The instability of the demand for money

Abstract

The demand for money plays an important role in the assessment of the efficacy of monetary policy. Prior to the early 1970s, there was a consensus among the empirical literature that a stable demand for money function existed. During the early 1970s, most empirical studies indicated that the demand for money had shifted about in an unpredictable manner, making the assessment of the efficacy of monetary policy hazardous. This thesis investigates the causes of the instability of the demand for money by going back to first fundamentals of the theory of the demand for money. Two main possible causes are identified, viz: financial innovation, and frequent changes in taxation regimes. With regard to financial innovation, which may take on the form of lower transaction costs, improved cash-management techniques and the increased proliferation of new substitutes for money, the following propositions are made: that a change in transactions costs affects the demand for money, and that improved cash-management techniques and new substitutes for money will lead to increased interest-elasticities for the demand for money. The use of divisia monetary aggregates as a possible replacement for simple-sum aggregates is also considered. With regard to frequent changes in taxation regimes, the theoretical relationship between expected inflation and interest rates as embodied in the Fisher hypothesis is analysed. Two neoclassical monetary growth models are discussed in which each model has a different method of capital financing by the firm, viz: all-debt, and debt-equity financing. The Fisher hypothesis is then refined to take into account the different features of each taxation regime. Whilst the original Fisher hypothesis predicts that the nominal interest rate will adjust pari passau in response to expected inflation, the refined hypothesis predicts that nominal interest rates will adjust by more than the expected rate of inflation. The refined Fisher hypothesis is then incorporated into the steady-state demand for money, and it is suggested that frequent changes in taxation regimes can lead to the instability of the steady-state demand for money.