Competitive Interest Payments on Bank Deposits and the Long-Run Demand for Money: Reply

Abstract

This paper tests two assumptions made in previous demand for studies. The first assumption concerns role assigned to interest rate in demand for function. Common practice identifies rate of interest with the opportunity cost of holding money. In Section I, this formulation is shown to blur an important distinction between the price of money and the price of substitutes and to implicitly assume that relevant price variable is difference between these two distinct prices. A second assumption is that current ban on interest payments on demand deposits is fully effective. In Section II, I operationally define these price variables and estimate perfectly competitive interest payments on commercial bank deposits. This is done by crudely measuring commercial bank marginal costs and assuming that all excess profit is passed on to depositors in indirect ways. Section III presents estimates of a more complete longrun demand for relationship which explicitly includes an own price and a cross price as separate influences, and assumes that prohibition of payment of interest on deposits is totally ineffective. Although no firm conclusion is reached concerning proper functional specification of demand function, results significantly improve upon previous demand for estimates which assumed that interest payment prohibition is totally effective. In Section IV, results are summarized and implications of analysis for monetary theory are presented. My competitive demand for formulation leads to a reinterpretation of existing evidence on what is generally referred to as the interest elasticity of demand for money. This estimate is shown to be significantly biased downward. It also implies that demand for and supply of are more interdependent than is usually assumed.

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