THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 600

568 PA R T V I I Monetary Theory Moreover, the implication of a unitary income elasticity can be tested by reformulating Equation 3-A as log a M b = a + b log Yt + Pt P t and (using time series data) testing the null hypothesis H0:b = * Regarding other empirical approaches to the demand for money, see Apostolos Serletis, The Demand for Money: Theoretical and Empirical Approaches (Springer, 2007) Interest Rates and Money Demand Earlier in the chapter we saw that if interest rates not affect the demand for money, velocity is more likely to be a constant or at least predictable so that the quantity theory view that aggregate spending is determined by the quantity of money is more likely to be true However, the more sensitive the demand for money is to interest rates, the more unpredictable velocity will be, and the less clear the link between the money supply and aggregate spending will be Indeed, there is an extreme case of ultrasensitivity of the demand for money to interest rates, called the liquidity trap, in which monetary policy has no direct effect on aggregate spending because a change in the money supply has no effect on interest rates (If the demand for money is ultrasensitive to interest rates, a tiny change in interest rates produces a very large change in the quantity of money demanded Hence in this case, the demand for money is completely flat in the supply and demand diagrams of Chapter Therefore, a change in the money supply that shifts the money supply curve to the right or left results in it intersecting the flat money demand curve at the same unchanged interest rate.) The evidence on the interest sensitivity of the demand for money found by different researchers for different countries is remarkably consistent Neither extreme case is supported by the data In situations in which nominal interest rates have not hit a floor of zero, the demand for money is sensitive to interest rates, and there is little evidence that a liquidity trap has ever existed However, as we saw in Chapter 4, when interest rates fall to zero, they can go no lower In this situation, a liquidity trap has occurred because the demand for money is now completely flat Indeed, Japan has been experiencing a liquidity trap of this type in recent years, and this is one reason why it has been difficult for the monetary authorities to stimulate the economy Stability of Money Demand If the money demand function, like Equation or 6, is unstable and undergoes substantial unpredictable shifts, as Keynes thought, then velocity is unpredictable, and the quantity of money may not be tightly linked to aggregate spending, as it is in the modern quantity theory The stability of the money demand function is also crucial to whether the central bank should target interest rates or the money supply (see Chapter 23) Thus it is important to look at the question of whether or not the money demand function is stable because it has important implications for how monetary policy should be conducted