1 defn

Money is anything that is generally accepted as a medium of exchange, a store of value, a

measure of value, and a means for the standard of deferred payment. Money considers
everything that can be used for an accomplishment of a business transaction and settlement
of the business claims like currency notes, coins, cheques, etc. There is not just one definition
of money; instead, it can be defined legally, functionally, based on liquidity, and based on
scope.

What is Demand for Money?

Goods and services like rice, wheat, parlour, cleaning, etc., have demand in the market
because they possess utility. However, money does not possess a utility that can measure or
determine the satisfaction level of consumers. Therefore, the motive behind the demand for
money in an economy is different. The three main motives for which money is needed or
demanded by people are Transaction Motive, Precautionary Motive, and Speculative
Motive.

1. Transaction Motive
The transaction motive to demand money is for the conduction of day-to-day transactions.
Transaction motive can be seen from the perspective of households(income motive) and
business firms(business motive). Households demand money as they want their income to
meet their household needs and expenditure. Business firms demand money to carry on their
business activities. Therefore, the transaction motive for the demand for money is to meet the
current transactions of business firms and individuals. As the income of an individual is not
always constant; however, his/her expenditures are constant, they hold cash with them to
bridge this gap between changing income and constant expenditure.
According to Keynes, Transaction demand of money is positively associated with the level of
income; i.e., higher the level of income, larger would be the size of money holdings for
transactions.

2. Precautionary Motive

The precautionary motive to demand money is the desire of individuals to hold cash with them
for unforeseen contingent situations. People have a habit of saving money with them that can
provide them for the risk of unforeseen situations, such as accidents, sickness, etc. The
amount of money held by an individual as a precaution depends upon their nature and living
conditions. Besides, the demand for money for precautionary motives also depends upon the
income level of the individual. If an individual has a high income, he/she will store more cash
for contingencies. However, if an individual has less income, he/she will store less cash for
contingencies.
Generally, the reason behind holding cash for the transaction and precautionary motive
directly depend on the income level of people. However, there is a difference between the
Transaction Motive and Precautionary Motive.
People hold money with a transaction motive for conducting ordinary day-to-day transactions.
However, they hold money with a precautionary motive for fulfilling unforeseen contingent
transactions.
Holding money under transaction motive is convenient, and the money value in terms of other
commodities is quite certain. However, holding money under precautionary motive depends
on the uncertainty arising. It means that people hold more money in times of war or financial
crisis like COVID, and less money in normal conditions.

3. Speculative Motive

The speculative motive to demand money is the desire of individuals to hold cash as an
alternative to different financial assets such as bonds, etc. It is presumed under speculative
motive that individuals can hold money either in the form of cash balances or in the form of
bonds. The decision of people regarding their holdings in bonds or cash balances depends
upon their future expectations for the change in the interest rate or the capital value of
assets/bonds. There is an inverse relationship between the interest rate and the market value
of securities, like bonds. In other words, when the interest rate increases, the market value of
bonds declines. However, if the interest rate decreases, the market value of bonds rises.
Therefore, the demand for money at high interest rates becomes less, and at low interest
rates becomes high.
2 defn

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.

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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.

Table of contents

 What is Demand for Money?

o Demand for money Explained
o Types
o Factors
o Examples
o Relationship between demand for money and interest rate
o Frequently Asked Questions (FAQs)
o Recommended Articles

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.

3 defn

The Demand for Money

The demand for money is affected by several factors, including the level of income, interest
rates, and inflation as well as uncertainty about the future. The way in which these factors affect
money demand is usually explained in terms of the three motives for demanding money:
the transactions, the precautionary, and the speculative motives.

Transactions motive. The transactions motive for demanding money arises from the
fact that most transactions involve an exchange of money. Because it is necessary to
have money available for transactions, money will be demanded. The total number of
transactions made in an economy tends to increase over time as income rises. Hence,
as income or GDP rises, the transactions demand for money also rises.

Precautionary motive. People often demand money as a precaution against an

uncertain future. Unexpected expenses, such as medical or car repair bills, often
require immediate payment. The need to have money available in such situations is
referred to as the precautionary motive for demanding money.

Speculative motive. Money, like other stores of value, is an asset. The demand for an
asset depends on both its rate of return and its opportunity cost. Typically, money
holdings provide no rate of return and often depreciate in value due to inflation. The
opportunity cost of holding money is the interest rate that can be earned by lending or
investing one's money holdings. The speculative motive for demanding money arises
in situations where holding money is perceived to be less risky than the alternative of
lending the money or investing it in some other asset.

For example, if a stock market crash seemed imminent, the speculative motive for
demanding money would come into play; those expecting the market to crash would sell
their stocks and hold the proceeds as money. The presence of a speculative motive for
demanding money is also affected by expectations of future interest rates and
inflation. If interest rates are expected to rise, the opportunity cost of holding money will
become greater, which in turn diminishes the speculative motive for demanding money.
Similarly, expectations of higher inflation presage a greater depreciation in the
purchasing power of money and therefore lessen the speculative motive for demanding
money.