Different Approaches To Deriving The Demand For Money
Today we’ll talk about 3 different approach to the demand for money. There are three main approaches to deriving the demand for money and its role in the economy.
3 Approach To The Demand For Money
1- Money yields utility and can therefore be incorporated into the utility function. Similarly, money can be incorporated into the production function. Alternatively, while money is not directly a component of the utility and production functions, it saves labor time in making payments. So that it can be indirectly introduced into the utility and production functions.
2- Money is not directly or indirectly in the utility and production functions. But it is required for certain types of transactions, so that a cash in advance analysis becomes appropriate.
3- Money is not directly or indirectly in the utility and production functions and is not used as a medium of payments in a cash in advance manner. However, money is an asset that can be used for transferring purchasing power across periods. This approach is used in
the overlapping generations model of money.
Of these three approaches, the most common is the first approach: Money can be treated as a component of the utility and production functions.
Money In The Utility Function And The Production Function
Our preferred approach to money puts it in the individual’s utility function and the firm’s production function. Because it is the medium of payments in a monetary economy in which commodities (bonds) do not trade against other commodities or bonds but do so only
against money. This approach is known as the Money in the utility function (MIUF) and the money in the production function (MIPF) approach.
Many economists object to this approach on the grounds that real balances do not “directly yield satisfaction or increase production.”
An indirect route to this approach is a “transactions” approach. This approach initially keeps money out of the utility and production functions. However, the use of money allows the consumer to reduce transactions time for payments. And therefore increase leisure by using money. And its use also allows the firm to save on its labor resources. These arguments lead to the indirect utility and production functions.
However, many economists prefer to completely eschew the above lines of analyses. Some of them prefer to opting for money in an overlapping generations framework.
Money As A Durable Good
Financial assets are durable goods in an economic sense. The concept of the economic durability of money can be quite confusing and needs clarification. The demand for money is taken to be a demand for the average money balances held by the individual in a period and is often designated as the demand for nominal balances to hold. This demand differs from the amounts that the individual would hold at various points in time during the period but is a weighted average of the latter amounts, with the weights being the duration a particular amount is held. Consider the below example:
Money As A Durable Good Example
“Assume that an individual holds $100 at the beginning of a week. And then spends it at a continuous even rate over the week. His average money balances, designated as his demand for money, held over the month are $50 (= 100/2) which clearly differ from his money balance of $100 at the beginning of the week. And his money balance of zero dollars at the end of the week.
For comparable period analysis, assume that he spent $100/7 (=$14.29) per day of the week. He would then hold $85.71 (=100 – 14.29) for 6 days, $71.42 (= 85.71 – 14.29) for 5 days, and so on. The weighted average (i.e. weighted by the number of days held) of these amounts would be $42.86. So that there is a slight difference between the continuous and the discrete cases for the average calculation. We will proceed with the continuous even expenditure assumption, which implied the weighted average balance to be $50. Under this assumption, the individual would be taken to have had an average demand for $50 of money balances, a durable good, and to have used its services in financing his purchases during the week.”
However, an individual may or may not hold a durable good for its transactions services. He may instead use it as a means of transferring his wealth or real purchasing power from one week to the next. Consider the below example:
Store Of Value Function Example
“A pure store of value without any transactions usage would occur if the individual held $50 consistently. Then never spent any of it, from the beginning of the week to the end of the week. He would then have bequeathed this amount to the beginning of the following week, much in the manner of a durable consumer good such as a refrigerator, which outlasts the current week of usage and is still available to the individual at the beginning of the following week. Thus, for the pure store of value function, the individual could store the unplugged refrigerator or the $50 of money balances through the week without any intention of using their services for refrigeration or financing payments, respectively. In practice, both the refrigerator and the money balances will see some usage (the latter for financing transactions.) during the week and still act as stores of value. ”
Such a usage would be one of a store of value. (Friedman called the temporary store of value for which money is used an abode of purchasing power.) For convenience, monetary theory has generally treated the demand for money as a medium of payments under 2 category:
1-The transactions demand for money
2-The demand for money as a store of value (relative to other assets).
But any particular unit of money balances can be used for either function. And the division into the transactions and speculative balances must be taken to be an analytical division and not necessarily applicable to the real world.
Today we gave you 3 different approach to the demand for money. See you in another article…