Are the Micro-foundations of Money Demand Important?

EC607 is rapidly coming to a close. I’ve finished the RBC model and now I am on to discussing nominal rigidities and New Keynesian Economics. This transition is always somewhat awkward because I have to say something about the demand for money.

Prior to the crisis, money demand had nearly disappeared from mainstream macroeconomics. This might seem strange since so much of macroeconomics involves money, but it’s true. In Advanced Macroeconomics, when money is introduced, Romer simply adds real money balances to the utility function and then moves on to tackle the more important problems of macroeconomics (price rigidities in this case). That’s basically it for money demand: one paragraph and an ad hoc addition to the utility function which is basically never mentioned again.

I think the reason for the marginalization of money demand is two-fold. First, getting money into a neoclassical economic model is really tough. Fiat money (money that isn’t backed by anything with actual value) is simply not valued by market participants in a Walrasian setting. The Walrasian value of something that is intrinsically worthless … is zero. The fictitious Walrasian auctioneer is simply too nimble, too efficient to permit an equilibrium with valued fiat money. To get money in to these models (with any micro-foundations at all) requires that we create some kind of a “gap” in markets to create some room for an unbacked currency.

There are models that do the trick. Often researchers working on money demand use frameworks that are decendents of the Kiyotaki-Wright (1993) matching model. This model imagines that all transactions take place through random matching between individual traders. Because the probability of a “double coincidence of wants” in the Kiyotaki-Wright model is low, (it’s unlikely that you will bump into someone who wants what you have and has what you want) a fiat currency can circulate in equilibrium. More modern versions use an extension suggested by Lagos-Wright (2005) in which traders interact in two sub-periods. During the “day”, there is a centralized market where traders use state-contingent contracts. During the “night” they match in an anonymous trade stage.

These are elegant models and they do capture elements of the motives behind holding money. However, they are not used often by most macroeconomists, who often regard these models as being simply too abstract to be useful. Their abstract nature also makes empirical analysis of these models extremely difficult. (Incidentally, if you are a graduate student looking for a research topic, I would encourage you to look outside of this area. It’s a very difficult area and it doesn’t sell very well on the academic job market. Search and matching in general is very hot right now but “money-search” is not.)

The second reason why money demand has been largely relegated to the sidelines is that there are moderately persuasive arguments that we don’t actually need to understand it to study the macroeconomy – even to study monetary economics itself. The argument goes something like this: The Federal Reserve conducts monetary policy in terms of a nominal interest rate target. Once it decides on the setting for the funds rate it adjusts the money supply to enforce its target. The New Keynesian model is an excellent example of this approach. The simplest NK model has an equation governing the demand for goods and services, an equation governing inflation, and an equation describing the Fed’s operating rule. No mention is made of money supply or demand and many (most?) macroeconomists are perfectly happy with this state of affairs. The possibility that we could avoid the issue of money demand is very attractive – particularly given the difficulties of successfully modeling money demand.

Money demand may be making a comeback though. During the crisis, a lot of concern centered on malfunctioning markets for money-substitutes. Recent work by Arvind Krishnamurthy and Annette Vissing-Jorgensen, Stefan Nagel, and Adi Sunderam emphasize the liquidity aspects of many assets that are not traditionally considered “money.” Treasury bills, Commercial Paper, and highly rated securitized assets all have important liquidity components to their market values. In addition, many people think that the demand for liquid, low risk securities encouraged the creation of more and more securitized subprime loans. Not having a suitable model for money (or money substitutes) seems like a particular shortcoming given recent history.

In 1978, there was an amazing conference at the Federal Reserve Bank of Minneapolis devoted explicitly to the study of micro-foundations of money demand. The papers at the conference were later collected in Models of Monetary Economies.[1] In it, there is an interesting discussion by James Tobin who writes in part 

Why does fiat money … have value? What determines its value? This conference [is] based on two premises. One is that the two questions have not been satisfactorily and rigorously answered. The other is that the answer to the second question […] can be achieved if and only if [we have] a precise answer to the first question […]. I am dubious of both premises.

In hindsight, I think it’s clear that Tobin’s suggestion that we have a satisfactory and rigorous understanding of why people hold money – was at best not entirely correct. His second statement – that we might not need to rigorously understand why people hold money – might be right though my faith in his argument has definitely been shaken by recent events.

[1] This volume is available on line here. The 1978 conference lineup was amazingly good and the manuscript includes among other things, Lucas’ “Pure Currency” model, Townsend’s “Turnpike” model, and an excellent paper by Neil Wallace on money demand in the overlapping generations model. While it doesn’t have any of the modern matching models, it is still an impressive and insightful volume and should be required reading for anyone interested in the pure theory of money.