Demand for Money

In monetary economics, the demand for money is the desired holding of financial assets in the form of money: that is, cash or bank deposits rather than investments. It can refer to the demand for money narrowly defined as M1 (directly spendable holdings), or for money in the broader sense of M2 or M3.

Money in the sense of M1 is dominated as a store of value (even a temporary one) by interest-bearing assets. However, M1 is necessary to carry out transactions; in other words, it provides liquidity. This creates a trade-off between the liquidity advantage of holding money for near-future expenditure and the interest advantage of temporarily holding other assets. The demand for M1 is a result of this trade-off regarding the form in which a person’s funds to be spent should be held. In macroeconomics motivations for holding one’s wealth in the form of M1 can roughly be divided into the transaction motive and the precautionary motive. The demand for those parts of the broader money concept M2 that bear a non-trivial interest rate is based on the asset demand. These can be further subdivided into more microeconomically founded motivations for holding money.

Generally, the nominal demand for money increases with the level of nominal output (price level times real output) and decreases with the nominal interest rate. The real demand for money is defined as the nominal amount of money demanded divided by the price level. For a given money supply the locus of income-interest rate pairs at which money demand equals money supply is known as the LM curve.

The magnitude of the volatility of money demand has crucial implications for the optimal way in which a central bank should carry out monetary policy and its choice of a nominal anchor.

Types of demand for money

• Transaction demand: Money needed to buy goods; this is related to income.
• Precautionary demand: Money needed for financial emergencies.
• Asset motive/speculative demand: When people wish to hold money rather than buy assets/bonds/risky investment.

Asset motive

The asset motive states that people demand money as a way to hold wealth. This may occur during periods of deflation or periods where investors expect bonds to fall in value.

Precautionary demand for money

 Precautionary demand for money, the money we may need for unexpected purchases or emergencies.

Money Balances Held for Precautionary Reasons

Precautionary money balances are held to moderate the impact of unexpected spending needs that can occur in the future. The factors that drive the demand for precautionary money balances are similar to those analyzed for transaction money balances.

• As the level of economic activity and GDP rises, companies and consumers will increase the level of precautionary money balances for unforeseen spending needs. it is a natural consequence of trends, such as increasing consumer spending habits and rising inflation.
• The availability of credit and level of interest rates affect the level of precautionary money balances. Other conditions held equal, when credit is easily (hardly) available and interest rates are low (high), such money balances are expected to rise (decline).
• The balances held for precautionary reasons must be consistent with the level of spending of a company, family, or individual. For example, a precautionary balance of $500 would not be enough for a family that is spending $5,000 per month.

Transaction demand for money

The money we need to purchase goods and services in day-to-day life.

In the classical quantity theory of money. The demand for money is a function of prices and income (assuming the velocity of circulation is stable.) If income rises, demand for money will rise.

In an inventory model, the demand for holding money depends on the frequency of getting paid, and the cost of depositing money in a bank. When employees are paid, they will hold some money to buy goods. If they are paid once a month, they may deposit half to benefit from interest payments, and then withdraw after two months. However, electronic transfers and debit cards have made this less relevant.

Money Held for Transactions

The amount of money held for such a reason is called transaction money balances. Transaction money balances depend on several factors, but mainly:

• The overall conditions in the economy analyzed. When macroeconomic conditions improve, in the form of higher nominal GDP growth, lower unemployment, or higher salaries, it’s reasonable to assume that spending in the economy will improve. The conditions determine an increase in the demand for money needed to finance the purchase of goods and services.
• The citizens’ propensity to spend. Regardless of the overall macroeconomic conditions, the citizens of an economy may possess a higher propensity to spend on goods and services than another economy with similar characteristics, which would create, other conditions held equal, higher demand for money.

Money Held for Speculative Reasons

Money held for speculative reasons is also known as the portfolio demand for money. The money is held to take advantage of speculative opportunities or for covering/offsetting risks in other assets or the economy. There are several cases in which money is used as a speculative instrument:

• When there is deflation or when it is expected in the future. If prices decline, the money stored today will be more valuable tomorrow.
• When conditions in other markets are not favorable and are expected to deteriorate. For example, if the bond market doesn’t offer good returns, investors may prefer holding speculative cash balances to wait for better market conditions. In addition, if the prices of certain assets are expected to go down, investors may increase their cash positions for speculative purposes.
• When people want to speculate on changes in currency rates. For example, if somebody expects its domestic currency to depreciate significantly against a foreign currency, they can buy the foreign currency and store it and wait for its appreciation against the domestic currency.

Speculative Demand for Money and Asset Prices

We said that speculative demand also depends on the conditions in other markets, such as the bond market and the expectations of returns in those markets.

In general, an investor who chooses to hold money instead of financial instruments, such as bonds, is giving up the return he/she can earn holding such instruments.

That is why:

• The demand for money tends to increase when the potential returns in other asset classes decline or when the perceived risk of such investments increases.
• The demand for money tends to decline if the potential returns in other asset classes increase or when the perceived risk of such investments declines.

As a general rule, we can say that there is:

• A direct relationship between speculative demand for money and returns in other financial assets.
• An inverse relationship between speculative demand for money and risks in other financial assets.