Handbook of Monetary Economics Volume 1, Chapter 8

The Demand for Money

Stephen M. Goldfeld
Princeton University

Daniel E. Sichel
Board of Governors of the Federal Reserve System

1. Introduction

The relation between the demand for money balances and its determinants is a fundamental building block in most theories of macroeconomic behavior. Indeed, most macroeconomic models, whether theoretical or econometric, generally ignore the rich institutional detail of the financial sector and attempt to capture financial factors via the demand and supply of money. Furthermore, the demand for money is a critical component in the formulation of monetary policy and a stable demand function for money has long been perceived as a prerequisite for the use of monetary aggregates in the conduct of policy. Not surprisingly, then, the demand for money in many countries has been subjected to extensive empirical scrutiny. The evidence that emerged, at least prior to the mid-1970s, suggested that a few variables (essentially income and interest rates, with appropriate allowance for lags) were capable of providing a plausible and stable explanation of money demand.

As has been widely documented, especially for the United States but elsewhere as well, matters have been considerably less satisfactory since the mid-1970s. First, there was the episode of the "missing money" when conventional money demand equations systematically overpredicted actual money balances. Moreover, attempts to fit conventional demand functions to a sample that included the missing money period invariably produced parameter estimates with some quite unreasonable properties. Second, in the 1980s, U.S. money demand functions, whether or not fixed up to explain the 1970s, generally exhibited extended periods of underprediction as observed velocity fell markedly.

To be sure, the period since the mid-1970s has been marked by unusual economic conditions in many countries including supply shocks, severe bouts of high and variable inflation, record-high interest rates, and deep recessions. The period also coincided with the widespread adoption of floating exchange rates and, in a number of major industrial countries, with substantial institutional changes brought about by financial innovation and financial deregulation. Where institutional change was particularly marked, it also led to a change in what we think of as "money". The period since 1974 thus provided a very severe test of empirical money demand relationships and it is perhaps not so surprising that this period succeeded in exposing a number of shortcomings in existing specifications of money demand functions.1

The repeated breakdown of existing empirical models in the face of newly emerging data has fostered a vast industry devoted to examining and improving the demand for money function. This process has been aided by a growing arsenal of econometric techniques that has permitted more sophisticated examinations of dynamics, functional forms, and expectations. These techniques have also provided researchers with a wide variety of diagnostic tests to evaluate the adequacy of particular specifications. Initially, at least in the United States, this led to two strands of research. The first was what Judd and Scadding (1982a) called "reopening the pre-1973 agenda". As a practical matter this amounted to re-exploring variables (e.g. measures of transactions), functional forms, or dynamics that seemed to be unnecessary in a more tranquil period. A second strand of research was devoted to modifying existing specifications to account for changes brought about by financial innovation and deregulation.

While these various strands of research have yielded considerable insight, matters are still in a state of flux. Part of the reason is that, perhaps not surprisingly, the modeling of financial innovation and deregulation proved to be a quite difficult task. Some have even gone further, suggesting that instabilities in money demand are to be expected, reflecting structural change in the economic and financial environment. Spindt (1987) has characterized the unsettled flavor of the literature by noting that researchers either seem to conclude that no explanation is adequate to explain some recent money demand "puzzle" or that "the author's own, (usually many years old), specification still works just fine, so there isn't really any puzzle at all" [Spindt (1987, p. 1)]. Spindt goes on to suggest that we may need an alternative paradigm, a call that seems to be echoed in other recent reviews of empirical money demand [Judd and Scadding (1982a), Gordon (1984), Roley (1985)].

The outline of the chapter is as follows. Section 2 documents the nature of the difficulties with conventional demand functions, both in the United States and elsewhere. For the remainder of the chapter, however, when empirical results are presented the focus will be exclusively on the United States. Section 3 begins with a brief review of some underlying theoretical models and uses these as a vehicle to re-examine measurement and specification issues such as the definition of money and the appropriate scale and opportunity cost variables. Section 4 considers econometric issues starting with estimation issues in the partial adjustment model and then analyzes criticisms and modifications of the partial adjustment model. This section also discusses the estimation of money demand imposing assumed or estimated long-run relationships and considers questions of simultaneity and the so-called buffer-stock approach. The final section considers the recent behavior of money demand functions and summarizes the current state of affairs.

1It is perhaps ironic that the emergence of these shortcomings roughly coincided with the adoption by a number of central banks of policies aimed at targeting monetary aggregates. Some have argued that this association is more than mere coincidence. In any event, given the vested interest of policymakers in the existence of a reliably stable money demand function, it is hardly surprising that employees of central banks were among the most active contributors to the most recent literature on money demand.