Microfoundations for a Stable Demand for Money Function

Abstract

Scientific revolutions seldom occur when the prevailing theories appear to be performing well: it is only when the accepted theory fails to offer a satisfactory explanation of events that new and more robust theories are proposed. Of these new theories the one which can explain the successful performance of the previous theory and also the events which led to its demise becomes the replacement. So it is in the history of modern monetary economics. The failure of the partial adjustment model in the mid-I970s is well documented in the United Kingdom and the United States and the search for a replacement has been the main point on the agenda since that time. There are many contending theories, some of which are advocated by the other contributors to this controversy, but the mark of a truly better theory which can be claimed to supersede the partial adjustment model is one that can explain the success and the breakdown of the previous theory as well as the events subsequently. Central to the argument of this paper is the importance of individual behaviour in the context of a market for monetary assets. Only by means of careful investigation of the microeconomic behaviour underpinning monetary economics at the individual and the market level can the stability of the money demand function be restored. It is the purpose of this paper to suggest that the buffer stock approach has gone further than other approaches in dealing with the fundamental micro-foundations of the demand for money. It does not suggest that other approaches have no microfoundations but they tend to concentrate exclusively on specific aspects of the micro-structure such as separability and ignore others relating to the behaviour of individual optimisers in a monetary market. The buffer stock model has firm micro-foundations which can explain the events both before and after the breakdown of the partial adjustment model. Section I provides an historical background to the debate and Section II gives a brief overview of buffer stock models which shows that, unlike other approaches, they have been able to reconcile the past success of the partial adjustment model with its present failure: The nature of the microfoundations of buffer stock models are the source of the success and are discussed in more detail in Section III. The final section evaluates the buffer stock approach in the light of the other alternatives.