The Demand for Money: A Rational Expectations Approach

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Abstract
We derive a model of money demand for an optimizing consumer with rational expectations in a discrete time infinite horizon framework under uncertainty. Money demand responds to unanticipated changes in income, one period expectations of future bond and money interest rates, unanticipated current interest rates, and past anticipations of current rates. The derived consumption function mirrors money demand behavior. Joint estimation of the consumption and money demand equations by weighted nonlinear least squares corroborates the predicted effects, particularly income neutrality. This money demand model substantially outperforms a conventional specification in post-sample simulation over 1975-85.

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