Carnegie-Rochester Conference Series on Public Policy 29 (1988) 137-168 North-Holland

MONEY DEMAND IN THE UNITED STATES: A QUANTITATIVE REVIEW

ROBERT E. LUCAS, JR.1 The University of Chicago

I. INTRODUCTION
Allan Meltzer's research career has been so productive and so varied that it would be an act of folly, not friendship, to attempt to review it in a single paper. Yet I do want to talk about his research on this occasion, for research is what Allan's career is mainly about, and I want to do so in detail, because details are the way scholarship is carried out. Accordingly, I will focus my attention mainly on a single paper, one that has influenced my own thinking on monetary economics a great deal, Meltzer's "The Demand for Money: The Evidence from Time Series," published in the Journal of Political Economy in 1963. Meltzer's "Demand for Money" was one in a series of his empirical studies in monetary economics, much of which involved joint research with Karl Brunner. It followed earlier work by Latane and others, especially Friedman, and helped to stimulate closely related later contributions by Laidler and others.* The shared objective of this research program was, in Friedman's (1956) terms, to demonstrate that the demand for money is a "highly stable function" of a limited number of variables, to discover the most useful, operational measures of money and these other variables, and (again citing Friedman) to work "toward isolating the numerical 'constants' of monetary behavior." Meltzer's paper was the first to estimate an income

1This paper was prepared for the November t 1987 Carnegie-Rochester Conference. I would like to thank John Cochrane, Thomas Cooley, Milton Friedman, Lars Peter Hansen, Robert King, Leonardo Leiderman, Bennett McCallum, Sherwin Rosen, Thomas Sargent and Lawrence Summers for helpful discussions and/or comments on an earlier draft. I also benefitted from a stimulating discussion at the Conference. P.S. Eswar-Prasad provided excellent research assistance. 'Two important sequels to this paper are Brunner and M^lfzer (1963) and Laidler (1966). Of course, this and other work on money demand wss closely relate d to rther contemporary r e s e a r c h , e s p e c i a l l y t h e e a r l i e r c o n t r i b u t i o n s o f F r i e d m a n ( 1 9 5 6 ) a n d h i s s t u d e n t s , , a n d Friedman (1959). See Laidler (1977) and, more recently, McCallum and Goocf r i end (1987) for some of the relevant background.

0 167 - 2231/88/S3.50 1988 Elsevier Science Publishers B.V. (North-Holland)

(or wealth) elasticity and an interest elasticity simultaneously from time series data from a single country (the U.S.). The objective of the present paper will be to review and replicate these results, to reconsider how they might be interpreted theoretically, and to see how well they stand up to the 25 years of new data that have become available since Meltzer wrote. An estimated money demand function provides answers to two important questions of economic policy. The income elasticity, in a setting in which long run real output growth is both fairly predictable and insensitive to changes in monetary policy, provides the answer to the question: What rate of growth of money is consistent with long run price stability? The interest elasticity is the key parameter needed to answer the question: What are the welfare costs to society of deviations from long run price stability? Purely qualitative answers to these questions, along the lines of "Inflation rates are significantly related to money growth rates" or "Inflation reduces welfare" are interesting and useful, perhaps, but surely propositions such as "An HI growth rate of 3 percent per year will bring about price stability" or "A ten percent annual inflation rate has a social cost equivalent to a 0.5 percent decline in real income" are more interesting and, if accurate, much more useful. Though the objective of an economics that provides quantitative answers to important questions of economic policy is now very widely subscribed to, it is remarkable how little attention is paid in many of our discussions to the substance of parameter estimation, and how little honor is paid to those few economists who do it well. All of us have sat through many discussions of econometric work in which the theoretical underpinnings of the relationships estimated and tested and the econometric methods used are subjected to intense scrutiny and yet no one seems to care what the numerical results were! Even in Laidler's (1977) survey of the evidence on money demand, or in McCallum and Gcodfriend's (1987) more recent summary, it is difficult to find clear statements of what the money demand function is. As quantitative economists we often seem to be, in Samuel son's (1947) phrase, "like highly trained athletes who never run a race, and in consequence grow stale." Meltzer ran this particular race, in 1963, and turned in his two numbers. Much has happened since to monetary theory and to the development of econometric methods, and almost three decades of new data have since become available. In Section II I will sunmarize the evidence on the income (or wealth) and interest elasticities of money demand from 1900-58 data, essentially identical to those Meltzer used. Section III introduces a

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utility-theoretic framework for thinking about money demand, from which I will conclude that there is some reason to view these two parameters as structural. Section IV reviews U.S. time series evidence from the 1958-85 period, a period during which nominal interest rates reached levels about twice the highest levels attained in the U.S. in the earlier years of the century. Remarkably, in view of the stringent nature of the experiment, these new data precisely confirm the estimates Meltzer obtained in 1963.

II. REVIEW OF THE EVIDENCE FROM 1900 -1958

The hypothetical household decision problem underlying the results reported in Meltzer (1963) is that of allocating a given stock of wealth across different assets, given a vector of asset returns. I will come back to this problem in more detail in Section III, but I have said enough to rationalize a demand function for money of the form = f(r,w) . Throughout his paper, Meltzer used the log-linear form: in(mt) = a - b?n(rt) + can(wt) + ut , (1)

where m^. is the stock of real balances at t, w t is real wealth or real income, rt an interest rate, ut is an error term, and a, b and c are parameters. Meltzer used a long term interest rate to measure rt, treated as a stand-in for the entire vector of returns on alternative assets. He experimented with a very wide variety of income and wealth variables as measures of real wealth, and with both Ml and M2 as measures of the money stock. The sample period was 1900-1958, with results also reported for the two subperiods 1900-1929 and 1930-1958. lne experimental approach Meltzer used for measuring money and wealth is obviously suitable: we do not have theories that single out particular measures as clearly superior to others. One could indeed criticize the paper for reporting too few results, since the single interest rate he used to represent asset returns was arbitrarily chosen. But much of this experimentation indicated that the choice of wealth and money aggregates was not critically important. This finding has been confirmed by much subsequent research, as described in Laidler (1977). I will therefore report and

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replicate only a small subset of the results reported by Meltzer (1963). Table 1 transcribes results in Meltzer (1963). Line 1 is equation (3) on p. 225, with R1 reported instead of R and "standard errors" instead of "t-statistics."^ Lines 2,3,5,6,7 and 8 are from Table 2, p. 232. Line 4 is from Table 1, p. 229. Of course, al l regressions reported in this and al 1 other tables in this paper were estimated with constant terms. Since the units of the dependent variable I used are not meaningful, I wi 11 not report these constants. The central findings in lines 1-3 of Table 1 (these and all subsequent references are to tables in this paper), confirmed by other results in the original paper, are the wealth or income elasticities of about unity and the strong, negative effect of interest rates on real balances demanded. Notice that neither finding shows up very clearly when the period is divided in two, as reported in lines 4-8 of Table 1. For the early period, the income and wealth elasticities diverge, in different directions, from unity and the interest elasticities are much reduced. Meltzer does not report the results with wealth only for 1930-1958. From what is reported, however, it appears that the results for the full period were mainly dictated by events in the latter half.
)

Table 2 contains my replications of the results in Table 1. I dropped

1 The residuals from my replications of Meltzer's equations show very severe autocorrelation, and it is clear from the Durbin-Watson statistics reported in Meltzer (1964) t v iat this is also true of his original regressions. As a result, I do not know how to interpret the "standard errors" reported in these tables. I experimented with a variety of methods for correcting for serial correlation, but obtained only wildly erratic elasticity estimates. ^For money, I used Ml throughout the paper. For 1900 -14, this series is taken from Historical Statistics (1960), series X267. From 1914 -47, it is from Friedman and Schwartz (1970), pp. 704 -718, column 7. For 1948-85, it is the "IMF series 3" from the Inte rnational Monetary Fund's "International Financial Statistics" tape. (The primary source for these IMF data is the Federal Reserve Bulletin.) For 1900-49, real wealth is from Goldsmith (1956), Table W -3, column 1 ("total national wealth at 1929 prices"). For 1950-57, this series is from Historical Statistics (1960), series F446. For 1884-1975, real income is real net national product from Friedman and Schwartz (1982), Table 4.8. For 1976-85, it is taken from various July issues of the Survey of Current Busi ness. The price level (used to deflate Ml) is the implicit NNP deflator from the same sources. Permanent income is the geometrically weighted sum of current and past real NNP's used in Friedman (1957). The weight on current income is .33. The long term interest rate (used only for 1900-57) is the "basic yield on 20 year corporate bonds" in Historical Statistics (1960), series X346. The short term rate for 1900 75 .s the "6 month commercial paper" rate from Friedman and Schwartz (1982), Table 4.8, column 6. For 1976-85 I used Table B-68 in the Economic Report of Jhe President (1987).

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Meltzer (1963) Results Dependent variable: n(Mj/P)

TABLE 1

Coeff icients on: (standard errors) Line ___________ Years ___________ ftn(r) ___________ &n(W/P) __________ &n(Y/P) _______________ R* 1 1900-58 -.949 1.11 (.044) (.026) 2 3 4 5 1900-58 1900-58 1900-29 1900-29 -.79 (.083) -.92 (.053) -.32 (.107) -.05 (.094) .97 (.103) 1.84 (.114) .70 (.45) .48 (.240) .3) (.194) .94 (.094) 1.35 (.155) -.10 (.125) .980 .902 .960 .960 1.05 (.041) .13 (.093) .960 .980

.984 .960

5
7 8

1900-29
1930-58 1930-58

-.22
(.122) -.69 (.160) -1.15 (.097)

regressions track this well (of course, with the interest rate also included as a regressor). Real balances did not decrease nearly as much as did NNP in the 1930s, but they increased much more than income in the 1940s. I conclude (though this is the sort of issue reasonable people can disagree on) that current income induces "too much" cyclical responsiveness in predicted money demand, relative to wealth, and that wealth or some other "smoothed" income measure is preferred as the regressor. This is also the conclusion reached by Laidler (1977). In Table 3, I report the consequences of some variations on Meltzer's results. The objective of this experimentation is to locate a version of Meltzer's model that is reasonably faithful, conceptually and quantitatively, to the original and is at the same time inexpensive to test on more recent data.1 Line 1 in Table 3 uses permanent income (defined by Friedman's distributed lag on current and past real NNP's) in place of wealth. This change does an excellent job of reproducing line 1 of either Table 1 or 2. From a comparison of Figure 1 with Figure 2, one can see that permanent income behaves more like wealth than like current NNP in the 1930s. Lines 2 and 3 report two variations on line 1. In line 2, the long interest rate used by Meltzer is replaced by a short rate. I will explain my strong preference for the latter in Section III. The short rate (over this period) varies sympathetically with the long, but with more amplitude: hence its smaller coefficient. Otherwise, this variation doesn't matter much. In line 3, I use an unlogged short rate. The issue

The variations reported in Table 3 are very close to results in Laidler (1966). Laidle r used U.S. annual

series from 1892-1960, and deflated real balances and permanent income population. In his counterpart to line 1 of Table 3 (his Table 2, A, p.548) he obtained permanent income and interest elasticities respectively of 1.51 and .25. His counterpart of my line 2 (also Table 2, A in his paper) are 1.39 and .16. He did not try unlogged interest r a t e s .

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between the different functional forms in lines 2 and 3 is mainly aesthetic: the semielasticity at the sample mean value of r (3.26 for 1900-57) is, from the estimate of the elasticity in line 2, (-18)/(3.26) = .055. From line 3, this same semi-elasticity is estimated at .07. (In this, as in all other economic applications with which I am familiar, the choice of functional form is of little substantive consequence.) Thus I will take Table 3 as justifying my referring to the model reported in line 3 as "Meltzer's theory".

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Rjplicat ions Dependent variable: ln(Mj/P) Line Years ! n (r)

TABLE 1

Coeff icients on: (standard errors) tn(W/P)

in(Y/P)

R2

1900-57

-1 .v
( . 0 1)

1.32 (.056) 1.04 (.036) .49 (.122) .86 .68 (.095)

.957

2 3 4 5 6 7 8 9

1900-57 1900-57 1900 29 1900-29 1900-29 1930-57 1930 57 1930-57

67

.971 .978 .957

(.077) .90 (.089) -.21 (.099) -.07 (.119) -.20 (.098) -1.72 (.139) -.55 (.141) -.78 .264 .34 .332 .65 (.149) 1.53 (.163)

(.051)
.73 (.057) .19 (.132) .901 .93 (.075) .75 .191 .939 .937 .960 .932

Let me conclude this section with a somewhat less formal summary of the information on income and interest elasticities contained in this 190057 sample. Over this period, real Ml balances grew at the annual rate of .03356 and real permanent income at the rate .03126. Short term ir erest rates fluctuated between .69 (during World War II) and 7.4 (in 1920) but with a negligible trend. Hence the ratio of the money growth rate to the income growth rate, 1.07, is a good estimate of the income elasticity. This is about the number obtained, under various assumptions, in Table 3. Over long periods, it must always be the case that the trend in the dependent variable must be "explained" by that subset of the regressors that have trends. In this application, real income does and interest rates do not. Now imposing an income elasticity of unity, the semi-elasticity of money demand with respect to the interest rate is just the slope of a plot of ln(Ml/Pyp) against r$. This plot is displayed in Figure 3. This "estimation method" - get the income elasticity from money and income trends and then get the interest elasticity from a two-variable regression

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Figure 1

900
800 -

700 ( Q 4 > 3 *

600 -

>
T 3 0 >

500 400 300 200 -

c
CD

T o 3
->

U <

100
1900

i960

Actual Ml/P

144

 Predicted Ml/P using current income (line 2, Table 1). ,Predicted Ml/P using wealth (line 1, Table 1).

145

Figure 2

Year

Actual Ml/P Predicted Ml/P using current income (line 2, Table 1). Predicted Ml/P using permanent income (line 1, Table 3).

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TABLE 1

Variations on Table 2 for 1900-1957 Dependent variable: ftn(M1/P)

Coefficients on: (standard errors)

Line ftn(r) n(r s ) r s n(y p )

-.77 (.044)

1.03 (.021 )

.989

-.18

1.07 (.039 ) -.07

(.011

966

(.025) 3

1.06 (.042

963

) ) - does not depend very critically on our ability to characterize the residuals

accurately, or even on the residuals having a common structure over the entire period. Since we have much more reason, to which I will turn in the next section, for believing these elasticities to be stable than we have reason to believe anything in particular about the residuals, this seems to me a desirable feature.^ Of course, no estimation method is satisfactory under all assumptions about the errors, and the critical assumption here is that the errors are trend-free. If there were important technical changes, not occurring in response to interest rate movements, permitting agents to economize on their use of Ml balances my method (and Meltzer's too) has understated the income elasticity. I do not see how one can learn snore about this possibility by examining the series at hand.

'These informal remarks are not intended as a substitute for econometric theory. One would certainIy have a better understanding of the estimates reported here and below if one could write down a be I ievable stochastic model and use it to derive the proper t i es of these estimates explicitly. But I have not done this and so am obIiged to follow a second best route and explain why I proceeded as I did in a looser (and hence less infor mative) way.

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Figure 3 : 1900-57

6 Short-terrr Interest Rate

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III. A THEORETICAL FRAMEWORK

As an aid in interpreting the results reported in the last section and the additional results to be reported in Section IV, I will introduce a simple theoretical framework based on the model analyzed in Lucas and Stokey (1987). The framework has the advantage (relative to the framework Meltzer used) of being explicit about the connection between the portfolio and transactions demands for money, and the disadvantage of being unrealistically stylized about the way trading occurs. It will take some care to exploit the explicitness of this model without being led too far astray by its unrealistic features. We consider an economy in which the representative agent has the ultimate objective of maximizing the discounted expected utility from consumption of goods,
3 t E{ z 8 U(c.)} . z t=0

This agent lives in a Markovian world, the state of which at t is summarized by a vector s^.. The distribution of Sj.+j, given s^., is given by a fixed transition function F(s,A) = Pr{sul e A|s = s) . In this setting, all equilibrium date-t prices and quantities will be fixed (no time subscript) functions of the current state, s^. Agents are assumed to alternate between securities trading and goods trading in lockstep fashion. At the beginning of each period, all agents trade in securities, including money, in a single centralized market, all with full knowledge of the current realization of st. When securities trading is concluded, all agents disperse either to produce or to purchase consumption goods. Some of these goods can only be purchased with money acquired during the course of securities trading: This transactions requirement is the sole reason for including cash in a portfolio, in preference to interest bearing claims to future cash. Consider first the decision problem facing an agent who is engaged in securities trading at a time in which the state of the economy is s and his personal wealth in dollar terms is W. (In a centralized securities market all assets are priced, so the single number W summarizes his asset position fully.) Let v(s,W) denote the value of this agent's expected,

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discounted utility if he proceeds optimally from this point on. At this point, the agent is faced by a vector Q(s) of securities prices (in dollars, so the price of money is unity). He must choose money holdings M and a vector of securities holdings z, subject to a portfolio constraint: N + Q(s) z < W . (2)

Let G(M,z,s) be the indirect utility function he uses to make this choice. (Clearly G will depend on s, since the current state variable includes all the information he has about the returns from these securities.) Then v(s,W) must satisfy: v(s,W) = max G(M,z,s) subject to (2). M,z I call (3) the agent's portfolio problem. Now where does this indirect utility function G come from? Having completed securities trading, the agent is about to engage in purchasing a vector c of consumption goods. He will also receive an endowment y(s) of goods, but this he must sell for cash or future cash: He cannot consume his own endowment. The rules of trading in this goods market are summarized by a vector of constants a, where a^
e

(3)

[0,11 is the fraction of purchases of good i that must be covered by

money. It will be an expositional simplification in what follows to postulate a technology together with a choice of units for measuring goods such that all goods sell for the same nominal price P(s). In this case, the agent's Clower- or cash-inadvance constraint is: P(s)a c < M . (4)

The outcome (M,z) of the portfolio decision plus the outcome (c,y(s)) of his goods trades plus a given vector D(s') of nominal returns (dividends, interest, principal) on securities will determine this agent's nominal wealth position W as of tomorrow, conditional on tomorrow's state s'. He begins next period with his dollar holdings as of today, M, plus the dividends and resale value of his securities, (Q(s')+D(s'))"z, plus the dollar value of his endowment, P(s)S y (s), less the dollar value of his goods purchases, P(s)S c . That is:

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W = H + [Q(s')+D(s')lz + p(s)fIyi(s)-C|I These considerations determine what I call the transactions problem: G(M,z,s) = max U(c) + 3/ v(s',W)F(s,ds') subject to (4) , (6) c where W is defined in (5).

(5)

Eliminating the function G between (3) and (6) defines a functional equation in the value function v. See Lucas and Stokey (1987) for an analysis of this equation and its use in constructing an equilibrium for this economy. My purpose here is not so much analysis as it is clarifying what we mean by a "demand function for money," and hence in understanding what an empirical money demand function might mean. Let me begin with what I think Meltzer (1963) and certainly Hamburger (1977) meant by a "demand function for money." From the portfolio problem (3) one obtains the first order conditions: G(yj(M,z,s) = v , (7)

G (M,z,s) = (hv , j = l,...,m , J J

(8)

where \> is the multiplier associated with the wealth constraint (?) and where j indexes the m available securities. These m+1 equations together with (2) can be solved to obtain the demand functions for the assets (M,z) which have as arguments the prices Q and wealth W. Singling out the demand function (in this sense) for money: M = f(Q,W,s) . (9)

Note that the entire vector Q of securities prices enters on the right of (9). In practice, as in any empirical application of demand theory, one would focus on the prices of securities thought to have strong substitution or complementary relationships with money. In this spirit, Meltzer used a long term bond yield in his econometric work. In the same spirit, Hamburger (1977) experimented with equities yields and other securities returns in his. Certainly (9) is a respectable bas i s for an empirical study,

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consistent with what we knew then about monetary theory and, I would say, consistent with what we know now. Yet it does not seem to me that one would have any confidence that the demand function (9), based on portfolio considerations only as in my derivation, would remain stable over time. Included as suppressed arguments in this functions f are all variables s characterizing the current state of the system, including all the information used by agents in forecasting future returns on all securities. Moreover, if the stochastic environment in which agents operate (the "regime," as it is often called) should change from time to time, these changes too will induce shifts in f. Surely shifts in the realizations of informational variables and/or in the processes assumed to generate these realizations must have been substantial over so long a period as 1900-1958. To decide whether the fact that the functions f are not likely to be structural is an important objection to the empirical application of (9), consider the fact that by exactly the above argument on money demand, we could derive a demand function of the same form as (9) for any portfolio item. Would one, for example, attempt to estimate a demand function for Brazilian government securities, including as arguments only their own current yield and another interest rate standing in for the composite security consisting of all other portfolio items, and expect this relationship to be stable over a 60 year period? I think there is more to Meltzer's money demand theory than portfolio considerations alone. To see what this is, turn to the transactions problem (6), which also defines the indirect utility function G. The first order conditions for the n consumption goods in this problem are: Mc) = Bf vw(s',W')P(s)F(s,ds') + yP(s)ai , i=l,...,n, (10)

where y is the multiplier associated with the cash-in-advance constraint (4). One can also calculate the derivatives of the function G from (6): G|y|(M,z,s) = u + 0/ vw(s',W')F(s,ds') , (11)

Gz.(M,z,s) = Bf vw(s',W')[Qj(s')+Oj(s')]F(s,ds'), j=l,...,m. That is, the value (in utiIs) of a dollar is its "liquidity" value y during

(12)

goods trading plus the marginal value of nominal wealth one period hence. The value of any other security is the v/alue of the increment it provides

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to future wealth. Equations (11) and (12) thus reduce the values of securities, money included, to the values of their associated "fundamentals." Now suppose that among the m available securities is a (nominal) risk free, dollar denominated, one period bond. For this security, Qj(s') = 0 and Dj(s') = 1. Let its current price be i+r(s) , so r(s) is the one period nominal interest rate. Then combining (7) and (8) from the portfolio problem and (11) and (12) from the transactions problem (where both (8) and (12) are specialized to this one period bond) and inserting into the first order conditions (10) we obtain: Uj(c) - P(s)ulai + ^ry| , i = That is to say, the relative "prices" of these consumption goods, as seen by consumers (normalized so that the prices of each received by sellers are all equal to P(s)) depend on the cash holdings required to purchase them together with the opportunity cost of holding cash, as measured by the nominal interest rate. In the environment I have been describing, in which no new information reaches agents after they have switched from securities trading to goods trading, agents will plan money holdings so that the cash-in-advance constraint (4) holds with equality: In the theory, as in fact, cash is dominated by nominal bonds as a store of value. In this case (13) and (4) (with equality) form a system of n+1 equations in the consumption vector c and the multiplier p. It is not quite a demand system (since the "prices" in (13) are not the same as the "r.rices" in (4)) but it can be treated just as if it were and solved fp Vn consumption vector c as a
(13)

.''
function of iVP(s) and r(s), say: ^
C = g(p . r) .

(14)

Thus we obtain, from transactions considerations, ar exact relationship between agents' desired consumption mix, their demand for real balances, and the nominal interest rate. Noticc that no other securities prices or returns enter into this relationship, nor does the state s

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(except through the two prices P(s) and r(s)).^ Changes in information or in the information structure of the system will not shift these curves. They will be stable over time provided only that preferences are and that the trading technology as sunmarized in the coefficients a^,...,an is stable. It seems to me a violation of common usage to call the relationship (14) a "demand function for money." It is a relationship among complementary choice variables that the demand functions must satisfy. Whatever one calls it, however, it is a relationship that must obtain in equilibrium and it seems more likely to be an empirically stable one than does the "true" demand function (9). Why not provide an operational specification of these coefficients a^ and try to estimate it econometrically? This is the approach taken in a recent paper by Mankiw and Sumners (1986), with very interesting results that I wil 1 come back to in the next section, first, however, it will be useful to go into more detail about the connections between (9) and (14). Meltzer's estimated income and wealth elasticities are around unity, suggesting (under the utility-theoretic framework I am using here) that the current period utility function U takes the form of a constant relative risk aversion function of a homogeneous of degree one function of consumption. Let us impose this on the model above. Then equations (13) can be solved for the ratios c^/c of consumption of each good to total consumption c = Substituting into the cash constraint gives: = Eiaigi(r) c = h(r)c , (15) c^ = g^(r)c , say.

where the second equality defines the function h. This is just a consolidated special case of (14), stil1 not a demand function for money. Under these same assumptions, the "true" demand function for total

^Th i s rationale for (14) is essen t i a I I y the same as that used for a simila! purpose by McCallum and Goodfriend (1987). See Ando, Modigliani and Shell (1975) for the earliest derivation of (14) along these lines that I have found. These writers draw the same conclusion I have in the text: that on Iy the short rate ought to appear on the right side of a mone y demand function. Hamburger (1977) views (14) as a "Keynesian" formulation, explicitly contrasting it to the "monetarist" emphasis on portfolio considerations. If he is right, then my use of (14) to derive Mel^er's equat ion (18) is a very "un -monetar i si" argument. But one of the purposes of this sect ion is exactly to argue that port folio and transactions considerations are complementary in thinking about money demand.

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consumption c takes the form: c - k(Q,s) .

(16)

Then combining (15) and (16), we have shown that, under this homotheticity assumption, the true demand function for money (9) takes the form: p = h(r)k(Q,s) p . Now there is no theoretical reason to expect (17) to be more stable empirically than (9): They are the same relationship! But empirically, total consumption has been found to be a fairly stable function of permanent income, suggesting that k(Q,s)/r is nearly constant over a wide range of circumstances. If so, then: F *(r>*p where <t'(r) < 0 should serve as a stable relationship over the same range of circumstances. I am going to interpret (18) as the relationship Meltzer estimated. This involves using a short term interest rate for r, in contrast to the long term rate Meltzer used. It also precludes adding other yields to the right side of (18), as Hamburger did, unless these other variables can also be shown to affect the propensity to consume out of permanent income. This tighter theoretical rationale will, I hope, give some added insight into why Meltzer's empirical work was so successful In the model I have sketched in this section, it is the explicit

(17)

(18)

^lt is a perennial subject of debate among monetary economists whether there are advantages to being as explicit about the nature of transactions demand as I have been here, as opposed simply to including real balances as a "good" in agents' utility functions. I do not wish to be doctrinaire about this issue, but surely it cannot be wrong for monetary theorists to think about what people do with the money they hold. Economists who study the demand for coffee do not hesitate to use common knowledge about what people do with coffee, and this knowledge leads them to empirically useful ideas about what goods are likely to be close substitutes or complements for coffee, and hence what prices are likely to be useful in coffee demand functions. Why should those who study money demand not do the same thing? I found Tables 1 and 2 in Mankiw and Summers (1986) of great interest, and of evident use in guiding these authors' thinking about money demand. Researchers confined to thinking of money simply as something people like to hold, without asking why they like to hold it, would never have been led to seek out, display and utilize these data.

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characterization of transactions demand that leads to a relationship between real balances, short term interest rates and permanent income or wealth that one might want to view as structural. This characterization was made tractable by the assumption that everyone engages in securities trade at the same time, all with the same fixed period. That this assumption is unrealistic is obvious. That it is unrealistic in a way that is critical to the theory of money demand was shown by Grossman and Weiss (1983) and Rotemberg (1984), who examined theoretical settings in which only a subset of agents is engaged in securities trading at any time. This modification alters the way the system responds to open market operations, because when the central bank issues money for bonds, interest rates must move so that the subset of private agents on the other side of this exchange is willing to acquire a disproportionate share of the economy's new money supply. This alteration introduces a Keynesian "liquidity preference" element into money demand that is entirely absent from the formulation I have sketched. Cochrane (1988) appears to have identified these liquidity effects, for periods up to a year, in post-1979 U.S. weekly series on Treasury bill rates and money growth rates. (I say "appears" because the connections between theoretical models of the GrossmanWeiss-Rotemberg type and the estimation methods used by Cochrane have not been worked out in any detail.) By using annual data, it seemed possible that Meltzer's results and mine might avoid contamination from these "liquidity preference" effects. We will see in the next section, however, that this hope is not confirmed, at least for post-1958 data. The trick will thus be to get as much as we can out of a money demand theory that is not adequate to account for some short run events.

IV. HONEY DEMAND SINCE 1958

Econometric research on money demand has undergone considerable development since the early 1960s. In the main, this work (with the notable excption of Friedman and Schwartz's (1963) and (1982) studies of long U.S. and U.K. time series) has focused on evidence from postwar U.S. quarterly series. Meltzer's work is not cited in Judd and Scadding's (1982) review article (though they do make repeated use of Laidler (1977), which was in turn heavily influenced by Meltzer's work) and, in general, the research cited in this survey is not much concerned with comparison of postwar evidence with evidence from the earlier years of the century.

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The pioneering paper in this "modern" era of money demand studies is Goldfeld (1973), which introduced distributed lag methods that seem to be needed to obtain close fits to quarterly data. Subsequent work has, in large part, been devoted to the refinement of Goldfeld's studies and to dealing with the fact (stressed most forcefully by Goldfeld (1976)) that his equations deteriorated in fit on data outside the original sample period. There is no doubt that recent work is based on a much more sophisticated awareness of econometric issues specific to time series analysis than was the research of the 1950s and 60s. At the same time, the substantive results have been disappointing. Judd and Scadding refer to "the observed instability in the demand for money after 1973," and endorse the conclusion reached earlier by Cooley and LeRoy (1981) "that the negative interest elasticity of money demand reported in the literature represents prior beliefs much more than sample information." The unit income (or wealth) elasticity is no longer regarded as wel1-established, and most recent work has focused on find i "scale variables" that sharpen short-term forecast errors rather than on estimates of the income elasticity that stand up well over different data sets. In short, one gains the impression that subsequent research has generally failed to support Meltzer's findings, that the income and interest elasticities he estimated are inconsistent with more recent evidence and were even, perhaps, as much the product of his "prior" as they were inferences drawn from the time series he studied. I think al 1 of these conclusions, or impressions, are incorrect. In this section I will argue that Meltzer's 1963 results are not only qualitatively but quantitatively consistent with observations since 1958: that even if one takes the income and interest elasticities estimated, by his methods, from pre-1958 data alone one obtains a more useful account of money demand in the 25 year period sinee than is obtained from more recent distributed lag formulations. Moreover, I will exhibit the information on the interest elasticity of money demand contained in 1900-1985 data in such a way as to concentrate even Cooley and LeRoy4s posterior distribution on Meltzer's 1963 co .usion. At the sair.. time, this application of Meltzer's equation to more recent data will also reveal repeated, systematic patterns in the residuals. These are patterns that are not consistent with the theoretical model reviewed in Section II (and hence not consistent with Meltzer's theory as I have interpreted it). I think it will be easy to see why these patterns motivated Goldfeld and others to resort to distributed lag methods. But I

1900-85 -.07 (.044)

.97 .967 (.019)

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will argue that these methods have served to obscure rather than reveal both the sense in which this theory helps to understand recent events and the sense in which it falls short. Table 4 provides results for the entire 1900-85 period and for the recent subperiod 1958-85. Line 1 is exactly the same regression as line 3, Table 3 for the full period. Line 3 of Table 4 is the same regression for the period 1958-85 only. One can see that simply adding the later years to the full sample results in virtually no change in the estimated elasticities. However, the results for the later years taken by themselves show a drastic deterioration in fit and large changes in estimated coefficients as compared to the 1900-57 period. In lines 2 and 4 of Table 4, the income elasticity is constrained to be unity (so no "standard error" is reported). Line 2 is, not surprisingly, the same as line 1, but so too is line 4. Examining trends over the later period (as I did in Section II for the earlier years) helps in interpreting Table 4. In the 27 year period 195885, real money balances grew at an annual rate of .004 while real income grew at a rate of .03. Short term interest rates increased (though not at all smoothly) from around 3 percent to around 9 percent, or at a rate of about .22 percentage points per year. To fit these trends, the interest semi-elasticity nr and the income elasticity lie on the line: nr = -.02 + (.14)ny With an income elasticity of unity, this implies an interest semi-elasticity of .12. This pair of estimates is roughly have to

TABLE 4 Results from 1900-85 Dependent variable: n(Ml/P)

Coeff icients on: (standard errors) 2 Line Years r^

R

consistent

with the estimates 1.06 and .07 reported in line 3 of Table 3. It is also consistent with the estimates .97 and .07 in line 1 of Table 4, and with the constrained estimates in lines 2 and 4 of Table 4. Similarly, the unconstrained estimates .21 and -.01 on line 3 of Table 4 lie roughly on this line. One can account for the divergent trends in income and real balances over the 1953-85 period either with the 1900-57 estimated income and interest elasticities or with much lower income and interest
o

elasticities. Figure 4 illustrates, in part, why I prefer tu?. constrained estimates reported on lines 2 and 4 of Table 4 to the unconstrained estimates on line 3. This figure

158

plots the log of P/Pyp against the short term interest rate for the entire 1900-85 period, with the post 1957 observations indicated by different symbols from the 1900-57 observations. One can see that if one constrains the income elasticity for the entire period to be unity, one gets in return a single interest semi-elasticity for the entire period. The most recent points lie exactly or the line defined by the earlier ones and, since interest rates behaved so differently in the recent period, the estimate is greatly sharpened by the new observations. Let me try to summarize the sense in which Figure 4 confirms both Meltzer1s hypothesis that real money demand is a stable function of permanent income (or wealth) and interest rates and the numerical estimates h? obtained. Meltzer estimated these two parameters by least squares. As Figure 2 shows, the estimated income elasticity is mainly dictated by the common trend of real balances and income. At this estimated value of unity, Figure 3 shows that the interest elasticity is determined by a reasonably tight scatter of an(Ml/Pyp) against rs. If one imposes the same income elasticity of unity on the 1953-85 period, this same scatter., reproduced as Figure 4, confirms the original interest elasticity estimates and since interest rates were so much higher in the later period, the new experiment is a very good one. Notice that there is nothing arbitrary or experimental about Figure 4: It is precisely the scatter one would want to look at in view of the estimates Meltzer obtained using pre-1958 data only. However, as 1ine 3 of Table 4 shows, these two elasticity estimates cannot be recovered from the 1958-85 data using least squares (as Meltzer

159

Figure 1900-65
6

1.8

|".

1.6

5 - denotes observations from 1900 to 1957. 0 - denotes observations from 1958 to 1985.

160

m_ t4.

e * o * n r> *

fofl

0.8

0.6 4 6 8 10
12

14

16

Short-Term Interest Rate

1.4
1.2

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recovered them from the earlier data). There is a reason why these estimates came out as they did, as Figure 5 shows. Interest rates were not only increasing dramatically over the 1958-85 period but were also highly erratic. The relatively high interest semi-elasticity on line 3 reconciles the trends with a high income elasticity, but the cost of this reconciliation is that the "predicted" path of real balances from the constrained estimates is much too interest-sensitive to fit observed, year-to-year movements. Actual real balances move in the predicted direction in response to interest rate changes, but by much less than is predicted. These lead to large residuals, which are also strongly correlated with interest rates. This is why the order revealed in Figure 4 cannot be discovered using unconstrained least squares. Mankiw and Summers (1986) recover exactly an income elasticity of unity and an interest semi-elasticity of .05 from least squares applied to 1960-84 U.S. quarterly series. They do so using consumption in place of permanent income (justified in part by the kind of argument I used in Section III) and by using Almon lags to average the independent variables over time. One can conjecture from Figure 5 that averaging interest rates will "work," and Mankiw and Summers1s results confirm this. (I suspect that long interest rates worked as well as they did in Meltzer's study for much the same reason: Long rates are a kind of average of short rates.)

V. CONCLUSIONS
This paper has had three main objectives. As reported in Section II, I first replicated some of the results in Meltzer (1963), using his 1900-1957 sample period, and showed that two variations of interest to me are empirically indistinguishab1e from the model he used. Second, in Section III, I reviewed a theoretical model of money demand in which the two parameters Meltzer estimated could be expected to be "structural." Thirc?, in Section IV, I compared the predictions of Meltzer's model, with his original parameter estimates, to post-1958 data, and concluded that this comparison yields additional confirmation of the theory and of these two estimates. Meltzer (1963) was criticized (for example, by Courchene and Shapiro (1964)) for, among other things, his failure to correct his estimates for severely serially correlated residuals and his failure, despite great emphasis on the "stability" of the money demand function, to apply standard statistical tests for the stability of parameter estimates across different

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Figure 5

Year Actual Ml/P. Predicted Ml/P from line 4, Table 4.

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sample periods. These two criticisms can certainly be applied as well to the present paper, for I share Meltzer's emphasis on the "stability" of the money demand function. But I agree with Meltzer (1964) that these econometric criticisms are very badly off the economic point. We begin with a simple economic model that suggests a twoparameter description of money demand. When we hypothesize that this relationship is "stable," we mean that we expect these two parameters to reflect relatively stable features of consumer preferences and the way in which business is carried out, and we expect them not to shift around as monetary or other policies are altered over time. This theory does not suggest that the residuals can be characterized in a simple, elegant fashion over a given time period, or even that the stochastic structure of the residuals should be stable over time. Accordingly, there is little point in testing the theory by maintaining an extreme hypothesis on the residuals that is not implied by any theoretical considerations and then performing a Chi-square test for the equality of coefficients over subperiods. One needs a maintained hypothesis in which one has more, not less, confidence than one has in the hypothesis being tested. Thus Meltzer argued, and I agree, that we can only test the theory by comparing its numerical predictions to as wide a variety of data as we can find. In carrying out such tests, it is of no interest whatever to let the two crucial elasticities isolated by the theory change arbitrarily from one data set to the next. The theory is of no interest or use unless these two parameters are stable under a wide range of circumstances. Over the time period Meltzer studied, in which income has a strong trend and interest rates had none, the method of least squares isolates an income elasticity of unity, just as does a comparison of income and real balance trends. With this income elasticity, one can see from Figure 3 that there is enough interest variability to trace out a fairly clear demand curve. Over the more recent period, interest rates have a very strong upward trend, as does income, so that there are many combinations of elasticities that are consistent with trends in the holding of real balances. Least squares picks out a combination of elasticities that is very different from the pair that is consistent with earlier evidence. Yet imposing the same elasticities in the later period is also consistent with long term trends and, as Figure 4 shows, traces out a demand function that is consistent with the earlier data, and much clearer than was possible

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with those data alone.^ This picture did not arise by chance! The evidence from the post-1960 years also reveals strong patterns in the residuals from this estimated demand function that did not appear in the earlier years of the century. It is clear that, as investigators sinee Goldfeld have concluded, the portfolio adjustment process is subject to lags in a way that neither the theory Meltzer had in mind nor the cash-in- advance model I sketched in Section III helps to understand. This fact is hardly surprising: One is, if anything, surprised that this simple model captures as much as it does. In these circumstances, it seems to me that it is the econometrician1s job to display as clearly as he can the respects in which the model he has is a good approximation to reality and the sense in which it is not. This is what Meltzer did in his 1963 paper, and it is what I have tried to do in this one. I hope Figure 4 convinces anyone who sees it that the interest semi-elasticity of money demand has remained stable at something between .05 and .10 for nearly a century in the U.S. I hope Figure 5 helps to stimulate someone, perhaps along the lines suggested by Grossman, Weiss and Rotemberg, to discover the short run dynamics that can reconcile this fact with year-to-year or even quarter-to-quarter movements in observed money holdings.

^An income elasticity of unity is a I so consi stent wi th the

cross-section

evidence reported in Meltzer

(1963b). The interest semi-eIast i c i t i es est imated from U.S. t i me series are a I so consistent wi th the range ot estimates Cagan (1956) found in his study of hyper i nfI at ions.

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Ando, A., Modigliani, F., and Shell, K. 1975 Some Reflections on Describing Structures of Financial Sectors, in Gary Froran and Lawrence R. Klein, (eds.) Brookings Model Perspective and
Recent Developments. Amsterdam: North- Holland, 524-563.

Stunner, K. and Meltzer, A.H. 1963 Predicting Velocity: Implications for Theory and Policy. Journal of
Finance, 18: 319-354.

Cagan, P. 1956 The Monetary Dynamics of Hyperinflation, in Milton Friedman, (ed.),

Studies in the Quantity Theory of Money. Chicago: University of Chicago

Press. Cochrane, J.H. 1988 The Return of the Liquidity Effect: A Study of the Short Run Relation Between Money Growth and Interest Rates. Journal of Business and
Economic Statistics. Forthcoming.

Cooley, T.F. and LeRoy, S.F. 1981 Identification and Estimation of Money Demand. American Economic
Review, 71: 825-844.

Courchene, T.J. and Shapiro, H.T. 1964 The Demand for Money: A Notes from the Time Series. Journal of
Political Economy, 72: 498-503. Economic Report of the President

1987 Washington D.C. Friedman, M. 1956 The Quantity Theory of Money - A Restatement," in Milton Friedman, (ed.), Studies in the Quantity Theor)> of Money. Chicago: University of Chicago Press.

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Friedman, H. 1957

A Theory of the Consumption runction. Princeton: Princeton University

Press, for the National Bureau of Economic Research.

1959 The Demand for Money - Some Theoretical and Empirical Results. Journal rf
Political Economy, 67: 327-351.

________ and Schwartz, A.J. 1963 A Monetary History of Princeton University Research. ________ and _________ (1970) Monetary Statistics of the United States. New York: Columbia University Press for the National Bureau of Economic Research. ________ and _________ 1982 Monetary Trends in the United States and the United Kingdom. Chicago: University of Chicago Press, for the National Bureau of Economic Research. Goldfeld, S.M. 1973 The Demand for Money Revisited. Brookings Papers on Economic Activity, 577638.
the United States, 1867-1960. Princeton:

Press, for the National Bureau of Economic

1976 The Case of the Missing Money." Brookings Papers on Economic Activity, 683730. Goldsmith, R.W., et al. 1956 A Study of Saving in the United States, Vol. III. Princeton: Princeton University Press, for the National Bureau of Economic Research.

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Grossman, S. and Weiss, L. 1983 A Transactions-Based Model of the Monetary Transmission Mechanism."
American Economic Review, 73: 871-880.

Hamburger, M.J. 1977 Behavior of the Money Stock: Is There a Puzzle? Journal of Monetary
Economics, 3: 265-288.

Judd, J.P. and Scadding, J.L. 1982 The Search for a Stable Money Demand Function. Journal of Economic
Literature, 20: 993-1023.

Laidler, D.E.W. 1966 The Rate of Interest and the Demand for Money - Some Empirical Evidence. Journal of Political Economy, 74: 545-555.

1977 The Demand for Money: Theoretical and Empirical Evidence. Second Edition. New York: Dun-Donneley. Lucas, R.E., Jr. and Stokey, N.L. 1987 Money and Interest in a Cash-in-Advance Economy. Econometrica, 55: 491514. Mankiw, N.G. and Summers, L.H. 1986 "Money Demand and the Effects of Fiscal Policies. Journal of Money,
Credit, and Banking, 18: 415-429.

McCallum, B.T. and Goodfriend, M.S. 1987 Money: Theoretical Analysis of the Demand for Money." Paper prepared for The New Palgrave: A Dictionary of Economic Theory and
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Meltzer, A.H. 1963 The Demand for Money: The Evidence from the Time Series. Journal of
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Meltzer, A.H. 1963b The Demand for Money: A Cross-Section Study of Business Firms.
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1954 A Little More Evidence from the Time Series. Journal of Political Economy, 72: 504-508. Poole, W. 1970 Whither Money Demand? Brookings Papers on Economic Activity, 485-501. Rotemberg, J.J. 1984 A Monetary Equilibrium Model with Transactions Costs. Journal of Political
Economy, 92: 40-58.

Samuel son, P.A. (1947) Foundations of Economic Analysis. Cambridge: Harvard University Press. U.S. Bureau of the Census. 1960 Historical Statistics of the United States, Colonial Times to 1957. Washington D.C. 1958 from the sample because I could not find w for that year. Otherwise, I attempted to follow the sources and procedures described in Meltzer (1963). One can see that lines 1 and 2 from Tables 1 and 2 are very close, though closer for the income regression than the wealth regression. When both variables are included (line 3) I obtained very different results from his, for reasons I cannot explain. Notice, however, that Meltzer*s and my estimates of the sum of these coefficients are very close: I suspect this is all either of us is estimating with much precision. The other striking difference is in line 4 of Tables 1 and 2: my wealth elasticity for this subperiod is well below one; Meltzer's is 1.8. I wanted to use a graphical device to help me see how different a theory one obtains with different wealth or income measures. I know this question is not very well posed, but Figure 1 seems to me helpful. It exhibits three series, all for the full period 1900-1957. They are: actual Ml/P; the "predicted" Ml/P from line 1 of Table 2; and the predicted Ml/P from line 2 of Table 2. One can see that real balances followed a different trend from 1930 on than in the earlier years. Both the income and wealth

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2 3 4

190C-85 -.09

1.0 ~

(.001) ------------------1958-85 -.01 (.005) 1958-85 -.07 1.0 .21 .328 (.059) ---

(.008)

170

Poole (1570) argued much earlier that cnc - needs to constrain the income elasticity in ot der to obtain an interest elasticity from post-World War II data that is consistent vith pre -war evidence.

171