CHAPTER 21 The Demand for Money 567 be a function of permanent income and the expected returns on alternative assets relative to the expected return on money There are two major differences between Friedman s theory and Keynes s Friedman believed that changes in interest rates have little effect on the expected returns on other assets relative to money Thus, in contrast to Keynes, he viewed the demand for money as insensitive to interest rates In addition, he differed from Keynes in stressing that the money demand function does not undergo substantial shifts and so is stable These two differences also indicate that velocity is predictable, yielding a quantity theory conclusion that money is the primary determinant of aggregate spending The conclusion that money is the primary determinant of aggregate spending was the basis of monetarism, the view that the money supply is the primary source of movements in the price level and aggregate output EM PI RI CAL E VI DE NCE ON TH E DE MA ND F OR M ON E Y As we have seen, the alternative theories of the demand for money can have very different implications for our view of the role of money in the economy Which of these theories is an accurate description of the real world is an important question, and it is the reason why evidence on the demand for money has been at the centre of many debates on the effects of monetary policy on aggregate economic activity Here we examine the empirical evidence in the United States and Canada on the two primary issues that distinguish the different theories of money demand and affect their conclusions about whether the quantity of money is the primary determinant of aggregate spending Is the demand for money sensitive to changes in interest rates, and is the demand for money function stable over time?14 14 If you are interested in a more detailed discussion of the empirical research on the demand for money, you can find it in an appendix to this chapter on this book s MyEconLab at www.pearsoned.ca/ myeconlab A PP LI CATI O N Empirical Estimation of Money Demand Functions To see what empirical estimation of money demand functions is all about, suppose that we want to estimate the quantity theory of money demand function and test its theoretical implications.* That is, test the hypotheses that the price level elasticity of the demand for nominal money balances, h (M, P), equals and that the real income elasticity of the demand for real money balances, h (M/P, Y), equals The hypothesis h (M, P) * can easily be tested by reformulating Equation 3-A and estimating the following regression equation log Pt = - a - b log Yt + g log Mt + Pt using time series data, and testing the hypothesis H0: * *