1.

9
1.0
1.7
5
1.8
e 1.5
z
5
1.4
1.3
1.2
1.1
Figure 3 : 1900-57
t? 1
6s
*
+
u
0
*
2 3 4 5 6 7 0
Short-term Interest Rate
147
I I I , A THEORETI CAL FRAME
As an ai d i n i nterpreti ng the resul ts reported i n the l ast secti on and
the addi ti onal resul ts to be reported i n Secti on I V, I i l l i ntroduce a
si mpl e theoreti cal f ramework based on the model anal yzed i n Lucas and
Stokey ( 1987) .
The f ramework has the advantage ( rel ati ve to the f ramework
el tzer used) of bei ng expl i ci t about the connecti on between the portf ol i o
and transacti ons demands f or money,
and the di sadvantage of bei ng
unreal i sti cal l y styl i zed about the way tradi ng occurs.
I t wi l l take some
care to expl oi t the expl i ci tness of thi s model wi thout bei ng l ed too f ar
astray by i ts unreal i sti c f eatures.
We consi der an economy i n whi ch the representati ve agent has the
ul ti mate obj ecti ve of maxi mi zi ng the di scounted expected uti l i ty f rom
consumpti on of goods,
B t
E{ c t3 U(ct)} l
t=o
Thi s agent l i ves i n a Markovi an worl d, the state of whi ch at t i s
ari zed by a vector St. The di stri buti on of st+l , gi ven St, i s gi ven by
a f i xed transi ti on f uncti on
F( s, A) = Pr( st+I E A( s = s} .
I n thi s setti ng, al l equi l i bri umdate- t pri ces and quanti ti es wi l l be f i xed
( no ti me subscri pt) f uncti ons of the current state, s+_.
Agents are assumed to al ternate between securi ti es tradi ng and goods
tradi ng i n l ockstep f ashi on. At the begi nni ng of each peri od, al l agents
trade i n securi ti es, i ncl udi ng money, i n a si ngl e central i zed market, al l
i th f ul l knowl edge of the current real i zati on of St. hen securi ti es
tradi ng i s concl uded, al l agents di sperse ei ther to produce or to purchase
consumpti on goods. Some of these goods can onl y be purchased wi th money
acqui re4 duri ng the course of securi ti es tradi ng: Thi s transacti ons
requi rement i s the sol e reason f or i ncl udi ng cash i n a portf ol i o, i n
Pref erence to i nterest beari ng cl ai ms to f uture cash.
Consi der f i rst the deci si on probl em f aci ng an agent who i s engaged i n
securi ti es tradi ng at a ti me i n
hi ch the state of the economy i s s and hi s
. ( I n a ten l i zed securi ti es market
i s asset
ote the val ue of thi s agent' s expected,
148
di scounted uti l i ty i f he proceeds opti mal l y f romthi s poi nt on.
At thi s poi nt, the agent i s f aced by a vector Q( s) of securi ti es
pri ces ( i n dol l ars, so the pri ce of money i s uni ty) . He must choose money
hol di ngs and a vector of securi ti es hol di ngs z, subj ect to a portf ol i o
constrai nt:
+ Q(s) l z I:
(2)
Let be the i ndi rect uti l i ty f uncti on he uses to make thi s
choi ce. ( Cl earl y G wi l l depend on s, si nce the current state vari abl e
i ncl udes al l the i nf ormati on he has about the returns f rom these
securi ti es. ) Then v( s, W) must sati sf y:
v(s,W
= max G( M, z, s) subj ect to ( 2) .
( 3)
M, z
I cal l ( 3) the agent' s portf ol i o probl em.
Now where does thi s i ndi rect uti l i ty f uncti on G come f rom? Havi ng
compl eted securi ti es tradi ng, the agent i s about to engage i n purchasi ng a
vector c of consumpti on goods. He wi l l al so recei ve an endowment y(s)
of goods, but thi s he must sel l f or cash or f uture cash: He cannot consume
hi s own endowment. The rul es of tradi ng i n thi s goods market are summari zed
by a vector of constants a, where ai E [ OJ ] i s the f racti on of purchases
of good i that must be covered by money. I t wi l l be an exposi ti onal
si mpl i f i cati on i n what f ol l ows to postul ate a technol ogy together wi th a
choi ce of uni ts f or measuri ng goods such that al l goods sel l f or the same
nomi nal pri ce
P( s) -
In thi s case, the agent' s Cl ower- or cash- i n- advance
constrai nt i s:
P( s) a l c 5 ( 4)
The outcome ( M, z) of the portf ol i o deci si on pl us the outcome (&Y(S))
of hi s goods trades pl us a gi ven vector D( s' ) of nomi nal
returns
( di vi dends, i nterest, pri nci pal ) on securi ti es
i l l determi ne thi s agent' s
nomi nal weal th posi ti on 1 as of tomorroti ,
condi ti onal o
state s' . He begi ns next peri od wi th hi s dol l ar hol di ngs as
pl us the di vi dends and resal e val ue of hi s securi ti es,
pl us the dol l ar val ue of hi s endo
of hi s goods purchasesI P( s) S c .
That i s:
149
W zz + [ Q( s' ) +D( s' ) ] *Z + f'(S)~i[YiO-ciI l
(5)
These consi derati ons determi ne what I cal l the transacti ons probl em:
= max U( c) + B/ w( s' , ' ) F( s, ds' ) subj ect to ( 4) , ( 6)
C
where I i s def i ned i n ( 5) .
El i mi nati ng the f uncti on G between ( 3) and ( 6) def i nes a f uncti onal
equati on i n the val ue f uncti on v. See Lucas and Stokey ( 1987) f or an
anal ysi s of thi s equati on and i ts use i n constructi ng an equi l i bri um f or
thi s economy. My purpose here i s not so much anal ysi s as i t i s cl ari f yi ng
what we mean by a "demand f uncti on f or money, " and hence i n understandi ng
what an empi ri cal money demand f uncti on mi ght mean. Let me begi n wi th what
eTtzer ( 1963) and certai nl y Hamburger ( 1977) meant by a "demand
f uncti on f or money. "
Fromthe portf ol i o probl em( 3) one obtai ns the f i rst order condi ti ons:
GM( M, z, s) = u ,
(7)
G, _J J I ~z, s) = Qju , j = l,...,m ,
3
(8)
here v i s the mul ti pl i er associ ated wi th the weal th constrai nt ( 2) and
here j i ndexes the m avai l abl e securi ti es. These m+l equati ons
i th ( 2) can be sol ved to obtai n the demand f uncti ons f or the
hi ch have as arguments the pri ces Q and weal th W. Si ngl i ng
out the demand f uncti on ( i n thi s sense) f or money:
(9)
Note that the enti re vector Q of securi ti es pri ces enters J n the
ri ght of ( 9) . In practi ce, as i n any empi ri cal appl i cati on of demand
ul d f ocus on the pri ces of securi ti es thought to have strong
substi tuti on or compl ementary rel ati onshi ps wi th money.
I n thi s spi ri t,
el tzer used a l ong termbond yi el d i n hi s econometri c work.
I n the same
experi mented i th equi ti es yi el ds and other
a respectabl e basi s f or an empi ri cal study,
150
consi stent wi th what e knew then about monetary theory and, I woul d say,
consi stent i th what we know now. Yet i t does not seem to me t
woul d have any conf i dence that the demand f uncti on ( 9) , based on portf ol i o
consi derati ons onl y as i n my deri vati on, oul d remai n stabl e over ti me.
I ncl uded as suppressed arguments i n thi s f uncti ons f are al l vari abl es s
characteri zi ng the current state of the system, i ncl udi ng al l the
i nf ormati on used by agents i n f orecasti ng f uture returns on al l securi ti es.
oreover, i f the stochasti c envi ronment i n hi ch agents operate ( the
"regi me, " as i t i s of ten cal l ed) shoul d change f rom ti me to ti me, these
changes too wi l l i nduce shi f ts i n f . Surel y shi f ts i n the real i zati ons of
i nf ormati onal vari abl es and/ or i n the processes assumed to generate these
real i zati ons must have been substanti al over so l ong a peri od as 1900- 1958.
To deci de whether the f act that the f uncti ons f are not l i kel y to be
structural i s an i mportant obj ecti on to the empi ri cal appl i cati on of ( 9) ,
consi 4ri - the f act that by exactl y the above argument on money demand, we
coul d deri ve a demand f uncti on of the same f ormas ( 9) f or any portf ol i o
i tem. Woul d one, f or exampl e, attempt to esti mate a demand f uncti on f or
Brazi l i an government securi ti es, i ncl udi ng as arguments onl y thei r own
current yi el d and another i nterest rate standi ng i n f or the composi te
securi ty consi sti ng of al l other portf ol i o i tems, and expect thi s
rel ati onshi p to be stabl e over a 60 year peri od? I thi nk there i s more to
Mel tzer' s money demand theory than portf ol i o consi derati ons al one.
To see what thi s i s, turn to the transacti ons probl em ( 6) , whi ch al so
def i nes the i ndi rect uti l i ty f uncti on 6. The f i rst order condi ti ons f or
the n consumpti on goods i n thi s probl emare:
ui tc)
= B/ vw( s , W' ) P( s) F( s, ds' ) + uP( s) ai 9 i =l , . . . , n,
(10)
where u i s the mul ti pl i er associ ated i th the cash- i n- advance constrai nt
( 4) . One can al so cal cul ate the deri vati ves of the f uncti on G f rom[ 6) :
G AS) = lJ
( s' , W' ) F( s, ds' ) 9
)IQj(S)+Oj(S)IF(S,dS), j=l,...a
(11)
(12)
That i s, the val ue ( i n uti l s) of a dol l a
goods tradi ng
The val ue of any other securi ty i s the val ue of the i ncrement i t provi des
151
to f uture weal th.
Equati ons (11) and ( 12) thus reduce the val ues of
securi ti es, money i ncl uded, to the val ues of
thei r associ ated
"f undamental s. "
Now suppose that among the mavai l abl e securi ti es i s a ( nomi nal ) ri sk
f ree, dol l ar denomi nated, one peri od bond. For thi s securi ty, Qj ( S' ) = 0
and Oj ( S' ) = 1.
1
Let i ts current pri ce be p
l+r(s)
so r(s) is the one
peri od nomi nal i nterest rate. Then combi ni ng ( 7) and ( 8) f rom the
portf ol i o probl em and (11) and (12) f romthe transacti ons probl em ( where
both ( 8) and ( 12) are speci al i zed to thi s one peri od bond) and i nserti ng
i nto the f i rst order condi ti ons ( 10) we obtai n:
ui tc)
= P( S) u[ ai + r( s) 9 i = 19...,n.
4 (13)
That i s to say, the rel ati ve "pri ces" of these consumpti on goods, as seen
by consumers ( normal i zed so that the pri ces of each recei ved by sel l ers are
al l equal to P( s) ) depend on the cash hol di ngs requi red tc purchase them
together wi th the opportuni ty cost of hol di ng cash, as me. i sured by the
nomi nal i nterest rate.
I n the envi ronment I have been descri bi ng, i n whi ch no new i nf ormati on
reaches agents af ter they have swi tched f romsecuri ti es tradi ng to goods
tradi ng, agents wi l l pl an money hol di ngs so that the cash- i n- advance
constrai nt ( 4) hol ds wi th equal i ty: In the theory, as i n f act, cash i s
domi nated by nomi nal bonds as a store of val ue. In thi s case ( 13) and ( 4)
( wi th equal i ty) f orm a systemof ~1 equati ons i n the consumpti on vector
c and the mul ti pl i er v. I t i s not qui te a demand system ( si nce the
"pri ces" i n ( 13) are not the same as the ") . ri ces" i n ( 4) ) but i t can be
treated j ust as i f i t were and sol ved f ~: +?~~~ consumpti on vector c as a
f uncti on of / P( s) and r( s) , say: - / ' *"
c =
(14)
f rom transacti ons consi derati ons, an exact rel ati on-
desi red consumpti on mi x, thei r demand f or real
the nomi nal i nterest rate. Noti ce that no other securi ti es
ri ces or returns enter i nto thi s rel ati onshi p, nor dc, l rs the state s
152
( except through the two pri ces P( s) and r( s) ) . C&z; ~s i n i nf ormati on
or i n the i nf ormati on structure of the system
i l l noi . shi f t these curves.
They wi l l be stabl e over ti me provi ded onl y that pref erences are and that
the tradi ng technol ogy as su ari zed i n the coef f i ci ents al , . . . , a, i s
stabl e.
I t
( 14)
a
mentary
seems to me a vi ol ati on of common usage to cal l the rel ati onshi p
"demand f uncti on f or money. " I t i s a rel ati onshi p among compl e-
choi ce vay*i abl es that the demand f uncti ons must sati sf y. hatever
one Cal l s i t, however, i t i s a rel ati onshi p that must obtai n i n equi l i bri um
and i t seems more l i kel y to be an empi ri cal l y stabl e one than does the
"true" demand f uncti on ( 9) . Why not provi de an operati onal speci f i cati on
Of these coef f i ci ents ai and try to esti mate i t econometri cal l y? Thi s i s
the approach taken i n a recent paper by Manki w and Su ers ( 1986) , wi th
vc! f y i nteresti ng resul ts that I wi l l come back to i n the next secti on,
Fi rst, however, i t wi l l be usef ul to go i nto more detai l about the con-
necti ons between ( 9) and ( 14) .
Mel tzer' s esti mated i ncome and weal th el asti ci ti es are around uni ty,
suggesti ng ( under the uti l i ty- theoreti c f ramework I amusi ng here) that the
current peri od uti l i ty f uncti on U takes the f ormof a constant rel ati ve
ri sk aversi on f uncti on of a homogeneous of degree one f uncti on of con-
sumpti on. Let us i mpose thi s on the model above. Then equati ons ( 13) can be
sol ved f or the rati os
ci / c
of consumpti on of each good to total con-
sumpti on C = CiCi: Ci = gi(r)C , say. Substi tuti ng i nto the cash
constrai nt gi ves:
M
F
= Xiaigi(r) C = h[ rj c , (15)
where the second equal i ty def i nes the f uncti on h.
Thi s i s j ust a
consol i dated speci al case of ( 14) , sti l l not a demand f uncti on f or money.
Under these same assumpti ons, the Yrue' 1 demand f uncti on f or total
%- his rationale for (14) is essentially the same as
that used for a simi la! purpose by
McCallum and Goodfriend (1987). See Ando, Modigl iani and She11 (1975) for the earliest
derivation of (14) along these I ines that I have found.
These writers draw the same
conclusion I have in the text: that only the short rate ought to appear on the right side of a
money demand function. Hamburger (1977) views (14) as a Keynesian formulation, exPlicitlY
contrasting it to the monetarist emphasis on portfolio considerations.
If he is right, then
my use of (14) to derive Meltzers equation (18) is a ver\.
un-monetar i si digul?ierIt. But one
of the purposes of this section is exactly to argue that portfolio and transactions
considerations are complementary in thinking about money demand.
153
consumpti on c takes the f orm:
C
Then combi ni ng ( 15) and ( 16) , we have shown that, under thi s homotheti ci ty
assumpti on, the true demand f uncti on f or money ( 9) takes the f orm:
P
= h( r ) k( Q, s)
(17)
Now there i s no theoreti cal reason to expect ( 17) to be more stabl e
- - -
empi ri cal l y than ( 9) : They are the same rel ati onshi p!
But empi ri cal l y,
total consumpti on has been f ound to be a f ai rl y stabl e f uncti on of
permanent i ncome, suggesti ng that k( Q, s) / r i s nearl y constant over a wi de
range of ci rcumstances. I f so, then:
M
P =
WY, )
r
(18)
where e' ( r) < 0 shoul d serve as a stabl e rel ati onshi p over the same range
of ci rcumstances.
I am goi ng to i nterpret ( 18) as the rel ati onshi p Mel tzer esti mated.
Thi s i nvol ves usi ng a short term i nterest rate f or r, i n contrast to the
l ong termrate I t al so precl udes addi ng other yi el ds to the
ri ght si de of ( 18) , as Hamburger di d, unl ess these other vari abl es can al so
be shown to af f ect the propensi ty to consume out of permanent i ncome. Thi s
ti ghter theoreti cal rati onal e i l l , I hope, gi ve some added i nsi ght i nto
el tzer' s empi ri cal work was so successf ul .
7
In the model I have sketched i n thi s secti on, i t i s the expl i ci t
71t is a perennial subject of debate among monetary economists whether there are
advantages to being as explicit about the nature of transactions demand as I have been here,
as opposed simply to including real balances as a good in agents utility functions. I do
not wish to be doctrinaire about this issue, but surely it cannot be wrong for monetary
theorists to think about what people do with the money they hold.
Economists who study the
demand for coffee do not hesitate to use common knowledge about what people do with Coffee,
and this knowledge leads them to empirically useful ideas about what goods are likely to be
close substitutes or complements for coffee,
and hence what prices are likely to be useful in
coffee demand functions. Why should those who study money demand not do the same thing?
I found Tables 1 and 2 in Mankiw and Summers (1986) of great interest, and of evident use
in guiding these authors
thinking about money demand. Researchers confined to thinking Of
money simply as something people like to hold,
without asking why they like lT(3 hold it, would
never have been led to seek out, display and utilize these data.
154
characteri zati on of transacti ons demand that l ea l ati onshi p be-
i ween real bal ances,
short term i nterest rates an perni anent i ncome or
weal th that one mi ght ant to vi ewas structural , racteri zatj on
made tractabl e by the assumpti on that everyone engages i n securi ti es trade
at the same ti me, al l i th the same f i xed peri od. That thi s assumpti on i s
unreal i sti c is obvi ous, That i t i s unreal i sti c i n a way that i s cri ti cal to
the theory of money demand was shown by Grossman an ei ss ( 1983) and
Rotemberg ( 1984) , who exami ned theoreti cal setti ngs i n h only a subset
of agents i s engaged i n securi ti es tradi ng at any ti me- Thi s modi f i cati on
al ters the way the systemresponds to open marke4 operati ons, because when
the central bank i ssues money f or bonds, i nterest rates must move so that
the subset of pri vate agents on the other side of thi s exchange i s wi l l i ng
to acqui re a di sproporti onate share of the economy' s newmoney swpgl y, Thi s
al terati on i ntroduces a Keynesi an "l i qui di ty pref erence" el ement i n%o money
demand that i s enti rel y absent f rom the f ormul ati on I have sketched.
Cochrane ( 1988) appears to have i denti f i ed these l i qui di ty ef f ects, f or
peri ods up to a year, i n post- 1979 U. S. weekl y seri es on Treasury bi l l
rates and money growth rates. ( I say appears" because the connecti ons be-
tween theoreti cal model s of the Grossman- Wei ss- Rotemberg type and the edi -
mati on methods used by Cochrane have not been worked out i n any detai l . )
By usi ng annual data, i t seemed possi bl e that el tzer' s resul ts and
mi ne mi ght avoi d contami nati on f romthese "l i qui di ty pref erence" ef f ects.
We wi l l see i n the next secti on, however, that thi s hope i s not conf i rmed,
at l east f or post- 1958 data. The tri ck wi l l thus be to get as much as we
can out of a money demand theory that i s not adequate to account f or some
short run events.
I V I
Econometri c research on money demand has undergone consi derabl e
devel opment si nce the earl y 1960s. I n the mai n, thi s
i th %he notabl e
excrpti on of Fri edman and Schwartz' s ( 1963) and ( 1982) studi es o
and U. K. ti me seri es) has f ocused on evi dence f rom r U- S. quarter1
seri es. el tzer' s work i s not ci ted i n J udd and SC 2 ( 1982) revi e
arti cl e ( though they do make repeated use of Lai dl er ( I 977) ,
turn heavi l y i nf l uence
ci ted i n thi s surve
155
The pi oneeri ng paper i n thi s "modern" era of money demand studi es i s
Gol df el d ( 1973) , whi ch i ntroduced di stri buted l ag methods that seem to be
needed to obtai n cl ose f i ts to quarterl y data. Subsequent work has, in
l arge part, been devoted to the ref i nement of Gol df el d' s studi es and to
deal i ng wi th the f act ( stressed most f orcef ul l y by Gol df el d ( 1976) ) that
hi s equati ons deteri orated i n f i t on data outsi de the ori gi nal sampl e
peri od.
There i s no doubt that recent work i s based on a much more sophi sti -
cated awareness of econometri c i ssues speci f i c to ti me seri es anal ysi s than
was the research of the 1950s and 60s. At the same ti me, the substanti ve
resul ts have been di sappoi nti ng. J udd and Scaddi ng ref er to "the observed
i nstabi l i ty i n the demand f or money af ter 1973, " and endorse the concl usi on
reached earl i er by Cool ey and LeRoy (1981) "that the negati ve i nterest
el asti ci ty of money demand reported i n the l i terature represents pri or
bel i ef s much more than sampl e i nf ormati on. " The uni t i ncome ( or weal th)
PTasti ci ty i s no l onger regarded as we1 T- establ i shed, and most recent work
has f ocused on f i nd- 7 "scal e vari abl es" that sharpen short- termf orecast
errors rather than on esti mates of the i ncome el asti ci ty that stand up well
over di f f erent data sets. I n short, one gai ns the i mpressi on that subse-
quent research has general l y f ai l ed to support Mel tzer' s f i ndi ngs, that the
i ncome and i nterest el asti ci ti es he esti mated are i nconsi stent wi th more
recent evi dence and were even, perhaps, as much the product of hi s "pri or"
as they were i nf erences drawn f romthe ti me seri es he studi ed.
I thi nk al l of these concl usi ons, or i mpressi ons, are i ncorrect. Tn
thi s secti on I wi l l argue that Mel tzer' s 1963 resul ts are not only quali-
tati vel y but quanti tati vel y consi stent wi th observati ons si nce 1955: that
even i f one takes the i ncome and i nterest el asti ci ti es esti mated, by hi s
methods, f rom pre- 1958 data al one one obtai ns a more usef ul account of
money demand i n the 25 year peri od si nce than i s obtai ned f rommore recent
di stri buted l ag f ormul ati ons. Moreover, i l l exhi bi t the i nf ormati on on
the i nterest el asti ci ty of money demand contai ned i n 1900-1985 data in such
a way as to concentrate even Cool ey and LeRoy' s posteri or di stri buti on on
el tzer' s 1963 co* . dsi on.
At the sm. . ti me, thi s appl i cati on of Mel tzer' s equati on to more
recent data wi l l al so reveal repeated, systemati c patterns i n the resi du-
ah. These are patterns that are not consi stent wi th the t eoreti cal model
revi ewed i n Secti on I I ( and hence not co
have i nterpreted i t) . I thi n
d others to resort to di st
156