Micro-Economic Foundations of the Demand for Money

  • C. A. E. Goodhart


At the individual, or micro, level demand for money balances will be a function (i) of the differential between the perceived yield on money and on other assets; (ii) of the costs of transferring between money and other assets; (iii) of the price uncertainty of assets; and (iv) of the expected pattern of expenditures and receipts. In practice, analysis of the demand for money as a function of all these variables simultaneously has proved difficult to handle, and so the analysis has been artificially segmented into two main parts. First, consideration of asset-price uncertainty is suppressed and the ‘transactions’ demand for money is studied, involving minimisation of the costs of undertaking expenditures. Then the ‘speculative’ demand for money is analysed specifically incorporating asset-price uncertainty, but usually involving drastic simplifying assumptions about transfer costs and/or the time pattern of expenditures. This dichotomy is not valid; nevertheless the tradition of examining these two aspects of the demand for money separately is followed here, since this approach has been so common that the development, and literature, of the subject cannot be appreciated otherwise.

We concentrate on the inventory-theoretic analysis of the transactions demand for money, starting with Baumol’s simplified initial model — which largely abstracts from uncertainty — but moving on to the more complex but more realistic models, developed for example by Orr, in which there is uncertainty about the future flow of cash payments. Once such uncertainty is introduced it is difficult to distinguish the ‘transactions’ from the ‘precautionary’ motives for holding money. Section 1 then ends with a short summary of the attack made on this approach by Sprenkle. He claims, on empirical grounds, that the money holdings of companies, for example, are far larger than can be explained by the inventory theory, and on practical grounds that these models have overlooked many of the important institutional features of the monetary system.

In Section 2, we begin with the restatement of Tobin’s classic analysis of ‘Liquidity Preference as Behaviour towards Risk’ within a system with one safe and one risky asset in a single period context, an analysis which is compared and contrasted with Keynes’s analysis of the speculative demand for money. The approach is then extended to deal with the more general situation where the investor is confronted with an assortment of risky assets, touching here on modern portfolio analysis. Finally, some of the problems of moving from a single-period to a multi-period analysis are presented, though hardly solved.

In Section 3, we return to the inventory-theoretic approach, describing how this strand of analysis has been extended during the last decade into a new, more macro-economic, form, namely the ‘buffer-stock’ or ‘disequilibrium’ theory of money holding. There are several versions of this latter approach, and we assess these separately. It is noted how closely this inventory-theoretic, buffer-stock approach coheres with the paradigm of micro-markets outlined in Chapter 1, with market makers holding inventories of both cash and goods.


Unable to display preview. Download preview PDF.

Unable to display preview. Download preview PDF.

Copyright information

© C. A. E Goodhart 1989

Authors and Affiliations

  • C. A. E. Goodhart

There are no affiliations available

Personalised recommendations