Economic Data Analysis Project

Economic Data Analysis

L1D009

Oliver Frost

Student No. 4042216

CONTENTS:

Page number

1.  I. INTRODUCTION……………………………………………………….  3

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1. II. UNDERLYING THEORIES …………………………………………… 4

1. a. Keynes theory ……………………………………………………. 4-5

1. i. Precautionally demand for money…………………………..

2. ii. Speculative demand for money……………………………….

3. iii. Liquidity preference……………………………………………

4. b. Friedman’s theory………………………………………………… 5-6

5. III. MODEL SPECIFICATION AND ESTIMATION………………………7

6. i. Data………………………………………………………………… 7

7. ii. Model specification………………………………………………. 8

8. iii. Estimation of model……………………………………………… 9

1. IV. ANALYSIS OF THE RESULTS ………………………………………..   10

1. V. SUMMARY ……………………………………………………………….    11

1.  VI. BIBLIOGRAPHY ………………………………………………………..               12

1. I. INTRODUCTION:

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This is a study that focuses on the relationship that exist between the interest rates that prevail in an economy and the amount of money demanded in an economy, the intuition is that when interest rates are high then we expect that the amount of money demanded in the economy will be less, this is because interests rate is the opportunity cost of holding money.

When interest rates are high the opportunity costs of borrowed funds is too high and therefore less of it is demanded. When interest rates are low then people will demand more money in an economy. Government will therefore use interest rates as a tool to stabilise the economy in case of inflation caused by excess demand.

Various theories exist to explain the factors that determine the demand for money, this include the Keynesian demand for money theory, Milton Friedman’s quantity demand for money theory, Tobin’s liquidity preference theory and the Fisher’s money theory.

In this study we will use UK data from the year 1984 to the year 1994 to analyse the relationship that exist between the money supply and the interest rates that prevail in the economy, the data will be used to estimate the equation Md = F (IR) where Md is the money demanded in an economy, and IR is the interest rate. Therefore the model states that money demand is a function of interest rates.

1. II. UNDERLYING THEORIES:

Many theories have come up to explain the factors that determine demand for money in the economy; they include the Keynes theory, the Milton theory and the Fishers theory of money. All this scholars recognise the effect of changes in interest rates on money demanded.

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a. Keynes theory

Keynes argued that money demand in an economy is determined by three factors, the precautionally demand for money, liquidity preference and the speculative demand for money. The amount held by firms and individuals depend on the level of income and the institutional arrangements of the economy, they will hold money for their day to day transactions in order to purchase goods and services.

– Precautionally demand for money

The precautionally demand for money arises from uncertainties of life and unseen events, the amount held will depend on the level of income, the higher the level of income the higher the amount held for precautionally purposes, the prevailing interest rates will also determine the amount held for precautionally purposes, because the interest rates are the opportunity costs of holding money the higher they are the less is the amount held.

Institutional arrangement will also determine the amount held in that if an economy provides certain services such free medical care the less the amount held by the people for precautionally purposes.

Speculative demand for money

This demand for money arises when the individuals and firms in an economy hold money for the purpose of speculation, money is therefore held as an asset and therefore they will hold money for the purpose of purchasing other interest bearing assets. The amount held for speculation purposes depend on the level of interest rates and the level of income.

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Liquidity preference

This demand will arise from the fact that people and firms will hold money for the purpose of their day to day transactions; they will hold money to purchase goods and services. [1]

1. b. Friedman’s theory

According to Friedman sees money as just another way in which wealth can be held, he assumes that money is like any other asset. He argued that the demand of money is determined by the total wealth of an individual, the expected rate of interest, the ratio of human to non human wealth and the taste and preferences of people in an economy.

He derived the following model

Real demand for money = F (W, r, w, T)

Where:

W  is the total wealth of an individual, as W increases the demand for money also increases.

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r is the expected rate of interest, as the rate of interest rate increases the less is the amount of money demanded.

w is the ratio of human and non human wealth, human wealth is less liquid than any other form of wealth so an increase in the liquidity of human wealth will increase the amount of money demanded.

T is the taste and preferences, institutional arrangements and the culture of the people in an economy. [2]

Therefore the two scholars recognise the relationship between the rate of interest and the amount of money demanded. We therefore now establish the relationship between them using the data from the UK economy from the year 1984 to the year 1994. We shall use this data to estimate the equation Md = F (IR) where Md is the money demanded in an economy, and IR is the interest rate.

III. MODEL SPECIFICATION AND ESTIMATION:

– Data [3]

Table one.

Data for the UK from the year 1984 to1994: amount in million pounds

YEAR

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REAL DOMESTIC EXPEDITURE

NOMINAL DOMESTIC EXPEDITURE

INTEREST RATES

MEASURE OF MONEY HOLDINGS

PRICE INDEX

REAL MONEY SUPPLY

1984

450.949

326.498

1.1069

198.93

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1.381169

274.756

1985

464.316

354.291

1.1062

224.794

1.31055

294.6037

1986

487.33

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388.179

1.0987

258.304

1.255426

324.2816

1987

513.083

428.721

1.0947

304.948

1.196776

364.9544

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1988

553.461

488.953

1.0936

358.233

1.131931

405.495

1989

569.719

537.279

1.0958

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426.322

1.060378

452.0626

1990

566.238

566.238

1.1108

477.138

1

477.138

1991

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548.532

581.897

1.0992

504.133

0.942662

475.2269

1992

549.543

605.295

1.0912

517.883

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0.907893

470.1823

1993

561.346

638.4

1.0787

544.055

0.879301

478.3883

1994

580.092

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675.164

1.0805

567.157

0.859187

487.2938

[4]

– Model specification:

Our first assumption is that money supply is equals to the money demanded that is to say that Md = Ms, our model is specified as Md= F (IR), therefore we expect that the model will take the form of Md = B + IR x where B will the autonomous money demanded and x is the measure of the effect of interest on money demanded. We will assume that only interest rates will determine the amount of money demanded in the economy, we shall therefore run the regression that will determine the relationship between the money demanded and interest rates. [5]

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– Estimation of the model:

We will use the classical estimation model to estimate the model, the classical regression model states that when the model takes the form of Y= α + β x, then you estimate the model as follows:

α = Y- β x, and that β = n ∑x y – ∑ x∑ y

______________

n ∑ x2 – (∑ x) 2

Where n is the number of observations and therefore we estimate our model using the data provided, our y will be the money demand Md and x will be our interest rates IR, we therefore obtain our products for x and y, and x 2 . Our results are shown in table two. [6]

Table two

YEAR

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INTEREST RATES

MEASURE OF MONEY HOLDINGS

PRICE INDEX

REAL MONEY SUPPLY

x

y

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xy

x2

1984

1.1069

198.93

1.381169257

274.756

304.1274

1.225228

1985

1.1062

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224.794

1.310549802

294.6037

325.8906

1.223678

1986

1.0987

258.304

1.255425976

324.2816

356.2881

1.207142

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1987

1.0947

304.948

1.196775992

364.9544

399.5156

1.198368

1988

1.0936

358.233

1.131930881

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405.495

443.4493

1.195961

1989

1.0958

426.322

1.060378314

452.0626

495.3702

1.200778

1990

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1.1108

477.138

1

477.138

530.0049

1.233877

1991

1.0992

504.133

0.942661674

475.2269

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522.3694

1.208241

1992

1.0912

517.883

0.907892846

470.1823

513.0629

1.190717

1993

1.0787

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544.055

0.879301378

478.3883

516.0375

1.163594

1994

1.0805

567.157

0.859186805

487.2938

526.521

1.16748

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totals

12.0563

4381.897

11.92527292

4504.383

4932.637

13.21506

β = 377.1521317 α = 79.78093248

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Therefore our model takes the form of Y = 79.78093248 + 377.1521317 x

IV. ANALYSIS OF THE RESULTS:

According to the results of the estimated model which is

Y = 79.78093248 + 377.1521317 x

The autonomous money demanded is 79.8 million pounds and an increase in the interest rates by one unit will increase the amount of money demanded by 377.2 million pounds.

Therefore an increase in the money supply will increase the amount of money demanded, our results however have not shown the significance of an increase in interest rates, the resulting positive relationship between money demanded and interest rates is as a result of the small sample used, we did not also consider the other factors that influence money demand, also we used a simple regression model instead of a multiple regression model where we would have considered more than factor that influence demand.

We also assumed that money supply is equal to money demand; in this case we did not consider a case where the two values would be at disequilibrium, however if we reverted the model to assume that money supply is a function of interest rates then our model would be different in that an increase in interest rates will signal to the financial institutions to increase money supply.

V. SUMMARY

According to Keynes and Milton Friedman the quantity of money demanded is determined by other factors and these factors include interest rates, if an economy increased its interest rates then we would expect that the amount of money demanded will go down.

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However interest rates are used by central financial institutions to either increase or decrease the amount of money in the economy, an increase in interest rates reduces the amount of money in supply of an economy, and a decrease in these interest rates will increase the amount of money in the economy.

Economies will use interest rates as a way of stabilising the economy to avoid inflation and unemployment, when there is inflation monetary policy makers will increase interest rates. An increase in money supply will result into increased aggregate demand for goods and services in the economy but this may cause inflation, therefore monetary policy makers will only fine tune the economy using interest rates only when the economy is unstable.

VI. BIBLIOGRAPHY

H. Stratton (1999) Economics: A New Introduction, Pluto Press, USA

National statistics (2006) General practice research data base-UK 1987 to 2003, retrieved on 21

st

Dec. available at

http://www.statistics.gov.uk

P. A. Samuelson (1964) Economics, McGraw-Hill publishers, USA

P. Schmidt (1976) Econometrics, Marcel Dekker publishers, USA

Sergio J. Rey (1956) Advances in Spatial Econometrics: methodology, tools and applications, Springer publishers, USA

[1] H. Stratton (1999)

[2] P. A. Samuelson (1964)

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[3] National statistics (2006)

[4] National statistics (2006)

[5] Rey (1956)

[6] P. Schmidt (1976)

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