Empirical studies of money demand try to verify how well theoretical models (based on income and interest rates) explain real-world behavior. Early work by Milton Friedman and Anna Schwartz in their famous book A Monetary History of the United States (1963) showed that the demand for real money balances depends mainly on income and interest rates. Their findings suggested that money demand was stable over long periods, meaning peopleβs behavior regarding holding money was predictable.
Later, researchers like David F. Hendry and colleagues tested money demand models using long historical data. They found that for the period 1878 to 1975, money demand remained fairly stable despite major events like world wars. This supported earlier conclusions that traditional models worked well.
However, when the same models were applied to data from 1976 to 1993, the results changed significantly. Money demand appeared unstable, less sensitive to interest rates, and more volatile. The main reasons identified were:
- Financial innovation (new financial products and technologies)
- Deregulation of financial markets
- Expansion in the variety of financial assets (changing definition of money)
Thus, empirical evidence shows that money demand stability depends on the time period and financial environment.
Is Money Demand Stable?
The question of stability has been widely debated:
- Earlier View (Stable):
Economists believed money demand was stable and predictable, mainly influenced by income and interest rates. - Post-1975 View (Unstable):
Due to rapid financial changes, money demand became unstable and unpredictable. - Modern View (Conditional Stability):
Recent research suggests that instability may not be real but due to measurement problems. Traditional measures like M1 and M2 treat all money components equally.
New approaches, such as Divisia monetary aggregates, assign weights based on liquidity and usefulness of different assets. Studies by economists like William A. Barnett show that when properly measured, money demand appears stable even in modern times.
Thus, the conclusion is:
π Money demand may be stable, but only if measured correctly.
Importance of Money Demand Volatility for Monetary Policy
The stability or instability of money demand has major implications for how central banks conduct monetary policy.
Case 1: When Money Demand is Stable
If money demand is stable, central banks can use money supply targeting to control the economy.
This is explained by the quantity equation (in growth form):
gm + gv = Ο + gy
Where:
- (gm) = Growth of money supply
- (gv) = Growth of velocity
- (Ο) = Inflation rate
- (gy) = Growth of real output
If money demand is stable, velocity is constant:
gvβ=0
Then inflation becomes:
Ο = gm – gy
π This means inflation depends only on money supply growth.
π Therefore, controlling money supply ensures stable inflation.
π This supports the idea that inflation is a monetary phenomenon.
Case 2: When Money Demand is Unstable
If money demand is unstable, velocity is no longer constant. In this case:
- Changes in money demand cause fluctuations in interest rates
- Money supply targeting becomes unreliable
- Economic instability increases
π Here, central banks prefer interest rate targeting instead of controlling money supply directly.
π By adjusting money supply in response to demand, they stabilize interest rates and economic activity.
Policy Implications (IS-LM Perspective)
- If economic shocks mainly come from goods market (IS curve) β Money supply targeting is better
- If shocks come from money demand (LM curve) β Interest rate targeting is better
Thus, the choice of policy depends on the source of economic fluctuations.
Conclusion
Empirical studies show that money demand stability has changed over time due to financial innovations and measurement issues. While earlier economists found it stable, later evidence suggested instability. Modern research, however, indicates that with better measurement techniques, money demand can still be considered stable. This issue is extremely important because it determines whether central banks should target money supply or interest rates to maintain economic stability.