Money Demand in 2007–2008

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I’ve been asked a good question on my earlier post. Since I used money supply numbers that are the resultant of demand and supply, how do I know that aggregate money demand had not shifted higher (to the right or upwards)? I have several observations in response.

First, if money demand had shifted to the right, we might have expected higher money market rates in 2007 and up to mid-2008 (prior to the FED’s money pumping). However, these rates were actually 2 percent or more lower in 2008 than in 2006 and 2007. The 3-month eurodollar deposit rate was 3 percent in June 2008, 5.34 percent in June 2007, 5.48 percent in June 2006, and 3.46 percent in June 2005.

Second, if people wanted to hold more money, we might have expected commodity prices to have fallen. Actually, they were at a peak in 2008.

Third, if demand for money is supposed to have generally and/or suddenly shifted, we must ask why this shift would have occurred. There is no obvious explanation. However, we can easily see that at some point certain investors in certain financial institutions had decided to withhold funding for the sensible reason that the firms had become insolvent.

Fourth, even if aggregate demand for money had shifted, we observe that short-term rates in late 2008 went to near zero, coincident with the FED’s money creation. Supply of fiat money had to exceed demand greatly in order for this very unusual event to have occurred.

Fifth, when money demand shifts, why should a central bank be empowered to counteract it, if that is put forward as an economic rationale? The market can increase velocity if need be. It can devise money substitutes if need be. Free market players will jump on profit opportunities to supply money if it is in demand and if they are given a chance to meet that demand. By contrast, the incentives of the central bank are politically determined, vague, not measurable, and arbitrary, involving such things as price level stability and full employment.

UPDATE. An important fact, unmentioned above, is that the price of gold in dollars rose right along with the FED’s additions to monetary base. This directly contradicts the idea that demand for (the FED’s) money shifted to the right.

12:50 pm on June 20, 2012