A Critique of the Transaction-based Theory of the Demand For Money

There are several reasons why one might be suspicious of traditional explanations. Keynes was, perhaps, not as clear concerning the definition of money as he could have been. The absence of clarity may have been deliberate, enabling him to slip from one use to another, without the reader being aware. We focus our attention on demand deposits, because these are the part of money most directly under the control of monetary authorities, and then slightly more broadly, on M1, which includes currency.

Keynes spoke of three motives for holding money: the precautionary, the speculative, and the transactions motive. Given our definition, only the third is relevant. The other two motives are related to the use of money as a store of value; and as a store of value, money is dominated by treasury bills and money market mutual funds, which yield higher rates of interest. Though some economists have suggested that Keynes’s definition of money really did include these assets (“L” in the standard terminology), surely this broad aggregate is not under the control of monetary authorities. Even when monetary authorities set the money supply as a target, they never focus their attention on this broad measure. Empirical studies have concentrated their attention on narrower definitions, such as M1 (or, as M1 has done increasingly poorly, on M2).

Thus, an analysis of the demand for money (as opposed to dollar denominated government insured short term assets) must focus on the transactions demand for money. (Of course, in a general equilibrium model, demands for all assets are interdependent. Still, it is useful to think of individuals as first deciding on how much they wish to hold in shortterm dollar denominated government insured assets, and then to ask, of that total, how much should be held in the form of money, for transaction purposes.

The past fifteen years has witnessed remarkable changes in transactions technologies. Computers enable the velocity of circulation to become virtually infinite, for instance, in the use of money market accounts. The relationship between conventionally measured money and income has not been stable in recent years. That it would change would be predicted by the theory, given the changes in transactions technology. But the fact that the relationship is not stable, that the changes in velocity do not seem to be predictable not only undermine the usefulness of the theory for practical purposes.

They also force us to reconsider the foundations of the theory. Upon reflection, it becomes clear that the transaction-demand monetary theory was—and should have been recognized to be—badly flawed.

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