20.1 The Quantity Theory #Notebook

20.1 The Quantity Theory #Notebook

If inflation erodes the purchasing power of the unit of account, economic agents will want to hold higher nominal balances to compensate.

Md / Plv: f (Pi varies directly with, ERoB – ERoM varies indirectly with, ERoS – ERoM varies indirectly with, EIf – ERoM varies indirectly with)

Md / P = demand for real money balances

Md = money demand

Plv = price level

f means “function of” (not equal to)

Pi = Permanent income

ERoB – ERoM = the expected return on bonds - the expected return on money

ERoS – ERoM = the expected return on stocks (equities) minus the expected return on money

EIf – ERoM = expected inflation minus the expected return on money

According to Friedman's theory, the demand for real money balances increases when permanent income increases and declines when the expected returns on bonds, stocks, or goods increases versus the expected returns on money, which includes both the interest paid on deposits and the services banks provide to depositors.

Money demand is where the action is, because the central bank determines what the money supply will be, so we model it as a vertical line. 

Before the rise of modern central banking in the 20th century, the supply curve was sloped upward. Early monetary theorists did not discuss much of the nature of money demand since they also had to worry about the nature of the money supply. Under a specie standard, money was supplied exogenously. 

Consider the interest rate as the price of money on the vertical line, so when interest is high, more people want to supply money to the system because seigniorage is higher. And then, more people want to form banks, find ways of issuing money, and extant bankers want to issue more money (notes, and deposits).

Just like the price of gold or oil. When its price is low, there is less incentive to find more. But, when the price is high enough, more people want to go out to find more new gold veins or oilfields, or even more crimes associated with it.

If the return on financial investments decreases, they will want to hold more money because its opportunity cost is lower. 

If inflation expectations increase, but the return on money doesn’t, people will want to hold less money because the relative return on goods (land, gold, turnips) will increase.

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.