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Carnegie-Roch ester Conf erence Series on Pub lic Polic y 29 (1988) 137-168
North-Holland
MONEY DEMAND IN THE UNITED STATES: A QUANTITATIVE REVIEW
ROBERT E. LUCAS, JR.1
The University of Chicago
I. INTRODUCTION
Allan Meltzer's research career has been so productive and so varied that it
would be an act of folly, not friendship, to attempt to review it in a single paper. Yet
I do want to talk about his research on this occasion, for research is what Allan's
career is mainly about, and I want to do so in detail, because details are the way
scholarship is carried out. Accordingly, I will focus my attention mainly on a singlepaper, one that has influenced my own thinking on monetary economics a great
deal, Meltzer's "The Demand for Money: The Evidence from Time Series," published
in the Journal of Political Economy in 1963.
Meltzer's "Demand for Money" was one in a series of his empirical studies in
monetary economics, much of which involved joint research with Karl Brunner. It
followed earlier work by Latane and others, especially Friedman, and helped to
stimulate closely related later contributions by Laidler and others.* The shared
objective of this research program was, in Friedman's (1956) terms, to demonstrate
that the demand for money is a "highly stable function" of a limited number of
variables, to discover the most useful, operational measures of money and these
other variables, and (again citing Friedman) to work "toward isolating the numerical
'constants' of monetary behavior." Meltzer's paper was the first to estimate an
income
1This paper was prepared for the Novembert 1987 Carnegie-Rochester Conference. I would like to
thank John Cochrane, Thomas Cooley, Milton Friedman, Lars Peter Hansen, Robert King, Leonardo
Leiderman, Bennett McCallum, Sherwin Rosen, Thomas Sargent and Lawrence Summers for helpful
discussions and/or comments on an earlier draft. I also benefitted from a stimulating discussion at the
Conference. P.S. Eswar-Prasad provided excellent research assistance.
'Two important sequels to this paper are Brunner and M^lfzer (1963) and Laidler (1966). Of course,
this and other work on money demand wss closely related to rther contemporary research, especially
the ear l ier contr ibut ions of Fr iedman (1956) a n d h i s s t u d e n t s , , a n d Friedman (1959). See Laidler
(1977)and,more recently, McCallum and Goocf r i end (1987) for some of the relevant background.
0 167 - 2231/88/S3.50 1988 Elsevier Science Publishers B.V. (North-Holland)
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(or wealth) elasticity and an interest elasticity simultaneously from time series data
from a single country (the U.S.). The objective of the present paper will be to review
and replicate these results, to reconsider how they might be interpreted
theoretically, and to see how well they stand up to the 25 years of new data that
have become available since Meltzer wrote.
An estimated money demand function provides answers to two important
questions of economic policy. The income elasticity, in a setting in which long run
real output growth is both fairly predictable and insensitive to changes in monetary
policy, provides the answer to the question: What rate of growth of money is
consistent with long run price stability? The interest elasticity is the key parameter
needed to answer the question: What are the welfare costs to society of deviations
from long run price stability? Purely qualitative answers to these questions, along
the lines of "Inflation rates are significantly related to money growth rates" or
"Inflation reduces welfare" are interesting and useful, perhaps, but surelypropositions such as "An HI growth rate of 3 percent per year will bring about price
stability" or "A ten percent annual inflation rate has a social cost equivalent to a 0.5
percent decline in real income" are more interesting and, if accurate, much more
useful.
Though the objective of an economics that provides quantitative answers to
important questions of economic policy is now very widely subscribed to, it is
remarkable how little attention is paid in many of our discussions to the substance
of parameter estimation, and how little honor is paid to those few economists who
do it well. All of us have sat through many discussions of econometric work in
which the theoretical underpinnings of the relationships estimated and tested and
the econometric methods used are subjected to intense scrutiny and yet no one
seems to care what the numerical results were! Even in Laidler's (1977) survey of
the evidence on money demand, or in McCallum and Gcodfriend's (1987) more
recent summary, it is difficult to find clear statements of what the money demand
function is. As quantitative economists we often seem to be, in Samuel son's (1947)
phrase, "like highly trained athletes who never run a race, and in consequence
grow stale."
Meltzer ran this particular race, in 1963, and turned in his two numbers. Much
has happened since to monetary theory and to the development of econometric
methods, and almost three decades of new data have since become available. In
Section II I will sunmarize the evidence on the income (or wealth) and interest
elasticities of money demand from 1900-58 data, essentially identical to those
Meltzer used. Section III introduces a
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utility-theoretic framework for thinking about money demand, from which I will
conclude that there is some reason to view these two parameters as structural.
Section IV reviews U.S. time series evidence from the 1958-85 period, a period
during which nominal interest rates reached levels about twice the highest levels
attained in the U.S. in the earlier years of the century. Remarkably, in view of the
stringent nature of the experiment, these new data precisely confirm the estimates
Meltzer obtained in 1963.
I I . R E V I E W O F T H E E V I D E N C E F R O M 1 9 0 0 - 1 9 5 8
The hypothetical household decision problem underlying the results reported
in Meltzer (1963) is that of allocating a given stock of wealth across different assets,
given a vector of asset returns. I will come back to this problem in more detail in
Section III, but I have said enough to rationalize a demand function for money of the
form
= f(r,w) .
Throughout his paper, Meltzer used the log-linear form:
in(mt) = a - b?n(rt) + can(wt) + ut, (1)
where m^. is the stock of real balances at t, w tis real wealth or real income, rtan
interest rate, utis an error term, and a, b and c are parameters. Meltzer used a long
term interest rate to measure rt, treated as a stand-in for the entire vector of returns
on alternative assets. He experimented with a very wide variety of income and
wealth variables as measures of real wealth, and with both Ml and M2 as measures
of the money stock. The sample period was 1900-1958, with results also reported
for the two subperiods 1900-1929 and 1930-1958.
lne experimental approach Meltzer used for measuring money and wealth is
obviously suitable: we do not have theories that single out particular measures asclearly superior to others. One could indeed criticize the paper for reporting too few
results, since the single interest rate he used to represent asset returns was
arbitrarily chosen. But much of this experimentation indicated that the choice of
wealth and money aggregates was not critically important. This finding has been
confirmed by much subsequent research, as described in Laidler (1977). I will
therefore report and
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replicate only a small subset of the results reported by Meltzer (1963).
Table 1 transcribes results in Meltzer (1963). Line 1 is equation (3) on p. 225,
with R1reported instead of R and "standard errors" instead of "t-statistics."^ Lines
2,3,5,6,7 and 8 are from Table 2, p. 232. Line 4 is from Table 1, p. 229. Of course, al l
regressions reported in this and al 1 other tables in this paper were estimated with
constant terms. Since the units of the dependent variable I used are not
meaningful, I wi 11 not report these constants.
The central findings in lines 1-3 of Table 1 (these and all subsequent
references are to tables in this paper), confirmed by other results in the original
paper, are the wealth or income elasticities of about unity and the strong, negative
effect of interest rates on real balances demanded. Notice that neither finding
shows up very clearly when the period is divided in two, as reported in lines 4-8 of
Table 1. For the early period, the income and wealth elasticities diverge, in different
directions, from unity and the interest elasticities are much reduced. Meltzer doesnot report the results with wealth only for 1930-1958. From what is reported,
however, it appears that the results for the full period were mainly dictated by
events in the latter half.)
Table 2 contains my replications of the results in Table 1. I dropped
1
The residuals from my replications of Meltzer's equations show very severe autocorrelation, and it is
clear from the Durbin-Watson statistics reported in Meltzer (1964) t viat this is also true of his original
regressions. As a result, I do not know how to interpret the "standard errors" reported in these tables. I
experimented with a variety of methods for correcting for serial correlation, but obtained only wildly erratic
elasticity estimates.
^For money, I used Ml throughout the paper. For 1900-14, this series is taken from Historical
Statistics (1960), series X267. From 1914-47, it is from Friedman and Schwartz (1970), pp. 704-718, column
7. For 1948-85, it is the "IMF series 3" from the International Monetary Fund's "International Financial
Statistics" tape. (The primary source for these IMF data is the Federal Reserve Bulletin.)
For 1900-49, real wealth is from Goldsmith (1956), Table W-3, column 1 ("total national wealth at 1929
prices"). For 1950-57, this series is from Historical Statistics (1960), series F446.
For 1884-1975, real income is real net national product from Friedman and Schwartz (1982), Table 4.8.
For 1976-85, it is taken from various July issues of the Survey of Current Business. The price level (used to
deflate Ml) is the implicit NNP deflator from the same sources. Permanent income is the geometrically
weighted sum of current and past real NNP's used in Friedman (1957). The weight on current income is .33.
The long term interest rate (used only for 1900-57) is the "basic yield on 20 year corporate bonds" in
Historical Statistics (1960), series X346. The short term rate for 190075 .s the "6 month commercial paper"
rate from Friedman and Schwartz (1982), Table 4.8, column 6. For 1976-85 I used Table B-68 in the Economic
Report of Jhe President (1987).
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TABLE 1
141
Meltzer (1963) Results Dependent variable: n(Mj/P)
Coeff icients on:(standard errors)
regressions track this well (of course, with the interest rate also included as a
regressor). Real balances did not decrease nearly as much as did NNP in the 1930s,
but they increased much more than income in the 1940s. I conclude (though this is
the sort of issue reasonable people can disagree on) that current income induces
"too much" cyclical responsiveness in predicted money demand, relative to wealth,
and that wealth or some other "smoothed" income measure is preferred as the
regressor. This is also the conclusion reached by Laidler (1977).In Table 3, I report the consequences of some variations on Meltzer's results.
The objective of this experimentation is to locate a version of Meltzer's model that
is reasonably faithful, conceptually and quantitatively, to the original and is at the
same time inexpensive to test on more recent data.1
Line 1 in Table 3 uses permanent income (defined by Friedman's distributed
lag on current and past real NNP's) in place of wealth. This change does an
excellent job of reproducing line 1 of either Table 1 or 2. From a comparison of
Figure 1 with Figure 2, one can see that permanent income behaves more like
wealth than like current NNP in the 1930s.
Lines 2 and 3 report two variations on line 1. In line 2, the long interest rate
used by Meltzer is replaced by a short rate. I will explain my strong preference for
the latter in Section III. The short rate (over this period) varies sympathetically with
the long, but with more amplitude: hence its smaller coefficient. Otherwise, this
variation doesn't matter much. In line 3, I use an unlogged short rate. The issue
1The variations reported in Table 3 are very close to results in Laidler (1966). Laidle r used U.S. annual
series from 1892-1960, and deflated real balances and permanent income population. In his counterpart to
line 1 of Table 3 (his Table 2, A, p.548) he obtained permanent income and interest elasticities respectively
of 1.51 and .25. His counterpart of my line 2 (also Table 2, A in his paper) are 1.39 and .16. He did not try
unlogged interest rates .
Line ___________ Years ___________ ftn(r ) ___________ &n(W/P) __________ &n(Y/P)_____________ __ R*1 1900-58 -.949 1.11 .984
(.044) (.026)
2 1900-58 -.79 1.05 .960
(.083) (.041)
3 1900-58 -.92 .97 .13 .980
(.053) (.103) (.093)
4 1900-29 -.32 1.84 .960
(.107) (.114)
5 1900-29 -.05 .70 .960
(.094) (.45)
5 1900-29 -.22 .48 .3) .960
(.122) (.240) (.194)
7 1930-58 -.69 .94 .902
(.160) (.094)
8 1930-58 -1.15 1.35 -.10 .980
(.097) (.155) (.125)
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between the different functional forms in lines 2 and 3 is mainly aesthetic: the semi-
elasticity at the sample mean value of r (3.26 for 1900-57) is, from the estimate of
the elasticity in line 2, (-18)/(3.26) = .055. From line 3, this same semi-elasticity is
estimated at .07. (In this, as in all other economic applications with which I am
familiar, the choice of functional form is of little substantive consequence.) Thus I
will take Table 3 as justifying my referring to the model reported in line 3 as
"Meltzer's theory".
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TABLE 1
143
Let me conclude this section with a somewhat less formal summary of the
information on income and interest elasticities contained in this 190057 sample.
Over this period, real Ml balances grew at the annual rate of .03356 and real
permanent income at the rate .03126. Short term ir erest rates fluctuated between
.69 (during World War II) and 7.4 (in 1920) but with a negligible trend. Hence the
ratio of the money growth rate to the income growth rate, 1.07, is a good estimate
of the income elasticity. This is about the number obtained, under various
assumptions, in Table 3. Over long periods, it must always be the case that the
trend in the dependent variable must be "explained" by that subset of the
regressors that have trends. In this application, real income does and interest rates
do not.Now imposing an income elasticity of unity, the semi-elasticity of money
demand with respect to the interest rate is just the slope of a plot of ln(Ml/Pyp)
against r$. This plot is displayed in Figure 3. This "estimation method" - get the
income elasticity from money and income trends and then get the interest elasticity
from a two-variable regression
Rjplicat ions Dependent variable: ln(Mj/P)Line Years !n (r) Coeff icients on:
(standard errors)
tn(W/P)
in(Y/P) R
1 1900-57 -1 .v 1.32 .957
( . 0 1) (.056)
2 1900-57 6 7 1.04 .971
(.077) (.036)
3 1900-57 .90 .49 .68 .978
(.089) (.122) (.095)
4 1900 29 -.21 .86 .957
(.099) ( . 0 5 1 )
5 1900-29 -.07 .73 .932
(.119) (.057)
6 1900-29 -.20 .65 .19 .960
(.098) (.149) (.132)
7 1930-57 -1.72 1.53 .901
(.139) (.163)
8 1930 57 -.55 .93 .937
(.141) (.075)
9 1930-57 -.78 .34 .75 .939
.264 .332 .191
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900
144
(Q4>3*
>T30>
cCD
To3->
U
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Predicted Ml/P using current income (line 2, Table 1).
,Predicted Ml/P using wealth (line 1, Table 1).
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Actual Ml/P
Predicted Ml/P using current income (line 2, Table 1).
Predicted Ml/P using permanent income (line 1, Table 3).
Figure 2
Year
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TABLE 1
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ftn(r) n(rs)Line
rs
n(yp)
.9891.03
(.021
)
-.77
(.044)
96 61.07
(.039
)
2 -.18
(.025)
96 31.06
(.042
)
3 -.07
( . 0 1 1
)
Variations on Table 2 for 1900-1957
Dependent variable: ftn(M1/P)
Coefficients on: (standard errors)
- does not depend very critically on our ability to characterize the residuals
accurately, or even on the residuals having a common structure over the entire
period. Since we have much more reason, to which I will turn in the next section,
for believing these elasticities to be stable than we have reason to believe anything
in particular about the residuals, this seems to me a desirable feature.^
Of course, no estimation method is satisfactory under all assumptions about
the errors, and the critical assumption here is that the errors are trend-free. If there
were important technical changes, not occurring in response to interest rate
movements, permitting agents to economize on their use of Ml balances my
method (and Meltzer's too) has understated the income elasticity. I do not see how
one can learn snore about this possibility by examining the series at hand.
'These informal remarks are not intended as a substitute for econometric theory. One would
certainIy have a better understanding of the estimates reported here and below if one could write down a
be I ievable stochastic model and use it to derive the proper t i es of these estimates explicitly. But I have
not done this and so am obIiged to follow a second best route and explain why I proceeded as I did in alooser (and hence less informative) way.
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Short-terrr Interest Rate
Figure 3 : 1900-57
2 3 4 5 6
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I I I . A T H E O R E T I C A L F R A M E W OR K
As an aid in interpreting the results reported in the last section and the
additional results to be reported in Section IV, I will introduce a simple theoretical
framework based on the model analyzed in Lucas and Stokey (1987). The
framework has the advantage (relative to the framework Meltzer used) of being
explicit about the connection between the portfolio and transactions demands for
money, and the disadvantage of being unrealistically stylized about the way trading
occurs. It will take some care to exploit the explicitness of this model without being
led too far astray by its unrealistic features.
We consider an economy in which the representative agent has the ultimate
objective of maximizing the discounted expected utility from consumption of
goods,
3t E{z8U(c.)} .
t=0 z
This agent lives in a Markovian world, the state of which at t is summarized by a
vector s^.. The distribution ofSj.+j, given s^., is given by a fixed transition function
F(s,A) = Pr{sule A|s = s) .
In this setting, all equilibrium date-t prices and quantities will be fixed (no time
subscript) functions of the current state, s^.Agents are assumed to alternate between securities trading and goods
trading in lockstep fashion. At the beginning of each period, all agents trade in
securities, including money, in a single centralized market, all with full knowledge
of the current realization of st. When securities trading is concluded, all agents
disperse either to produce or to purchase consumption goods. Some of these
goods can only be purchased with money acquired during the course of securities
trading: This transactions requirement is the sole reason for including cash in a
portfolio, in preference to interest bearing claims to future cash.
Consider first the decision problem facing an agent who is engaged in
securities trading at a time in which the state of the economy is s and his personal
wealth in dollar terms is W. (In a centralized securities market all assets are priced,
so the single number W summarizes his asset position fully.) Let v(s,W) denote the
value of this agent's expected,
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discounted utility if he proceeds optimally from this point on.
At this point, the agent is faced by a vector Q(s) of securities prices (in
dollars, so the price of money is unity). He must choose money holdings M and a
vector of securities holdings z, subject to a portfolio constraint:
N + Q(s) z < W . (2)
Let G(M,z,s) be the indirect utility function he uses to make this choice. (Clearly G
will depend on s, since the current state variable includes all the information he has
about the returns from these securities.) Then v(s,W) must satisfy:
v(s,W) = max G(M,z,s) subject to (2). (3)M,z
I call (3) the agent's portfolio problem.
Now where does this indirect utility function G come from? Having completed
securities trading, the agent is about to engage in purchasing a vector c of
consumption goods. He will also receive an endowment y(s) of goods, but this he
must sell for cash or future cash: He cannot consume his own endowment. The
rules of trading in this goods market are summarized by a vector of constants a,
where a^ e [0,11 is the fraction of purchases of good i that must be covered by
money. It will be an expositional simplification in what follows to postulate a
technology together with a choice of units for measuring goods such that all goods
sell for the same nominal price P(s). In this case, the agent's Clower- or cash-in-
advance constraint is:
P(s)a c < M . (4)
The outcome (M,z) of the portfolio decision plus the outcome (c,y(s)) of his
goods trades plus a given vector D(s') of nominal returns (dividends, interest,
principal) on securities will determine this agent's nominal wealth position W as of
tomorrow, conditional on tomorrow's state s'. He begins next period with his dollar
holdings as of today, M, plus the dividends and resale value of his securities,
(Q(s')+D(s'))"z, plus the dollar value of his endowment, P(s)S y (s), less the dollar
value of his goods purchases, P(s)S c . That is:
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W = H + [Q(s')+D(s')lz + p(s)fIyi(s)-C|I
These considerations determine what I call the transactions problem:
G(M,z,s) = max U(c) + 3/ v(s',W)F(s,ds') subject to (4) , (6)c
where W is defined in (5).
Eliminating the function G between (3) and (6) defines a functional equation
in the value function v. See Lucas and Stokey (1987) for an analysis of this
equation and its use in constructing an equilibrium for this economy. My purpose
here is not so much analysis as it is clarifying what we mean by a "demand
function for money," and hence in understanding what an empirical money
demand function might mean. Let me begin with what I think Meltzer (1963) and
certainly Hamburger (1977) meant by a "demand function for money."From the portfolio problem (3) one obtains the first order conditions:
G(yj(M,z,s) = v , (7)
G (M,z,s) = (hv , j = l,...,m , (8)J J
where \> is the multiplier associated with the wealth constraint (?) and where j
indexes the m available securities. These m+1 equations together with (2) can be
solved to obtain the demand functions for the assets (M,z) which have as
arguments the prices Q and wealth W. Singling out the demand function (in this
sense) for money:
M = f(Q,W,s) . (9)
Note that the entire vector Q of securities prices enters on the right of (9). In
practice, as in any empirical application of demand theory, one would focus on theprices of securities thought to have strong substitution or complementary
relationships with money. In this spirit, Meltzer used a long term bond yield in his
econometric work. In the same spirit, Hamburger (1977) experimented with equities
yields and other securities returns in his.Certainly (9) is a respectable bas i s for an empirical study,
(5)
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consistent with what we knew then about monetary theory and, I would say,consistent with what we know now. Yet it does not seem to me that one would haveany confidence that the demand function (9), based on portfolio considerations onlyas in my derivation, would remain stable over time. Included as suppressedarguments in this functions f are all variables s characterizing the current state ofthe system, including all the information used by agents in forecasting futurereturns on all securities. Moreover, if the stochastic environment in which agentsoperate (the "regime," as it is often called) should change from time to time, these
changes too will induce shifts in f. Surely shifts in the realizations of informationalvariables and/or in the processes assumed to generate these realizations must havebeen substantial over so long a period as 1900-1958.
To decide whether the fact that the functions f are not likely to be structural is
an important objection to the empirical application of (9), consider the fact that by
exactly the above argument on money demand, we could derive a demand function
of the same form as (9) for any portfolio item. Would one, for example, attempt to
estimate a demand function for Brazilian government securities, including as
arguments only their own current yield and another interest rate standing in for the
composite security consisting of all other portfolio items, and expect thisrelationship to be stable over a 60 year period? I think there is more to Meltzer's
money demand theory than portfolio considerations alone.
To see what this is, turn to the transactions problem (6), which also defines
the indirect utility function G. The first order conditions for the n consumption
goods in this problem are:
Mc)= B fvw(s',W')P(s)F(s,ds') + yP(s)ai, i=l,...,n, (10)
where y is the multiplier associated with the cash-in-advance constraint (4). One
can also calculate the derivatives of the function G from (6):
G|y|(M,z,s) = u + 0/ vw(s',W')F(s,ds') , (11)
Gz.(M,z,s) =B fvw(s',W')[Qj(s')+Oj(s')]F(s,ds'), j=l,...,m. (12)
That is, the value (in utiIs) of a dollar is its "liquidity" value y during
goods trading plus the marginal valueof nominal wealth one period hence. The value
of any other security is the v/alue of the increment it provides
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to future wealth. Equations (11) and (12) thus reduce the values of securities,
money included, to the values of their associated "fundamentals."
Now suppose that among the m available securities is a (nominal) risk free,
dollar denominated, one period bond. For this security,Qj(s') = 0
and Dj(s') = 1. Let its current price be i+r(s) , so r(s) is the one
period nominal interest rate. Then combining (7) and (8) from the portfolio problem
and (11) and (12) from the transactions problem (where both (8) and (12) are
specialized to this one period bond) and inserting into the first order
conditions (10) we obtain:
Uj(c) - P(s)ulai+ ^ry| , i =
That is to say, the relative "prices" of these consumption goods, as seen by
consumers (normalized so that the prices of each received by sellers are all equalto P(s)) depend on the cash holdings required to purchase them together with the
opportunity cost of holding cash, as measured by the nominal interest rate.
In the environment I have been describing, in which no new information
reaches agents after they have switched from securities trading to goods trading,
agents will plan money holdings so that the cash-in-advance constraint (4) holds
with equality: In the theory, as in fact, cash is dominated by nominal bonds as a
store of value. In this case (13) and (4) (with equality) form a system of n+1
equations in the consumption vector c and the multiplier p. It is not quite a demand
system (since the "prices" in (13) are not the same as the "r.rices" in (4)) but it can
be
treated just as if it were and solved fp Vn consumption vector c as a
. ' 'function of iVP(s) and r(s), say: ^
C = g ( p . r ) .
Thus we obtain, from transactions considerations, ar exact relationshipbetween agents' desired consumption mix, their demand for real balances, and the
nominal interest rate. Noticc that no other securities prices or returns enter into
this relationship, nor does the state s
(13)
(14)
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(except through the two prices P(s) and r(s)).^ Changes in information or in the
information structure of the system will not shift these curves. They will be stable
over time provided only that preferences are and that the trading technology as
sunmarized in the coefficients a^,...,anis stable.
It seems to me a violation of common usage to call the relationship (14) a
"demand function for money." It is a relationship among complementary choice
variables that the demand functions must satisfy. Whatever one calls it, however, it
is a relationship that must obtain in equilibrium and it seems more likely to be an
empirically stable one than does the "true" demand function (9). Why not provide
an operational specification of these coefficients a^ and try to estimate it
econometrically? This is the approach taken in a recent paper by Mankiw and
Sumners (1986), with very interesting results that I wil 1 come back to in the next
section, first, however, it will be useful to go into more detail about the connections
between (9) and (14).Meltzer's estimated income and wealth elasticities are around unity,
suggesting (under the utility-theoretic framework I am using here) that the current
period utility function U takes the form of a constant relative risk aversion function
of a homogeneous of degree one function of consumption. Let us impose this on
the model above. Then equations (13) can be solved for the ratios c^/c of
consumption of each good to total consumption c = c^ = g^(r)c , say.
Substituting into the cash constraint gives:
= Eiaigi(r) c = h(r)c , (15)
where the second equality defines the function h. This is just a consolidated
special case of (14), stil1 not a demand function for money. Under these same
assumptions, the "true" demand function for total
^Th i s rationale for (14) is essen t i a I I y the same as that used for a simila! purpose by McCallum
and Goodfriend (1987). See Ando, Modigliani and Shell (1975) for the earliest derivation of (14) along these
lines that I have found. These writers draw the same conclusion I have in the text: that on Iy 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 Mel^er's equat ion (18) is a very "un-monetar i si" argument. But
one of the purposes of this sect ion is exactly to argue that port folio and transactions considerations are
complementary in thinking about money demand.
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(16)
155
consumption c takes the form:
c - k(Q,s) .
Then combining (15) and (16), we have shown that, under this homotheticity
assumption, the true demand function for money (9) takes the form:
p = h(r)k(Q,s) p .
Now there is no theoretical reason to expect (17) to be more stable
empirically than (9): They are the same relationship! But empirically, total
consumption has been found to be a fairly stable function of permanent income,
suggesting that k(Q,s)/r is nearly constant over a wide range of circumstances. If
so, then:
F *(r>*p
where
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characterization of transactions demand that leads to a relationship between real
balances, short term interest rates and permanent income or wealth that one might
want to view as structural. This characterization was made tractable by the
assumption that everyone engages in securities trade at the same time, all with the
same fixed period. That this assumption is unrealistic is obvious. That it is
unrealistic in a way that is critical to the theory of money demand was shown by
Grossman and Weiss (1983) and Rotemberg (1984), who examined theoretical
settings in which only a subset of agents is engaged in securities trading at any
time. This modification alters the way the system responds to open market
operations, because when the central bank issues money for bonds, interest rates
must move so that the subset of private agents on the other side of this exchange
is willing to acquire a disproportionate share of the economy's new money supply.
This alteration introduces a Keynesian "liquidity preference" element into money
demand that is entirely absent from the formulation I have sketched. Cochrane(1988) appears to have identified these liquidity effects, for periods up to a year, in
post-1979 U.S. weekly series on Treasury bill rates and money growth rates. (I say
"appears" because the connections between theoretical models of the Grossman-
Weiss-Rotemberg type and the estimation methods used by Cochrane have not
been worked out in any detail.)
By using annual data, it seemed possible that Meltzer's results and mine
might avoid contamination from these "liquidity preference" effects. We will see in
the next section, however, that this hope is not confirmed, at least for post-1958
data. The trick will thus be to get as much as we can out of a money demand theory
that is not adequate to account for some short run events.
I V . H O N E Y D E M A N D S I N C E 1 9 5 8
Econometric research on money demand has undergone considerable
development since the early 1960s. In the main, this work (with the notable excption
of Friedman and Schwartz's (1963) and (1982) studies of long U.S. and U.K. timeseries) has focused on evidence from postwar U.S. quarterly series. Meltzer's work
is not cited in Judd and Scadding's (1982) review article (though they do make
repeated use of Laidler (1977), which was in turn heavily influenced by Meltzer's
work) and, in general, the research cited in this survey is not much concerned with
comparison of postwar evidence with evidence from the earlier years of the
century.
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The pioneering paper in this "modern" era of money demand studies is
Goldfeld (1973), which introduced distributed lag methods that seem to be needed
to obtain close fits to quarterly data. Subsequent work has, in large part, been
devoted to the refinement of Goldfeld's studies and to dealing with the fact
(stressed most forcefully by Goldfeld (1976)) that his equations deteriorated in fit
on data outside the original sample period.
There is no doubt that recent work is based on a much more sophisticated
awareness of econometric issues specific to time series analysis than was the
research of the 1950s and 60s. At the same time, the substantive results have been
disappointing. Judd and Scadding refer to "the observed instability in the demand
for money after 1973," and endorse the conclusion reached earlier by Cooley and
LeRoy (1981) "that the negative interest elasticity of money demand reported in the
literature represents prior beliefs much more than sample information." The unit
income (or wealth) elasticity is no longer regarded as wel1-established, and mostrecent work has focused on find i "scale variables" that sharpen short-term
forecast errors rather than on estimates of the income elasticity that stand up well
over different data sets. In short, one gains the impression that subsequent
research has generally failed to support Meltzer's findings, that the income and
interest elasticities he estimated are inconsistent with more recent evidence and
were even, perhaps, as much the product of his "prior" as they were inferences
drawn from the time series he studied.
I think al 1 of these conclusions, or impressions, are incorrect. In this section
I will argue that Meltzer's 1963 results are not only qualitatively but quantitatively
consistent with observations since 1958: that even if one takes the income and
interest elasticities estimated, by his methods, from pre-1958 data alone one
obtains a more useful account of money demand in the 25 year period sinee than is
obtained from more recent distributed lag formulations. Moreover, I will exhibit the
information on the interest elasticity of money demand contained in 1900-1985 data
in such a way as to concentrate even Cooley and LeRoy4s posterior distribution on
Meltzer's 1963 co .usion.
At the sair.. time, this application of Meltzer's equation to more recent data
will also reveal repeated, systematic patterns in the residuals. These are patterns
that are not consistent with the theoretical model reviewed in Section II (and hence
not consistent with Meltzer's theory as I have interpreted it). I think it will be easy to
see why these patterns motivated Goldfeld and others to resort to distributed lag
methods. But I
4 1900-85 -.07 .97 .967
(.044) (.019)
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will argue that these methods have served to obscure rather than reveal both the
sense in which this theory helps to understand recent events and the sense in
which it falls short.
Table 4 provides results for the entire 1900-85 period and for the recent
subperiod 1958-85. Line 1 is exactly the same regression as line 3, Table 3 for the
full period. Line 3 of Table 4 is the same regression for the period 1958-85 only. One
can see that simply adding the later years to the full sample results in virtually no
change in the estimated elasticities. However, the results for the later years taken
by themselves show a drastic deterioration in fit and large changes in estimated
coefficients as compared to the 1900-57 period. In lines 2 and 4 of Table 4, the
income elasticity is constrained to be unity (so no "standard error" is reported).
Line2is, not surprisingly, the same as line 1, but so too is line 4.
Examining trends over the later period (as I did in Section II for the earlier
years) helps in interpreting Table 4. In the27 year period 195885, real money
balances grew at an annual rate of .004 while real income grew at a rate of .03.
Short term interest rates increased (though not at all smoothly) from around 3
percent to around 9 percent, or at a rate of about.22percentage points per year. To
fit these trends, the interest semi-elasticity nrand the income elasticity have to
lie on the
line: nr= -.02 + (.14)ny With an income elasticity of unity, this implies an interest
semi-elasticity of .12. This pair of estimates is roughly
TABLE 4
Results from 1900-85 Dependent variable: n(Ml/P)
Coeff icients on:(standard errors)
2
Line Years r^ R consistentwith the estimates 1.06 and .07 reported in line 3 of Table
3. It is also consistent with the estimates .97 and .07 in line 1 of Table4, and with the constrained estimates in lines 2 and 4 of Table 4. Similarly, the
unconstrained estimates .21 and -.01 on line 3 of Table 4 lie roughly on this line.
One can account for the divergent trends in income and real balances over the
1953-85 period either with the 1900-57 estimated income and interest elasticities or
with much lower income and interesto
elasticities.
Figure 4 illustrates, in part, why I prefer tu?. constrained estimates reported
on lines 2 and 4 of Table 4 to the unconstrained estimates on line 3. This figure
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plots the log of P/Pyp against the short term interest rate for the entire 1900-85
period, with the post 1957 observations indicated by different symbols from the
1900-57 observations. One can see that if one constrains the income elasticity for
the entire period to be unity, one gets in return a single interest semi-elasticity for
the entire period. The most recent points lie exactly or the line defined by the
earlier ones and, since interest rates behaved so differently in the recent period,
the estimate is greatly sharpened by the new observations.
Let me try to summarize the sense in which Figure 4 confirms both Meltzer1s
hypothesis that real money demand is a stable function of permanent income (or
wealth) and interest rates and the numerical estimates h? obtained. Meltzer
estimated these two parameters by least squares. As Figure 2 shows, the estimated
income elasticity is mainly dictated by the common trend of real balances and
income. At this estimated value of unity, Figure 3 shows that the interest elasticity
is determined by a reasonably tight scatter of an(Ml/Pyp) against rs. If one imposesthe same income elasticity of unity on the 1953-85 period, this same scatter.,
reproduced as Figure 4, confirms the original interest elasticity estimates and since
interest rates were so much higher in the later period, the new experiment is a very
good one. Notice that there is nothing arbitrary or experimental about Figure 4: It is
precisely the scatter one would want to look at in view of the estimates Meltzer
obtained using pre-1958 data only.
However, as 1ine 3 of Table 4 shows, these two elasticity estimates cannot be
recovered from the 1958-85 data using least squares (as Meltzer
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Figure 4 :1900-65
160
6
J * 5| " .
5 - denotes observations from 1900 to 1957. 0 - denotes
observations from 1958 to 1985.
1.8
1.6
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161
1612 144 6 8 10
Short-Term Interest Rate
m_ e * t 4 .
f o f l o * n r> * C
0.8
0.6
1.4
1.2
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162
recovered them from the earlier data). There is a reason why these estimates came
out as they did, as Figure 5 shows. Interest rates were not only increasing
dramatically over the 1958-85 period but were also highly erratic. The relatively high
interest semi-elasticity on line 3 reconciles the trends with a high income elasticity,
but the cost of this reconciliation is that the "predicted" path of real balances from
the constrained estimates is much too interest-sensitive to fit observed, year-to-year
movements. Actual real balances move in the predicted direction in response to
interest rate changes, but by much less than is predicted. These lead to large
residuals, which are also strongly correlated with interest rates. This is why the
order revealed in Figure 4 cannot be discovered using unconstrained least squares.
Mankiw and Summers (1986) recover exactly an income elasticity of unity and
an interest semi-elasticity of .05 from least squares applied to 1960-84 U.S. quarterly
series. They do so using consumption in place of permanent income (justified in part
by the kind of argument I used in Section III) and by using Almon lags to average the
independent variables over time. One can conjecture from Figure 5 that averaging
interest rates will "work," and Mankiw and Summers1s results confirm this. (I
suspect that long interest rates worked as well as they did in Meltzer's study for
much the same reason: Long rates are a kind of average of short rates.)
V. CONCLUSIONS
This paper has had three main objectives. As reported in Section II, I first
replicated some of the results in Meltzer (1963), using his 1900-1957 sample period,
and showed that two variations of interest to me are empirically indistinguishab1e
from the model he used. Second, in Section III, I reviewed a theoretical model of
money demand in which the two parameters Meltzer estimated could be expected to
be "structural." Thirc?, in Section IV, I compared the predictions of Meltzer's model,
with his original parameter estimates, to post-1958 data, and concluded that this
comparison yields additional confirmation of the theory and of these two estimates.
Meltzer (1963) was criticized (for example, by Courchene and Shapiro (1964))
for, among other things, his failure to correct his estimates for severely serially
correlated residuals and his failure, despite great emphasis on the "stability" of the
money demand function, to apply standard statistical tests for the stability of
parameter estimates across different
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Actual Ml/P.
Predicted Ml/P from line 4, Table 4.
Figure 5
Year
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sample periods. These two criticisms can certainly be applied as well to the present
paper, for I share Meltzer's emphasis on the "stability" of the money demand
function.
But I agree with Meltzer (1964) that these econometric criticisms are very badly
off the economic point. We begin with a simple economic model that suggests a two-
parameter description of money demand. When we hypothesize that this relationship
is "stable," we mean that we expect these two parameters to reflect relatively stable
features of consumer preferences and the way in which business is carried out, and
we expect them not to shift around as monetary or other policies are altered over
time. This theory does not suggest that the residuals can be characterized in a
simple, elegant fashion over a given time period, or even that the stochastic structure
of the residuals should be stable over time. Accordingly, there is little point in testing
the theory by maintaining an extreme hypothesis on the residuals that is not implied
by any theoretical considerations and then performing a Chi-square test for the
equality of coefficients over subperiods. One needs a maintained hypothesis in
which one has more, not less, confidence than one has in the hypothesis being
tested.
Thus Meltzer argued, and I agree, that we can only test the theory by comparing
its numerical predictions to as wide a variety of data as we can find. In carrying out
such tests, it is of no interest whatever to let the two crucial elasticities isolated by
the theory change arbitrarily from one data set to the next. The theory is of no
interest or use unless these two parameters are stable under a wide range of
circumstances.
Over the time period Meltzer studied, in which income has a strong trend and
interest rates had none, the method of least squares isolates an income elasticity of
unity, just as does a comparison of income and real balance trends. With this income
elasticity, one can see from Figure 3 that there is enough interest variability to trace
out a fairly clear demand curve. Over the more recent period, interest rates have a
very strong upward trend, as does income, so that there are many combinations of
elasticities that are consistent with trends in the holding of real balances. Least
squares picks out a combination of elasticities that is very different from the pair thatis consistent with earlier evidence. Yet imposing the same elasticities in the later
period is also consistent with long term trends and, as Figure 4 shows, traces out a
demand function that is consistent with theearlierdata, and much clearer than was
possible
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with those data alone.^ This picture did not arise by chance!
The evidence from the post-1960 years also reveals strong patterns in the
residuals from this estimated demand function that did not appear in the earlier
years of the century. It is clear that, as investigators sinee Goldfeld have
concluded, the portfolio adjustment process is subject to lags in a way that neither
the theory Meltzer had in mind nor the cash-in- advance model I sketched in
Section III helps to understand. This fact is hardly surprising: One is, if anything,
surprised that this simple model captures as much as it does.
In these circumstances, it seems to me that it is the econometrician1s job to
display as clearly as he can the respects in which the model he has is a good
approximation to reality and the sense in which it is not. This is what Meltzer did in
his 1963 paper, and it is what I have tried to do in this one. I hope Figure 4
convinces anyone who sees it that the interest semi-elasticity of money demand
has remained stable at something between .05 and .10 for nearly a century in the
U.S. I hope Figure 5 helps to stimulate someone, perhaps along the lines suggested
by Grossman, Weiss and Rotemberg, to discover the short run dynamics that can
reconcile this fact with year-to-year or even quarter-to-quarter movements in
observed money holdings.
^An income elasticity of unity is a I so consi stent wi th the cross-section evidence reported in Meltzer
(1963b). The interest semi-eIast i c i t i es est imated from U.S. t i me series are a I so consistent wi th the
range ot estimates Cagan (1956) found in his study of hyper i nfI at ions.
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REFERENCES
Ando, A., Modigliani, F., and Shell, K.
1975 Some Reflections on Describing Structures of Financial Sectors, in Gary
Froran and Lawrence R. Klein, (eds.)Brookings Model Perspective and
Recent Developments .Amsterdam: North- Holland, 524-563.
Stunner, K. and Meltzer, A.H.
1963 Predicting Velocity: Implications for Theory and Policy. Journal of
Finance, 18: 319-354.
Cagan, P.
1956 The Monetary Dynamics of Hyperinflation, in Milton Friedman, (ed.),
Studies in the Quantity Theory of Money. Chicago: University of Chicago
Press.
Cochrane, J.H.
1988 The Return of the Liquidity Effect: A Study of the Short Run Relation
Between Money Growth and Interest Rates.Journal of Business and
Economic Statist ics. Forthcoming.
Cooley, T.F. and LeRoy, S.F.
1981 Identification and Estimation of Money Demand. Amer ican Economic
Review, 71: 825-844.
Courchene, T.J. and Shapiro, H.T.
1964 The Demand for Money: A Notes from the Time Series.Journal of
Pol i t ical Econom y, 72: 498-503.
Economic Repor t of the President
1987 Washington D.C.
Friedman, M.
1956 The Quantity Theory of Money - A Restatement," in Milton Friedman,
(ed.),Studies in th e Quantity Theor)> of Money. Chicago: University of
Chicago Press.
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A Theory of the Consumpt ionrunct ion.Princeton: Princeton University
Press, for the National Bureau of Economic Research.
1959 The Demand for Money - Some Theoretical and Empirical Results.Journal r f
Pol i t ica l Econom y,67: 327-351.
________ and Schwartz, A.J.
1963A Monetary History of the United States, 1867-1960.Princeton:
Princeton University Press, for the National Bureau of Economic
Research.
________ and _________
(1970)Monetary Stat ist ics of th e United States.New York: Columbia University Press
for the National Bureau of Economic Research.
________ and _________
1982Monetary Trends in the United States and the United Kingdom.
Chicago: University of Chicago Press, for the National Bureau of
Economic Research.
Goldfeld, S.M.
1973 The Demand for Money Revisited.Brookings Papers on Economic A ct iv i ty
, 577-638.
1976 The Case of the Missing Money."Brookings Papers on Economic Act iv i ty, 683-
730.
Goldsmith, R.W., et al.
1956A Study of Saving in th e United States,Vol. III. Princeton: Princeton University
Press, for the National Bureau of Economic Research.
Friedman, H.
1957
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Grossman, S. and Weiss, L.
1983 A Transactions-Based Model of the Monetary Transmission Mechanism."
Amer ican Economic Review, 73: 871-880.
Hamburger, M.J.
1977 Behavior of the Money Stock: Is There a Puzzle?Journal of MonetaryEconomics, 3: 265-288.
Judd, J.P. and Scadding, J.L.
1982 The Search for a Stable Money Demand Function.Journal of Economic
Literature, 20: 993-1023.
Laidler, D.E.W.
1966 The Rate of Interest and the Demand for Money - Some Empirical
Evidence.Journal of Pol i t ica l Economy,74: 545-555.
1977The Demand for Mo ney: Theoret ical and Empir ical Evidenc e. Second Edition. New
York: Dun-Donneley.
Lucas, R.E., Jr. and Stokey, N.L.
1987 Money and Interest in a Cash-in-Advance Economy. Econometr ica, 55: 491-
514.
Mankiw, N.G. and Summers, L.H.
1986 "Money Demand and the Effects of Fiscal Policies.Journal of Money,
Credit , and Bankin g, 18: 415-429.
McCallum, B.T. and Goodfriend, M.S.
1987 Money: Theoretical Analysis of the Demand for Money." Paper
prepared for The New Palgrave: A Dict ionary of Economic Theory and
Doctr ine.
Meltzer, A.H.
1963 The Demand for Money: The Evidence from the Time Series. Journal of
Pol i t ical Econom y, 71: 219-246.
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Meltzer, A.H.
1963b The Demand for Money: A Cross-Section Study of Business Firms.
Quarter ly Jo urnal of Econom ics,77: 405-422.
1954 A Little More Evidence from the Time Series.Journal of Pol i t ica l Economy,72:
504-508.
Poole, W.
1970 Whither Money Demand?Brookings Papers on Economic A ct iv i ty , 485-501.
Rotemberg, J.J.
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Economy,92: 40-58.
Samuel son, P.A.
(1947)Foundat ions of Econom ic Analysis.Cambridge: Harvard University Press.
U.S. Bureau of the Census.
1960Histor ical Stat ist ics of the United States, Colonial Times to 1957. Washington D.C.
1958 from the sample because I could not find w for that year. Otherwise, I attempted
to follow the sources and procedures described in Meltzer (1963). One can see that
lines 1 and 2 from Tables 1 and 2 are very close, though closer for the income
regression than the wealth regression. When both variables are included (line 3) I
obtained very different results from his, for reasons I cannot explain. Notice,
however, that Meltzer*s and my estimates of the sum of these coefficients are very
close: I suspect this is all either of us is estimating with much precision. The other
striking difference is in line 4 of Tables 1 and 2: my wealth elasticity for this
subperiod is well below one; Meltzer's is 1.8.
I wanted to use a graphical device to help me see how different a theory one
obtains with different wealth or income measures. I know this question is not very
well posed, but Figure 1 seems to me helpful. It exhibits three series, all for the fullperiod 1900-1957. They are: actual Ml/P; the "predicted" Ml/P from line 1 of Table 2;
and the predicted Ml/P from line 2 of Table 2. One can see that real balances followed
a different trend from 1930 on than in the earlier years. Both the income and wealth
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2 190C-85 -.09 1.0 ~
(.001) -------------------
3 1958-85 -.01 .21 .328
(.005) (.059)
4 1958-85 -.07 1.0 ---
(.008)
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171
Q
Poole (1570) argued much earlier that cnc- needs to constrain the income elasticity in ot der to obtain an
interest elasticity from post-World War II data that is consistent vith pre-war evidence.
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