Demand For Money

Article byKosha Mehta
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Demand For Money?

Demand for money refers to the aggregate sum of cash individuals within an economy are interested in possessing. The reason for such demand for money may differ according to the motive since it may be due to precautionary, speculative, or transaction purposes.

demand for money

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The term ‘liquidity preference‘ is another name for this phenomenon. Income, interest rates, and people’s preferences on whether they would rather retain cash (money) or illiquid assets like money have a role in the demand for money.

Key Takeaways

  • Demand for money implies the demand for liquid assets in the economy.
  • The current price level, the current interest rate, and the real gross domestic product determine the amount of money that is demanded.
  • Majorly demand for money is due to three main reasons/purposes. They are the following – transactional, precautionary, and speculative reasons.
  • Demand for money will decrease in proportion to an increase in interest rates.

Demand For Money Explained

The demand for money refers to the number of assets people would want to keep in their possession in the form of money. The following are the primary advantages of holding cash instead of investing in bonds, stocks, or any other type of financial asset class.

One that has to do with business transactions – A preventative rationale, since an unforeseen need might frequently emerge; a speculative reason if they believe the value of such money to increase in comparison to other asset classes. People require money regularly to pay their expenses and support their discretionary expenditures.

The level of income, interest rates, and inflation, in addition to an individual’s uncertainty regarding the future, are all elements that might impact a person’s desire for money. The effect of these factors on demand for money is typically discussed in terms of the three reasons people want money: the transactional, the preventive, and the speculative reasons.

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Types

Following are the types of demand for money.

#1 – Transactional

The demand for money that arises from transactions is the money required to make day-to-day purchases of goods and services, in the traditional formulation of the quantity theory of money. Prices and income affect people’s desire for currency, assuming the velocity of circulation is stable. If people have more income, there will be a greater need for it.

When using an inventory model, the demand for retaining money is determined by the regularity of receiving payments and the expense associated with depositing money in a financial institution. When workers are paid, they will put part of that money aside so they may make purchases later. For example, if they get paid once a month, they may put half of their money in the bank to earn interest and then take the other half out when two months have passed. Nevertheless, using debit cards and electronic transfers has rendered this less significant.

#2 – Precautionary

Precautionary money reserves are kept so that the impact of unforeseen expenditure demands arising in the future can be moderated. The variables that trigger the demand for transaction money and the factors driving the need for preventive money are similar. Rising economic activity and Gross Domestic Product (GDP) lead to an increase in firms’ and consumers’ precautionary money balances. Both aim to prepare for unexpected spending demands.

A corporation, a family, or an individual’s spending must always be considered when determining an appropriate level of precautionary savings. For instance, a family of four whose monthly expenses amount to $5,000 would not be able to get by with a precautionary reserve of only $500.

#3 – Speculation

The desire for money held in portfolios for speculative purposes is often referred to as the portfolio demand for money. The funds are kept in reserve, so speculative possibilities can be taken advantage of. They can sometimes cover or mitigate risks associated with other assets or the economy. Money may be utilized as a speculative tool in a few different scenarios, including the following –

Suppose there is actual deflation or whenever it is anticipated that it will occur in the future. Then, if prices continue to fall, the money saved today will be worth more the following day.

If circumstances in other markets are unfavorable and are projected to get worse in the near future. People in developing countries and frontier markets, characterized by unstable currencies and high inflation, frequently engage in this practice. They do so for speculative reasons, and the most common target currencies are the United States dollar, the euro, and other relatively stable currencies.

Factors

The level of income, interest rates, and inflation, in addition to an individual’s uncertainty regarding the future, are all elements that impact a person’s desire for money. For example, speculative demand for money will be reduced if there is an expectation that interest rates will continue to climb. It is so because this would result in a higher opportunity cost associated with holding onto one’s money. Similarly, the anticipation of higher inflation forecasts a greater decline in the purchasing power of money. This, as a result, reduces the speculative motivation for the desire for money.

People’s desire for money can be understood by looking at the demand for money in the market. This is because transactions can only be managed with money, and those transactions’ value determines how much money people wish to maintain. The greater the number of transactions, the greater the amount expected to be paid. Therefore, it should be obvious that growth in earnings leads to a rise in the demand for money, as the volume of transactions is directly proportional to the amount of money earned.

Examples

Let us look at the following examples to understand the concept better.

Example#1

An article published by ‘Finextra’ reflects on research conducted by the European Central Bank on the subject of the payment attitudes of customers regarding cash and digital mediums. It predicts that cash and digital payment demand will stay high shortly. It states that most people believe having cash as a payment option is crucial.

The article offers some insights into the logic of the need for money. Consumers believe carrying cash is advantageous because it helps them keep track of their spending. Also, it helps them safeguard their privacy and to settle transactions swiftly.

Example#2

Consider a hypothetical case to comprehend the United States (US) transactional demand for money. Suppose that ‘X’ amount of money is necessary for current transactions by U.S. residents. An example of an individual’s transactional need for money may include carrying cash to purchase food, electronics, stationery, etc. Suppose that the demand for money in US business transactions is Y dollars.

It may be to cover recurring or operating expenses. Transaction demand for money is the amount necessary for current transactions of individuals and businesses. Thus adding X and Y would yield the entire transaction demand for money for the US.

Relationship Between Demand For Money And Interest Rate

Demand for money will decrease in proportion to an increase in interest rates. Once it has decreased to the point where it is equivalent to the newly created money supply, there will no longer be any difference between the amount of money people have and the amount they wish to hold. This is why a reduction in the money supply causes a rise in the interest rate.

Changing the amount of money in circulation enables the Federal Reserve to control the interest rate. It does this by employing open market operations, changes to discount rates, or adjustments to reserve rations. These instruments work on the banking system to grow or decrease the stock of money circulating throughout the economy. As a result, this mechanism impacts the interest rate when there is a shift in the total amount of money in circulation.

People choose to save their money rather than store it in illiquid assets; a bank account earns them interest. Thus, the amount of money people save depends on the interest rate when it is saved.

Frequently Asked Questions (FAQs)

Is the demand for money inversely related to interest rate?

There is a negative correlation between the interest rate and the speculative demand for money. When the interest rate on securities is extremely high, people typically anticipate a subsequent decline in interest rates. This indicates that future bond prices will increase, resulting in a capital gain for those who now possess bonds.

What are the three demands for money?

The effect of these factors on demand for money is typically discussed in terms of the three reasons people want money: the transactional, the precautionary, and the speculative reasons.

What determines the demand for money?

The current price level, the current interest rate, and the real gross domestic product determine the amount of money that is demanded. Therefore, the proportion of a person’s money that they keep in liquid forms for shopping, such as cash and checks, and the proportion of their wealth that they keep in interest-bearing assets is determined by the interaction of these three elements.

This has been a guide to what is Demand For Money. We explain it in detail with its types, factors, examples, and relationship with interest rates. You can learn more about finance from the following articles –