge form ulation implies ( 1 )

a dem and-for-

folios.

Similarly, falling interest rates, by low ering

k P y with the incom e co n ­

the opportunity cost o f holding m oney relative to the

straint, P y = Y , appearing as an explicit independent

brokerage costs o f converting it into and out o f bonds,

variable;

w ould m ost likely cause a rise in the cash balance

m oney equation M d =
(2 )

supply M g =

an exogenously

determined

m oney

M ; and ( 3 ) an equilibrium (m arket-

clearing) condition stating that m oney supply must

12


ratio.

Strangely, how ever, there was no explicit

recognition of any yield or substitution effects in the

MONTHLY REVIEW, DECEMBER 1973

Cambridge equations.

Instead, the Cambridge k

ratio was treated as a numerical constant rather than
as a variable whose magnitude is functionally related
to rates of return on non-cash assets, i.e., k =

k (r ).

A pparently the failure to include interest rates as a
determinant of m oney demand stemmed from the
C am bridge sch ool’s inability to see the full im plica­
tions of its analytical approach. A fter constructing a
fram ework conducive to the study of factors influenc­
ing cash-holding decisions,

Cambridge economists

failed to exploit this innovation fully.

T rue, one can

K eynes’s Formulation A s p re v io u s ly m en tion ed ,
the main shortcom ing of the Cambridge cash balance
analysis was its failure to incorporate yield or cost
variables into the money demand function.
This
oversight was partially rectified in John M aynard
K eynes’s analysis o f the speculative or liquidity
preference demand for money, presented in his 1936
classic, T he General T h eory of E m ploym ent, Interest,
and M on ey.
Keynes separated the demand for money into tw o
distinct p a rts : ( 1 )

a demand for transactions or

find in the writings of the Cambridge school refer­

active balances to satisfy the transactions and pre­
cautionary motives for holding cash and ( 2 ) a d e­

ences to a representative individual striking a balance

mand for idle or asset balances to satisfy a speculative

between his holdings of cash and non-cash assets as

motive.

well as some mention of trade-offs between costs and

M 2, respectively.

Keynes labeled these tw o demands M i and

returns (convenience, safety, etc.) on cash holdings.

It was in conjunction with the speculative demand

But such passages were infrequent, and the insights

that he gave explicit consideration to the yields on

they contain were never incorporated systematically

assets that com pete with money in individuals’ p ort­

into the Cam bridge analysis.

folios.

F or the most part,

Cambridge economists, when describing the determ i­
nants of k, referred to the same technological-institu­
tional factors that Fisher had cited in his discussion
of velocity.
T he constancy of k in the Cambridge analysis had
the same policy implications as the invariability of
velocity in F isher’s theory.

Keynes argued that individuals make their

cash-holding decision by com paring the interest in­
com e that w ould be sacrificed by holding money with
the expected capital gain or loss on holding bonds.
The latter depends on decision makers’ anticipations
of future movements in bond prices and the degree o f
certainty with which those expectations are held.
A ccord in g to Keynes, these anticipations are form u ­

Both implied stability of

lated via com parisons of the current rate o f interest

the dem and-for-m oney function and thus the powerful

with some expected “ norm al” or permanently main­

influence of monetary policy on prices and nominal

tainable rate. If the observed rate is above the normal

incomes.

rate, individuals will expect it to fall. Since bond
prices vary inversely with bond yields, however,

A ccord in g to the Cambridge analysis, the

impact of policy-induced changes in the m oney supply
w ould not be weakened or negated by perverse or
unexpected shifts in the demand for m oney. T o the
contrary, the constant desired k ratio was interpreted
as a reliable strategic link in the transmission m ech­
anism connecting m oney to prices. Thus, any in­

anticipations of falling interest rates mean expecta­
tions of rising bond prices and thus capital gains.
The higher the current rate of interest the greater
the amount o f capital gains expected. W h y ? Because
the larger the spread between the current and e x ­
pected maintainable rates, the greater the likelihood

crease in the m oney supply would, first, raise the
actual m on ey/in com e ratio above the desired level ;
actual k w ould be greater than desired k. Then, in­
dividuals, finding that they were holding more cash
than they wanted in relation to their incomes, would
increase spending. T he increased expenditure in a

that the interest
and the greater
pected to fall.
the m ore costly
expected capital

fully em ployed econom y w ould push up market prices,

incom e foregone.

thereby raising nominal income.

This increased rate

the quantity of cash demanded to satisfy the specu­

of spending w ould continue until the subsequent rise

lative motive.
Conversely, if the observed rate is below the e x ­

in the price level and nominal income was sufficient

rate will fall (b on d prices will rise ),
the amount by w hich it can be e x ­
Thus, the higher the current yield,
are idle cash holdings in terms of
gains sacrificed, as well as interest
Consequently, the smaller will be

to bring the actual cash /in com e ratio into equality

pected normal rate, anticipations o f rising bond yields

with the desired ratio.

and declining bond prices render cash the preferred

Since the desired ratio is co n ­

stant, nominal income and the price level w ould have

asset in individuals’ portfolios.

to rise in exactly the same proportion as the money

pecting the price o f bonds to fall at a rate that w ould

A n individual e x ­

stock.

A t this point the com m unity w ould just be

m ore than offset the interest earned on them w ould

willing to hold the augmented stock of m oney and

be motivated to hold zero-yield cash rather than the

the adjustm ent process w ould be complete.

overpriced bonds.




FEDERAL RESERVE BA N K OF RIC H M O N D

Generally, the low er the current
13

rate, the m ore unanimous will be the expectations
that interest rates will subsequently rise, im posing
capital losses on bond holders. Thus, the low er the
current rate of interest the greater the num ber o f
people w ho prefer to hold cash rather than bonds and

positive rate of interest so low that if the current rate
were actually at that level, no one would expect it to
go any low er and everyone w ould expect it to rise.
In other w ords, anticipations of falling bond prices

therefore the greater the total quantity o f cash de­

w ould be unanimous. A t this point, anticipated cap ­
ital losses would offset interest returns, and there

manded.

A ggregating over all individual portfolio

would be no advantage to holding bonds. Cash w ould

optimizers gives a smooth dow nw ard-sloping fu n c­

become a perfect substitute for bond holdings, and
the demand for money w ould becom e insatiable, i.e.,

tion, M 2 — f ( r ) , relating the quantity o f speculative
or asset balances demanded to the current interest
rate.
A s for the transactions balance com ponent o f the

infinitely sensitive to the slightest change in the rate
of interest— a pathological condition that Keynes
called absolute liquidity preference.

U nder these cir ­

total demand for money, i.e., the portion held to

cumstances, any increase in the m oney supply w ould

finance day-to-day purchases and to provide a reserve
for emergencies, Keynes agreed with his predeces­

be com pletely absorbed into idle cash balances with

sors, Fisher and the Cam bridge school, that it would
exhibit a simple, linear (p rop ortion a l) relation to

bank acted to increase the money supply by purchas­

nominal income.
In fact, K eynes’ s form ulation o f
the transactions demand function is identical to the

up of bond prices w ould simply induce individuals to

C am bridge sch ool’s and may be expressed by the
Cam bridge cash balance equation, M i = k Y . T he

no reduction in interest rates.

Thus, if the central

ing bonds on the open market, the slightest biddingsell their bonds to the central bank and absorb the
cash proceeds.

Since at the floor rate of interest the

reader will note that Keynes did not apply rational

demand for cash is insatiable and the willingness to
sell bonds is absolute, no amount of open market

choice, optim izing considerations to the transactions
com ponent of the demand for money. T his task re­

operations would overcom e absolute liquidity p refer­
ence and force interest rates to g o any low er.

mained for later analysts, w h o showed that trans­

Both the instability and infinite elasticity properties

actions balances also respond to cost and yield c o n ­

of the m oney demand function, Keynesians pointed

siderations.

out, w ould have pessimistic policy implications.

C om bining the tw o com ponents of demand gives
the Keynesian total money demand function, M =

stability of the money demand function w ould make

M i -f- M 2 =

k Y -f- f ( r ) .

A ccordin g to this fu n c­

In ­

accurate forecasting of the effects o f monetary policy
impossible.

Confronted with a volatile and unpre­

tion, the quantity of money demanded w ould vary in

dictable

direct proportion to income and inversely with the
interest rate. It should be noted that the last term in
this equation is im properly specified. A ccord in g to

w ould never know whether shifts in demand would
m agnify or nullify policy-induced shifts in the m oney
supply. M oreover, even if the monetary authorities

K eynes’s discussion, the demand fo r speculative bal­
ances depends on the current rate o f interest in rela­
tion to some expected normal rate. Thus the latter
rate properly should be included as one o f the explan­
atory variables determining the quantity of money
demanded. Keynes and his follow ers, how ever, chose

m oney

demand

function,

the

authorities

could predict the behavior o f m oney demand, m one­
tary policy still w ould be powerless if conditions of
absolute liquidity preference prevailed. In the latter
case, increases in the m oney supply w ould have no
effect on nominal incom e or econom ic activity through
the interest rate channel. Since no cash holder would

to treat the expected rate as an exogenous factor

be willing to bid for bonds, there w ould be no rise in

contributing to erratic shifts in the functional rela­

bond prices and consequent fall in interest rates to

tionship between the quantity of m oney demanded

stimulate business investment spending. M oreover,
none of the monetary injection w ould enter the spend­

and the current rate.
K eynes and his follow ers also broke new ground

ing stream.

Instead, all of the new money w ould be

in their discussion o f the behavior of the dem and-for-

absorbed in idle cash balances. In short, the econom y

money function.

would be caught in a liquidity trap.

First, unlike Fisher and the Cam ­

bridge school, Keynesians argued that the money
demand function is highly unstable, shifting errati­

deep depression, m oney stock changes w ould be ne­

cally under the impact of volatile market expectations.

gated by offsetting changes in velocity or the Cam­

Second, Keynesians thought that in times o f deep
depression the m oney demand function w ould becom e

T o summarize, Keynesians argued that in times of

bridge k.

W ith variable velocity, ©r k, absorbing all

the impact of m oney stock changes, none w ould be

horizontal (infinitely elastic) at some floor rate o f

transmitted to nominal income.

interest.

between money and econom ic activity postulated by

T hey argued that there is some critical

14



M ONTHLY REVIEW, DECEMBER 1973

T he rigid linkage

earlier economists w ould be severed.
Thus, K e y ­
nesians arrived at policy conclusions at variance with
those reached by Fisher and the Cambridge school.
J. R. H icks’s Analysis

K e y n e s ’s ch ie f c o n tr ib u ­

tion to the analysis of the demand for money was the
introduction of a variable representing the cost of
holding cash (the rate of interest) into the money
demand function.

transactions or spending that is closely related to the
flow of income. H ick s’s use of the wealth constraint,
by contrast, called attention to the stock of m oney as
a store of wealth, i.e., a service or utility-yielding
asset alternative to other asset stocks.
In addition to his pioneering proposal that ordinary
demand analysis be applied to m oney in its role as a
balance sheet asset, H icks also took the initial step

This innovation permitted exam i­

in extending the theory of choice or optim izing be­

nation of the substitution effects on the demand for

havior to explain the demand for transactions (as
distinct from asset) balances. P rior to H icks, no one

money stemming from changes in relative rates of
return. In giving explicit consideration to the yields

had attempted this.

Even Keynes had limited his

on assets that com pete with money, Keynes became

application of rational choice analysis to the asset

one o f the founders of the portfolio balance approach

com ponent of m oney demand.
M oreover, no one
previously had provided a convincing explanation of
why individuals would be willing to hold trans­

to monetary analysis, i.e., the approach that inter­
prets the demand for money as part of the choice of
an optimum portfolio of assets. A t least equal recog­
nition for originating the portfolio approach, however,

actions balances when riskless, interest-bearing assets
of virtually instantaneous redeemability (e.g., time

should be given to British econom ist John R. Hicks,

deposits) were available.

who in 1935 first suggested that the demand for

voluntarily sacrifice the option of holding interestyielding, speedily-convertible assets for the option o f
holding cash ? Because the latter option may be less

money be treated as a problem of balance sheet equi­
librium or asset choice to be analyzed along the lines
of orth od ox com m odity demand theory.
H icks pointed out that if money were to be analyzed
as a capital asset and not just as a mechanical medium

W h y w ould transactors

costly, said H icks. In short, the existence of trans­
actions balances could be explained as the outcom e of
rational, cost-m inim izing behavior. M ore specifically,

of exchange, the dem and-for-m oney equation would

the only reason for holding transactions balances, sug­

have to include as explanatory variables total wealth

gested H icks, was the conversion costs (brokerage

and expected rates of return on other assets.

fees, effort and inconvenience, etc.) of transferring

The

wealth variable would represent the budget co n ­

cash into earning assets and vice versa.

straint on money holdings, since at the m axim um
individuals could choose to hold their entire wealth

pointed out that it would not pay to get out o f cash

portfolios in the form o f cash.

tw o-w ay conversion costs exceeded the interest in ­

A nd the yield vari­

H icks

into earning assets for short periods of time if the

ables w ould represent both the opportunity costs of

com e foregone by holding cash.

holding money and the portfolio-substitution effects

H ick s’s observation that the demand for trans­
actions balances stems from cost-m inim izing behav­

of changes in relative rates of return.
Individual
portfolio optimizers would com pare these yields with
the imputed convenience and security yield on money
balances in deciding whether to substitute other assets
for cash in their balance sheets.
H ick s’s specification of wealth as the constraint

ior, together with his proposal that cash holdings be
analyzed as a com ponent o f a portfolio of assets,
served to eliminate much o f the remaining disparity
between m oney demand theory and conventional de­

variable, it should be noted, was a significant depar­

mand theory. T he final steps, however, were taken
in the 1950's by analysts w orking along the lines

ture from the Cam bridge and Keynesian form ula­
tions, both of which used incom e in the m oney d e­

opened up by H icks. Chief am ong the contributions
stemming from H ick s’s w ork were M ilton Friedm an’ s

mand equation.

elaboration o f the portfolio balance approach and

This shift from income to wealth as

the constraint variable underscored the shift from the

B aum ol’s and T o b in ’s refinement o f the transactions

transactions approach to the capital asset or p ort­

cost approach. These studies succeeded in integrating

folio approach in H icks’s article. Incom e is a m agni­

money demand analysis into the optim izing behavior

tude having the time dimension of a flow (an amount

fram ework o f orth od ox demand analysis.

that occurs over an interval of time, or so much per
W ealth, 011 the other hand, has the

M oney as a Capital A s s e t: Friedman’s Contribu­

time dimension of a stock (s o much existing at a

tion F o llo w in g H ic k s ’s s u g g e s tio n , M ilto n F rie d ­

given point in tim e).

unit of tim e).

T he rationale for the income

man in 1955 em ployed the procedures of conven­

constraint in the Cam bridge and Keynesian form u ­

tional com m odity demand theory to construct a de­

lations was that money is used to finance a flow of

tailed




dem and-for-m oney

FEDERAL RESERVE BA N K OF RIC H M O N D

function.

Like

H icks,
15

Friedm an interpreted the demand for m oney as a
problem in balance sheet equilibrium or asset choice.
H ow ever, unlike earlier analysts (especially K e y n e s),
he did not seek to explain the demand fo r m oney in
terms of special m otives that are satisfied by cash
holdings. Instead, he treated money as a capital good,
which, like any other capital good, yields a flow of

specific substitute for a narrow range of financial
assets led him to reject the Keynesian conclusions
that m onetary policy may be relatively ineffective.
Keynes had argued that if a monetary change does
influence econom ic activity, it does so through an
indirect interest rate mechanism rather than through

services that makes it desirable to hold. T his ap­
proach is characteristic o f orth od ox demand analysis,

the direct expenditure o f m oney for goods. S pecifi­
cally, in the Keynesian m odel, a m onetary increase
initially upsets the preexisting optimum cash-bond

which avoids considerations of psychological motives

m ix in wealth portfolios.

prom pting the purchase of goods.

tempt to restore portfolio equilibrium by substituting

Friedm an’s contribution consisted of a step-by-step
demonstration of how a household’s m oney demand

bonds for cash. T he increased demand for bonds
pushes their prices up and their yields down. F all­

function could be derived from first principles of
Equally important, h ow ­

ing interest rates stimulate investment expenditure
for new capital goods, and the increased investment

ever, was his precise and complete specification o f the

spending has a multiplied effect on national income.

relevant constraint and opportunity cost variables
entering the function.
T he relation between these
variables and the quantity of money demanded may

But K eynes thought these indirect effects w ould be
weak for tw o reasons. First, he thought cash and

orth od ox demand analysis.

be expressed as M d = f ( W , rb, re, rr, p ) , where W
is w ea lth ; rb, re, rr are the expected real rates o f re­
turn on bonds, equities, and real assets, respectively;
and p is the anticipated percentage change in the
price level, a measure of the expected rate o f depreci­
ation in the purchasing pow er of m oney balances.
Like H icks, Friedm an specified wealth as the ap­

W ealth holders then at­

bonds were such close substitutes that only slight
reductions in bond yields w ould be necessary to in ­
duce people to add the extra cash to their portfolios.
Thus, increases in the m oney supply could generate
only slight reductions in interest rates. Second, he
thought that investment spending w ould be insensi­
tive to small changes in the interest rate.

defined

Friedman, however, argued that since m oney is a
substitute for real good s and services as well as bonds,

wealth somewhat unconventionally as the present

changes in the quantity of m oney w ould spill over into

value of expected future receipts from all sources,
including human wealth (personal earning capacity)

the market for consum ers’ and producers’ goods,

as well as real property and financial capital.

spending and not merely a weak indirect effect via
the bond interest rate. That is, excess cash balances
are at least as likely to be spent directly for good s as
for long-term bonds.
M oreover, Friedm an main­

propriate

budget

constraint,

although

he

Unlike

Keynes, w ho view ed bonds as the only asset co m ­
peting with cash, Friedm an regarded all types of
wealth as potential substitutes for cash holdings in
individuals’ balance sheets.

Thus, in sharp contrast

to the single interest rate variable in the Keynesian
liquidity preference equation, Friedm an’s list of rela­
tive yield variables entering the money demand func­
tion included the expected rates of return on bonds,

thereby exerting a strong direct effect on private

tained that since the substitution effects between
m oney and other assets w ould be dispersed over such
a wide spectrum o f assets, the particular substitution
effect between m oney and any one class o f assets
would tend to be small. Thus, contrary to Keynes,

equities, and real assets. One additional novel feature

Friedman believed that the quantity o f m oney d e­

was the inclusion of the expected rate of change o f the

manded w ould be relatively insensitive to changes in

price level as a measure of the rate o f return on (o r

the yield on bonds.

the depreciation cost o f) money holdings.

T he ra­

relatively unresponsive to interest rate changes, then

tionale for this particular variable is that cash hold­

the problem of hoarding anticipated in the Keynesian

A n d if the demand for m oney is

ers, recognizing that inflation erodes and deflation

liquidity trap case will not arise.

augments the purchasing pow er o f cash balances,

believes, as did Fisher and the Cam bridge school,

would take the expected rate of depreciation or ap­
preciation of money into account in form ulating their

that the link between m oney and nominal incom e is

cash holding decisions.

m oney stock have a pow erful impact on econom ic

N obod y prior to Friedman

had thought to incorporate the anticipated rate of

In sum, Friedman

strong and relatively stable and that changes in the
activity.

inflation into the demand function as one of the rateThe Inventory Approach to the Transactions D e ­

of-return or relative yield arguments.
Friedm an’s interpretation of m oney as a general

mand for M oney

substitute for all form s o f wealth rather than as a

K eynes-H icks-F riedm an


16


MONTHLY REVIEW, DECEMBER 1973

T h e ch ie f d e fic ie n c y o f the
asset

choice

or

portfolio

form ulation was that it was not addressed specifi­
cally to the question of w hy anyone would hold trans­
actions (as distinct from asset) balances when they
had the alternative of holding riskless, easily co n ­

tion via his conjecture that transactions balances are

consists not o f utility m axim ization but o f cost m ini­
mization. Specifically, the optim izing transactor will
attempt to manage his cash inventory in order to
minimize the sum o f tw o c o s t s : ( 1 ) the opportunity
costs o f holding cash instead of bonds and ( 2 ) the
transfer costs (brokerage fees, inconvenience, etc.)
of converting bonds into cash. A s long as the costs

held simply to avoid bond conversion costs.

vertible, interest-yielding securities. A s previously
mentioned, H icks had attempted to answer the ques­
But

of frequent bond conversions exceed the interest in­

H ick s’s con jectu re was not supported by rigorous

come foregone by holding cash, the rational trans­

proof until the m id-1950’s, when W illiam J. Baumol
and James T obin applied inventory management

actor will add to his average cash balances and reduce
the number of conversions from bonds to cash. N o ­

analysis to transactions balances, thereby integrating
the latter into the rational choice optim izing fram e­
work of general demand theory.
Baumol and T obin showed that the optimum in­
ventory o f transactions balances could be expressed
in terms of the so-called lot-size or square-root fo r ­

tice that nothing is said about the services that m oney
yields. In the B aum ol-T obin analysis, transactions
money is held fo r one reason only, to minimize the
total costs o f transactions.
In sum, the notion of the balancing o f tw o co m ­
peting costs in order to minimize their total form s

mula of inventory theory. A ccord in g to this form ula,

the basis of the demonstration that an inventory o f

the average cash holdings of an individual transactor
would be directly proportional to the square root of

transactions balances is kept, not fo r the services it
provides, but because it is too costly to continually

both the volum e o f payments (transactions) to be

switch in and out of bonds.

made and the brokerage cost per conversion from
bonds to cash and inversely proportional to the

The M oney Demand Equation in the S M P Model

square root o f the carrying cost (interest incom e fore­

T his article has sketched the evolution over time of
the theory of the demand fo r m oney. This lon g p r o ­

gon e) of the cash inventory. Thus, given the level
of transactions, the size of average cash holdings
would depend on the relation between the yield on
securities and the costs of buying and selling them.
If the latter were greater than the form er, it would
not pay to substitute earning assets for m on ey; co n ­
sequently, cash holdings w ould be relatively large.
But as yields rose relative to conversion costs, it
would pay to econom ize on transactions balances.
Hence, the size of average cash holdings w ould be
negatively related to the rate of interest. If the v o l­
ume of transactions varied, however, the demand for
money w ould vary in the same direction but less than
proportionately. T his implies that the m ore prosper­
ous a person is, the smaller w ill be the increase in his
cash balance necessary to cover a given increase in
his transactions.

cess o f theoretical developm ent has culminated in the
money demand equations appearing in large-scale
econom etric models currently in use. It is, therefore,
fitting to close the article with a brief look at the
dem and-for-m oney equations in one particular econ o­
metric model. F or this purpose, the S S R C -M I T P E N N ( S M P ) model was chosen. T he S M P model
is em ployed by Federal R eserve economists in fore­
casting future levels o f econom ic activity and in
simulating the effects of policy actions and other
changes on the econom ic system.
A s represented in the S M P model, the demand for
money is broken dow n into its demand deposit and
currency com ponents. T here is a separate equation
for each com ponent. In each case, the basic form of
the equation is M = k ( r ) Y , where M is the quantity

H o w did the B aum ol-T obin inventory analysis co n ­

of m oney demanded, k is the Cam bridge cash balance

tribute to the closing of the gap between orth od ox

or m on ey/in com e ratio (the reciprocal o f the income

demand theory and m oney demand th eory?

velocity o f circulation) expressed as the inverse func­

In the

first place, it indicated that the quantity of trans­

tion of a vector of interest rates on short-term assets,

actions cash demanded, like the quantity of a com ­

r, and Y is the level of nominal national income.

m odity demanded by a household, w ould be deter­

These basic equations are used to express the general

mined to a significant extent by relative price or

long-run equilibrium or desired level of m oney bal­

opportunity cost variables. Second, and m ore im por­

ances, M *, associated with the current interest rate

tant, it demonstrated that rational choice, or opti­

vector and current income.

Since time is required to

mizing behavior, governs the demand for transactions

adjust actual cash balances to this desired level, h ow ­

balances just as it does the demand for asset balances

ever, the actual demand for m oney in a given time

or com m odities.

T he only difference is that in the

period may differ from the long-run equilibrium level.

case of transactions balances optim izing behavior

A ccordin gly, a stock adjustm ent process is in cor­




FEDERAL RESERVE B A N K OF R IC H M O N D

17

porated into the monetary sector of the S M P model
to represent the dynamic sequence o f short-run ad­
justments to the desired long-run equilibrium p osi­

that rising interest rates induce the substitution o f
relatively higher yield assets (b o n d s ) fo r relatively
low er yield ones (m o n e y ) in asset portfolios and ( 2 )

tion described by the equation M * =

The

the B aum ol-T obin hypothesis that the ratio o f cash

stock adjustm ent mechanism embodies the hypothesis

k (r )Y .

to transactions (o r in com e) is controlled by the in­

that in any given period money holders adjust their

terest obtainable on bonds relative to the cost o f c o n ­
verting cash into bonds.

cash balances by a fixed proportion o f the discrepancy
between the desired stock, M *, and the actual stock

Still another feature is the stability o f the m oney

of m oney in existence at the end o f the previous

demand relation. Statistical tests of the S M P equa­
tion indicate that the parameters o f the equation are
very stable, changing at best only slow ly over time.

period, M _ i.

If b represents the proportion o f the

gap closed in a given time period, then the change in
m oney balances, A M , may be written as A M =
b (M * — M _ i).
Since the long-run equilibrium
demand for m oney is expressed as M * =

k ( r ) Y and

since the change in the demand for money by defi­
nition is A M = M — M _ i, the demand for money
in the current period may be shown to be M =
b k (r ) Y —

(1 — b )M _ L .

These findings conform to Friedm an’s hypothesis that
the demand for money is a stable function o f a rela­
tively few variables.
Perhaps the m ost controversial aspect of the S M P
formulation is the use of current incom e rather than
wealth as the constraint variable.

Similar to other

models that stress the transaction or cost-m inim izing

T he S M P m oney demand equation is particularly

approaches to the demand for money, the S M P model

instructive because it embodies so many of the ele­
ments or features stressed in the various theories

specifies incom e as the appropriate budget constraint
on m oney holding. A s previously mentioned, h ow ­

surveyed in this article.
One such feature is the
prominence of yield and income variables in the equa­

ever, analysts who adhere to the portfolio-balance or

tion, which conform s to the post-K eynesian practice
of incorporating relative price (y ield s) and budget
constraint arguments into the demand function.

the relevant budget constraint.
Since incom e and
wealth are closely related variables, however, the
difference between the tw o approaches may not be as

M oreover, the appearance of the transactions-related

great as it appears at first glance. Specifically, wealth
is the present value o f expected future income. A n d

income variable in the equation links the S M P ver­
sion to earlier theories that emphasized the role of
money as a transactions medium of exchange.

In

fact, the authors of the S M P money demand equa­
tions designate their form ulation “ the neo-Fisherian
approach” and state that the demand for m oney is

utility-m axim izing approach maintain that wealth is

expected future income may be measured empirically
by the weighted average of current and past levels
of income. It follow s, therefore, that m oney demand
equations using current incom e as the constraint are
not incompatible with equations em ploying wealth as

basically related to the flow of transactions and arises
from a lack of synchronization between receipts and
payments. T he same hypothesis, of course, underlies
Irving F isher’s form ulation as well as the B aum ol-

the constraint, as long as the form er equations also
include lagged values of past income as supplementary
variables. It can be demonstrated that recursive sub­
stitution for lagged values o f the money demand vari­

T ob in theory.

able M _ ! in the equation M = b k ( r ) Y — ( 1 — b ) M _ i

A nother noteworthy feature is the reemergence of
the Cam bridge k in the S M P model.

In fact, the

causes the transactions variable, Y , to enter the equa­
tion in the form o f an exponentially weighted average

S M P m oney demand equation may be viewed as an

of current and past levels of income. Thus, the S M P

im proved, augmented version of the old Cambridge

stock adjustm ent form ulation reconciles the incom e

cash balance equation.

and wealth approaches to specifying the constraint on

T he chief difference between

the older and the newer version is the latter’s treat­

the demand fo r money.

ment of k as an inverse function of the rate o f interest
rather than as a numerical constant.

T he original

Summary

T h is a rticle has tra ced th e seq u en ce

Cam bridge form ulation implied that changes in bond

o f steps that brought the theory o f the demand for

yields w ould exert no substitution effects on cash

money into the rational choice, optim izing fram ew ork

holdings.

o f conventional demand analysis.

B y contrast, the S M P equation implies

that, at a given level of income, a rise in bond yields

T he integration

process was accom plished in three stages.

will induce a reduction in cash balances demanded.

First was the development, in the 1920’s, of the

The postulated inverse relation between k and the

cash balance approach, which replaced the concept o f

rate o f interest is consistent with both

transactions velocity with the alternative concept o f

K eynes-H icks-F riedm an

18


balance

sheet

(1 )

the

hypothesis

the desired m on ey/in com e ratio.

M ONTHLY REVIEW, DECEMBER 1973

T he cash balance

analysis tended to shift attention to factors affecting
the holding, as distinct from the spending, o f money.
It also led to the form ulation of a rudimentary de-

SELECTED BIBLIOGRAPHY

m and-for-m oney function containing the cash balance
ratio as a parameter and nominal income as the co n ­
straint variable.

Baumol, William J. “ The Transactions Demand for
Cash: An Inventory Theoretic Approach.” Quarterly
Journal o f Economics, 66 (November 1952), 545-58

T he second step was taken in the 1930’s, when
variables representing relative yields and costs were

Friedman, Milton. “ The Quantity Theory of Money— A
Restatement.” Studies in the Quantity Theory of
Money. Ed. Milton Friedman, Chicago: University of
Chicago Press, 1956, pp. 3-21.

introduced into the money demand function, and the
demand for m oney was interpreted as part o f the
choice of a portfolio of assets optimally com posed
with regard to alternative yields. Incorporation of in­
terest rate variables into the demand function per­
mitted systematic analysis of the substitution effects
between m oney and com peting assets stemming from
changes in relative rates of return.
T he most recent stage occurred in the 1950’s when
it was shown ( 1 ) that the demand function for asset
money could be derived from the utility-maximization
analysis of conventional demand theory and ( 2 ) that
holdings of transactions balances are consistent with
rational cost-m inim izing behavior.
A ssociated with each of these stages of theoretical
development were certain policy implications.

The

cash balance approach led to the belief in the potency
o f monetary policy. T his belief stemmed from the
assumed stability (con stan cy) o f the cash balance
ratio linking money to nominal income. Coinciding

------------------. “ Money: Quantity Theory.” International
Encyclopedia o f the Social Sciences. Vol. 10. Ed
David L. Sills. New York: Macmillan and Free Press,
1968, 432-47.
Hicks, John R. “ A Suggestion for Simplifying the
Theory of Money.” Economica, 2 (February 1935).
1-19.
Laidler, David. The Demand fo r M oney: Theories and
Evidence. Scranton, P a.: International Textbook,
1970.
Modigliani, Franco. “ Liquidity Preference.” Interna­
tional Encyclopedia o f the Social Sciences. Vol. 9.
Ed. David L. Sills. New York: Macmillan and Free
Press, 1968, 394-408.
----------------------, Robert Rasche, and J. Philip Cooper
“ Central Bank Policy, the Money Supply, and the
Short-Term Rate of Interest.” Journal of Money,
Credit and Banking. 2 (May 1970), 166-218.

with the introduction o f cost and yield considerations
into money demand analysis in the 1930’s, however,
was a reversal of the belief in the potency o f m one­
tary policy. Analysts began to emphasize such policydebilitating forces as the high interest elasticity and
the extrem e instability of the dem and-for-m oney rela­
tionship. These views contributed to the doctrine,
widespread in the 1930’s and 1940's, of the ineffec­
tiveness of monetary policy. Since the 1950’s, h ow ­
ever, the consensus has tended to swing back tow ard
belief in the potential pow er of monetary policy.
Recent theoretical and empirical findings o f the sta­

Patinkin, Don. “ Keynesian Monetary Theory and the
Cambridge School.” Banca Nazionale del Lavoro
Quarterly Review. (June 1972), 3-23.
Teigen, Ronald L. “ The Demand for and Supply of
Money.” Readings in Money, National Income, and
Stabilization Policy. Ed. W . L. Smith and R. L.
Teigen, 2nd Ed. Homewood, Illinois: R. D. Irwin, Inc..
1970, p p . 74-92.
Tobin, James. “ The Interest-Elasticity of Transactions
Demand for Cash.” The Review o f Economics and
Statistics, 38 (August 1956), 241-47.

bility and relative interest inelasticity of the demandfor-m oney function tend to support this latter view.
Thomas M . H um phrey

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FEDERAL RESERVE BA N K OF RIC H M O N D

19

MONTHLY REVIEW INDEX
Volum e 59, 1973
FEDERAL RESERVE B A N K OF R IC H M O N D
JANUARY

Financial Highlights of 1972
Personal Income in the Fifth District in 1971
Employment and Unemployment Since 1969

FEBRUARY

Philip H. Davidson and
B. G ayle Burgess
John W. Scott
W illiam E. Cullison

Econometric Models: The Monetarist and Non-M onetarist
View s Com pared

Joseph M. Crews

Forecasts 1973
Financial Forecasts: 1973

W illiam E. Cullison and
Carla R. Gregory
Philip H. D avidson

MARCH

The Dismal Science Revisited
Bank Affiliates and Their Regulation: Part I

Thomas M. Humphrey
W illiam F. Upshaw

APRIL

Bank Affiliates and Their Regulation: Part II

i

Time and Savin gs Deposits in the Fifth District
The District Economy in Perspective: 1972
Spotlight on Agriculture

W illiam F. Upshaw
Susan P. Krug
B. G ayle Burgess
S ad a L. Clarke

JUNE

Bank Affiliates an d Their Regulation: Part III

W illiam F. Upshaw

International Agricultural Trade and the U.S. Balance of Payments

MAY

Thomas E. Snider

Sources of Bank Expansion in the Fifth District:
Internal and External G row th
Labor Turnover: Another View of the Labor Market

Clyde H. Farnsworth, Jr.
Glenn Picou

Rural Housing in the Fifth District

Thomas E. Snider
Thomas M. Humphrey
B. G ayle Ennis

Using the Futures M arket to Hedge

Thomas E. Snider

Recent Changes in Fifth District S M S A 's

A U G U ST

C h an gin g View s of the Phillips Curve
The Fifth District Labor Force

JULY

Patricia G. Rhodes
Susan P. Krug

The Household W orker

DECEMBER




The Cyclical Behavior of Consum er Credit

Glenn Picou
Sharon M. Haley

Economic Aspects of Health Care and Medical Insurance Program s

W illiam E. Cullison

Fifth District Bank Loans: 1965-1972

NO VEM BER

Timothy Q. Cook
D ou glas H. Lemmonds

Behind the Unemployment Rate

OCTOBER

Some Factors Affecting Long-Term Yield Spreads in Recent Years
Edge Corporations: A Microcosm of International Banking Trends

SEPTEMBER

Susan A. Whitlock

The Role of the Money Supply in the Conduct of M onetary Policy

Arthur F. Burns

Evolution of the Concept of the Dem and for M oney

Thomas M. Humphrey

MONTHLY REVIEW, DECEMBER 1973


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