CHAPTER 21 The Demand for Money LE A RNI NG OB JE CTI VE S After studying this chapter you should be able to describe how the demand for money is determined define the theories of the demand for money (classical and Keynesian theories and Milton Friedman s reformulation of the quantity theory of money) present empirical evidence on how the demand for money is affected by changes in interest rates and the level of income PRE VI EW In earlier chapters we spent a lot of time and effort learning what the money supply is, how it is determined, and what role the Bank of Canada plays in it Now we are ready to explore the role of the money supply in determining the price level and total production of goods and services (aggregate output) in the economy The study of the effect of money on the economy is called monetary theory, and we examine this branch of economics in the chapters of Part VII When economists mention supply, the word demand is sure to follow, and the discussion of money is no exception The supply of money is an essential building block in understanding how monetary policy affects the economy because it suggests the factors that influence the quantity of money in the economy Not surprisingly, another essential part of monetary theory is the demand for money This chapter describes how the theories of the demand for money have evolved We begin with the classical theories refined at the start of the twentieth century by economists such as Irving Fisher, Alfred Marshall, and A C Pigou; then we move on to the Keynesian theories of the demand for money We end with Milton Friedman s modern quantity theory A central question in monetary theory is whether or to what extent the quantity of money demanded is affected by changes in interest rates Because this issue is crucial to how we view money s effects on aggregate economic activity, we focus on the role of interest rates in the demand for money.1 In Chapter 23 we will see that the responsiveness of the quantity of money demanded to changes in interest rates has important implications for the relative effectiveness of monetary policy and fiscal policy in influencing aggregate economic activity 551