Demand for Money:

The old idea about the demand for money was that money was demanded for completing the business transactions. In other words, the demand for money depended on the volume of trade or transactions. As such the demand for money increased during boom period or when the trade was brisk and it decrea­sed during depression or slackening of trade .

The modern idea about the demand for money was put forward by the late Lord Keynes, the famous English economist, who gave birth to what has been called the Keynesian Economics. According to Keynes, the demand for money, or liquidity preference as he called it, means the demand for money to hold.

Broadly speaking, there are three main motives on account of which money is wanted by the people by the people, viz:

(i) Transactions motive

(ii) Precautionary motive

(iii) Speculative motive

Now a word about each one of them. 

(i) Transactions Motive:

This motive can be looked at:

(a) From the point of consumers who want income to meet the household expenditure which may be termed the income motive, and

(b) From the point of view of the businessmen, who require money and want to hold it in order to carry on their business, i.e., the business motive.

(a) Income Motive:

The transactions motive relates to the demand for money or the need for cash for the current transactions of individual and busi­ness exchanges. Individuals hold cash in order “to bridge the interval between the receipt of income and its expenditure.” This is called the income Motive’.

Most of the people receive their incomes by the week or the month, while the expenditure goes on day by day. A certain amount of ready money, therefore, is kept in hand to make current payments. This amount will depend upon the size of the individual’s income, the interval at which the income is received and the methods of payments current in the locality.

(b) Business Motive:

The businessmen and the entrepreneurs also have to keep a proportion of their resources in ready cash in order to meet current needs of various kinds. They need money all the time in order to pay for raw materials and transport, to pay wages and salaries and to meet all other current expenses incurred by any business of exchange.

Keynes calls it the ‘Business Motive’ for keeping money. It is clear that the amount of money held, under this business motive, will depend to a very large extent on the turnover (i.e., the volume of trade of the firm in question). The larger the turnover, the larger in general, will be the amount of money needed to cover current expenses.

(ii) Precautionary Motive:

Precautionary motive for holding money refers to the desire of the people to hold cash balances for unforeseen contingencies People hold a certain amount of money to provide tor the risk of unemploy­ment, sickness, accidents and other more uncertain perils. The amount of money held under this motive will depend on the nature of the individual and on the conditions in which he lives.

(iii) Speculative Motive:

The speculative motive relates to the desire to hold one’s resources in liquid form in order to take advantage of market movements regarding the future changes in the rate of interest (or bond-prices). The notion of holding money for speculative motive is a new typically keynesian idea. Money held under the speculative motive serves as a store of value as money held under the precautionary motive does. But it is a store of money meant for a different purpose.

The inverse relationship between the price of bonds and bond yields.

Portfolio motive

The portfolio motive is another way of considering the asset motive. This theory was developed by James Tobin. He placed emphasis on the trade off between asset growth and risk aversion. For example, if an individual is nervous about future economic trends, he will hold money rather than purchase more risky bonds and shares. If the individual is optimistic, he will take risks and purchase fewer bonds and shares.

Evaluation how stable is demand for money?

The demand for money can vary due to many factors other than income and interest rates. These include

• Technological changes – e.g. debit cards, make holding cash less important. Easy access to current accounts can enable people to hold less cash.
• Availability of credit. If credit is more available, precautionary demand for money will fall as individuals feel they can borrow – if they meet short-term difficulties.
• Irrational behaviour of asset prices. Markets can enter boom and busts driven by psychological factors such as over-exuberance. In these bubble periods, demand for assets will rise and demand for holding money will fall.
• Empirical evidence in A Monetary History of the United States (1963) Friedman and Schwartz suggested a relationship between demand for money and income and interest rates. However, this relationship seems to break-down post-1975
• It depends on how you define money. Narrow definitions such as M0 and M1 are quite different from broader definitions. Also, there is near-money which includes short-term gilts with the maturity of fewer than six months .

Money demand in a liquidity trap

In a liquidity trap, the demand for money is perfectly elastic. Increasing the money supply doesn’t reduce interest rates and the impact of increasing the money supply is ineffective in boosting demand.