The money demand literature has a long and checkered history. The breakdown of previously stable relationships has led to re-specification of models throughout the post-war period. Notable examples are the “case of the missing money” in the 1970s and the under-prediction of money in the 1980s. Nevertheless, policy makers continue to pay attention to monetary aggregates and the charter of the European Central Bank lists money as one of the pillars of its monetary policy.
A stable money demand function has long been sought after because it can be very useful for explaining, and even predicting, the behavior of other aspects of the macro-economy. In traditional formulations, money demand is a function of a scale variable, like nominal GDP, and the opportunity cost of holding money. If 1.) the elasticity with respect to the opportunity cost is known, and 2.) the relationship between money with GDP is stable, then the observation of money data, which tend to be relatively high frequency, can help to predict nominal output, which is observed at a lower frequency. While both of those conditions are important, it is the second that is most often called into question.
Conceptually, money is an asset with a particular set of characteristics, most notably its liquidity. Like other financial assets, demand for money is part of a portfolio allocation decision, in which an agent’s wealth is distributed among competing assets based on each asset’s relative benefits (see e.g., Tobin 1969). To a certain extent, agents are willing to give up the higher return of alternative assets in order to receive the benefit of liquidity that money provides.
Thus, standard money demand equations include an interest rate or interest rate spread to measure the opportunity cost of holding non-interest earning money. Typically the assumed alternative asset used to measure the opportunity cost of holding money is a risk-free instrument, such as a Treasury security, though this is often viewed as a proxy for all substitute assets for money.
Money Demand and Equity Markets