Microeconomic Foundation of Open Economy Money Demand

This chapter discusses demand for money by building a missing sound microeconomic foundation shopping time model for an open economy. This model’s multi-period utility function is an increasing function of both leisure and expenditure on goods and services. Households have positive time preference, and their multi-period utility function exhibits a Cobb–Douglas production function behavior. Leisure is also a function of spending on goods and services, real cash balance, and real effective exchange rate. Households are assumed to optimize by maximizing multi-period utility function subject to inter-temporal budget constraint, which is obtained by equating resources brought from previous year to current expenditure of households to obtain a Lagrangian equation, which is differentiated with respect to expenditure on goods and services, and leisure. The leisure function is expressed as a function of three variables to capture the role of medium of exchange, which is maximized by differentiating the leisure equation with respect to consumption of goods and services, real cash balances, and real effective exchange rate, and solving them by setting them to zero. Solutions of the first-order optimality condition are real cash balances, real income, and real interest rate, as the effective exchange rate is zero which cancels out its effect on foreign trade. This solution is expressed by making the real cash balance a function of income or expenditure of goods and services as the scale variable, and interest rate as the opportunity cost measure, which is an exogenous variable, to obtain the derived demand for money.