A study of the effect of term structure of interest rates on the demand for money

Abstract

The demand for money has been a subject of considerable research in the past. Most of the empirical work to date has tried to determine whether a long-term rate of interest or a short-term rate is a better measure of the opportunity cost of holding money. Both theory and evidence have given conflicting answers. Some argue that the interest rate on long-term bonds is relevant, since it is more representative of the average rate of return on capital in the economy and therefore a better indicator of the opportunity cost of holding money than is the yield on short-term debts. Others contend that short-term securities are closer substitutes for money than longer-term bonds so that the short-term rates are more relevant. The results varied according to the data used and whether one tested a long-run or a short-run demand for money. The controversy continued even when it was recognized that, theoretically, the whole spectrum of interest rates was related to the demand for money. There are very few instances when the joint effect of the various market rates of interest are incorporated in a study of the aggregate demand for money. Recently Friedman has presented an analysis in which he argues that the whole term structure of holding period yield from the very shortest holding period to the very longest is relevant to the cash balance decision. The weight given to various interest rates is itself a decision variable determined jointly with the cash balances and cannot be specified in advance. This research endeavour undertakes to investigate the various conclusions presented in Friedman's model. In Chapter I we present a brief resume of some of the most discussed empirical work on the demand for money. The role of the variously termed interest rates is particularly noted. Chapter II gives the highlights of Friedman's analysis and the implications that he draws from it. In Chapter III we formalize some of his arguments to verify their conclusion analytically. In Chapter IV we seek to verify his hypothesis by statistically investigating the various implications. A summary and some conclusions appear in Chapter V.