Question

How is the classical money demand function similar and different from the monetarist view about themoney demand equation? Provide the equation, discuss what the terms mean, and how the equations are similar and different.

Answer 1

Classical Theory of Demand for Money

Classical economists did not themselves devise any explicit theory of demand for money. However, it is evident in theier theory which started in the mid 16th century but was later formulated by Fisher. Fisher gave his famous 'Equation of Exchange' in the year 1911 which can be written as follows:

MV = PT

?where M- demand (quantity) for money; V- velocity of money, that is, number of hands a particular note changes over a given period of time (usually an year); P- price level; T- total amount of goods and services transacted during the given period. Simply put, it can be asserted that:

? since V, T are constant in the short run.

Monetarit's View on Demand for Money:

?Monetarist approach was put forward by Milton Friedman His view is essentially a restatement of the quantity theory of money. He treats the demand for money as a stable function in the economy. It can be mathematically represented as:

M_d = f (W, h, r_m, r_b, r_e, P, ?P/P, U)

where M_d?- nominal demand for money, W- wealth of citizens, h-proportion of human wealth to total wealth, r_m ?- rate of interest (return) on money, r_b?- return on bonds, r_e?- return on investment, P- price level, ?P/P- change in price level, U- institutional factors like wage payments, bill payments etc. that influence the demand for money. A simplified version can be written as (assuming there is no price change):

M_d = f (W,r) where r is combined rate of interest; and h, U are constant in the short run.

Similarities:

1. Both consider money demand as a stable function.

2. Both attach great value to price level as a determinant to demand for money.

Differences:

1. Fisher only talks about transactions demand for money.

2. Monetarist approach takes into account the rate of return on investment (rate of return on bonds, equity and money)