Demand for Money in a Stochastic Environment

Abstract

The author reexamines the demand-for-money theory in an intertemporal optimization model. The demand for real money balances is derived to be a function of real income and the rates of return of all financial assets traded in the economy. Unlike the traditional money-demand relation, however, where the elasticities are assumed to be constant, the coefficients of the explanatory variables are not constant and depend on the degree of an agent's risk aversion, the volatilities of the price level and income, and the correlation of asset returns. The author shows that the response of households to increased volatilities in the financial markets, economic activity, and prices cannot be predicted, because a rise in general uncertainties has an ambiguous impact on the demand for money. This suggests that increased uncertainty is not very helpful for the planning decisions of households, because the optimal level of money holdings in the period of uncertainty cannot be ascertained.

Economic policy uncertainty and the UK demand for money: evidence from the inter-war period

“…As indicated above, lately, the influence of economic uncertainty on the demand for money has received considerable attention. The uncertain economic conditions may affect the demand for money as economic agents may prefer to hold safe and liquid monetary assets instead of risky assets to store their wealth in under conditions of rising risk perception during the uncertain economic conditions (Atta-Mensah, 2004;Choi and Oh, 2003;Greiber and Lemke, 2005) [10]. During uncertainty periods an increase in the interest rate risk (volatility) increases the risk of fixed-income securities inducing agents to substitute these securities for money.…”

“…A historical study of inter-war period may provide implications for the modern period which is also infected with economic uncertainty. Atta-Mensah (2004) indicates that economic uncertainty measures improve the stability performance of Canadian money demand. A similar result is provided by Greiber and Lemke (2005) for Europe, Bahmani-Oskooee and Xi (2011) for Australia, and Bahmani-Oskooee et al (2015) for the UK [8].…”

How justified is abandoning money in the conduct of monetary policy in Australia on the grounds of instability in the money‐demand function?

“…In the contemporary literature on money demand, the foreign interest rate and the real or nominal exchange rate of domestic currency are included as other determinants of money demand on the grounds that they capture the adjustments of wealth‐holders' portfolios to changes in the rates of return on domestic and foreign assets—including both real assets and financial ones (Agénor & Khan, ; Bahmani‐Oskooee, , ; Cuddington, ). Furthermore, recent studies, namely, Atta‐Mensah () and Hossain (, ), suggest that financial risk, financial uncertainty, and inflation or economic uncertainty could play a determining role in money demand, especially in countries with open capital accounts, such as Australia. An expanded model incorporating the above arguments can, therefore, be considered more appropriate for investigating the question of money‐demand instability in Australia using data for a period covering several successive monetary‐policy regimes, exchange rate arrangements, and restrictions over capital movements.…”

“…Risk exists when numerical probabilities can be assigned to random events. In contrast, random events to which probabilities cannot be assigned involve uncertainty (Atta‐Mensah, ). Economic uncertainty is a broader concept than inflation uncertainty and can be estimated as the sum of various uncertainties in an economy.…”

“…Atta‐Mensah () has derived a money‐demand specification that shows that shocks to an economy affect the quantity of money demand. Money‐demand shocks do, and could, originate from a variety of sources: monetary and fiscal policies, financial markets, economic activities and technological innovations.…”