This essay aims to investigate the claim that “The demand for money is exclusively based on transactions.” It will begin by studying the concept of money.
According to the text, people have three main reasons for possessing money as an asset: the transactions motive, the precautionary motive, and the asset or speculative motive. These motives are commonly known as theories of money demand. Money is defined as something widely accepted for payment and serves four important roles: being a medium of exchange, acting as a unit of account, functioning as a store of value, and operating as a standard of deferred payment.
Money is a representation of currency and deposits in circulation at a specific time. People retain money for future expenses. Wealth can be held in various forms, including physical money, bills, bonds, stocks, and property.
The demand for money is the desire to keep one’s wealth in the form of money, rather than spending it on goods and services or purchasing financial assets like bonds or shares. This desire arises from three motives: the transactions motive, the precautionary motive, and speculative motive. The transactions demand for money occurs when individuals need to hold money for daily transactions such as buying petrol, paying for groceries, or purchasing a newspaper. Every person will hold a specific amount of money.
The average amount of money held for transactions is affected by three factors: money income, price level, and frequency of pay days. When money income is higher, people tend to spend more on goods and services, which in turn increases the need for transaction balances. Similarly, an increase in the price level encourages a greater demand for money used in transactions. Additionally, if pay days are less frequent within a specific time period, there will be a greater demand for money used in transactions.
The demand for money can vary depending on interest rates. When interest rates increase, the transaction demand for money decreases, while it expands when interest rates decrease. It is more convenient to retain some money rather than invest in assets that generate interest because buying and selling these assets involve costs and efforts when purchasing is necessary. Moreover, the need to be prepared for unexpected situations also influences the demand for money. The precautionary demand for money enables individuals to have funds accessible to handle unforeseen events like car breakdowns, prolonged illnesses, or sudden job losses.
As income per time period increases, the potential cost of unexpected events such as job loss also increases, leading to a greater need for holding money as a precautionary measure. The precautionary demand for money will decrease as the interest rate goes up.
Transactions (T) and precautionary (P) demands for money vary inversely with the interest rate. As the interest rate declines, T + P rises, and vice versa. When there is a change in income level at a given interest rate (e.g. 1), the T + P curve shifts to the right, leading to an increase in the quantity of money demanded from M1 to M2.
The speculative demand for money differs from the transaction and precautionary motives. The former is based on the anticipation of gaining or avoiding losses, while the latter two are related to using money as a medium of exchange. To meet speculative demand, individuals can hold either money or fixed income bonds. As bond prices increase, investors find them more appealing than holding onto cash.
Investors hold contrasting opinions regarding the interest rate, with some expecting it to rise and others predicting a decrease. When individuals perceive the interest rate as excessively high, they generally anticipate a future decline. Consequently, when the interest rate declines, bond prices increase and create opportunities for profitable investments. Conversely, when the interest rate is high, there is substantial demand for bonds but limited demand for holding money for speculative purposes.
If the interest rate is perceived as insufficiently low, it is generally expected to rise in the future. As a consequence, bond prices will decline and lead to losses for bond holders. In anticipation of this price decrease, bond owners will have a strong desire for money as they attempt to sell their bonds prior to the reduction in price. The decrease in interest rate from r1 to r2 stimulates this surge in speculative demand.
When the interest rate is very low (r3), there is a strong reaction in the demand for money due to speculation. It is widely believed that this interest rate will increase in the future. Consequently, individuals are reluctant to invest in bonds and opt to keep cash instead. Conversely, when the interest rate is perceived as high (r4), everyone expects a decline in the interest rate, which may lead to potential capital gains.
When speculation decreases, individuals tend to prefer bonds over money as the demand for money is influenced by factors such as prices, real income, and interest rates. The diagram below illustrates the advantages of holding money through transactions, precautionary, and speculative motives. Money enables people to buy goods.
The x-axis represents real money holdings, which is calculated by dividing nominal money in current pounds by the average price of goods and services. The MC line represents the marginal cost of holding money, which is the interest that could be earned by investing in bonds instead. The position of the MC line may shift upwards if interest rates increase. The MB schedule, on the other hand, is drawn based on a specific real income and shows the additional benefits gained from holding an additional pound of money.
As money holdings increase, the marginal benefit decreases. The desired point is E, where the marginal cost equals the marginal benefit. Increasing interest rates cause the opportunity cost schedule to shift from MC to MC’, reducing desired money holdings from L to L’. A rise in real income leads to an increase in the marginal benefit of adding to real balances.
The MB schedule moves from MB to MB’ when facing the schedule MC. When there is a shift from MB to MB’, the real money holdings increase to L”. If all prices of goods and services double while interest rates and real income stay the same, both MC and MB remain unchanged. The desired point E and the desired level of real money L still remain.
Due to the doubling of prices, individuals are now holding twice as much nominal money in order to maintain their real money balances at L. If bond interest rates increase, the cost of holding money also increases. This increase is represented in the diagram by the upward shift from MC to MC’. As a result, the desired point shifts to E’ and the desired real money holding decreases from L to L’.
The demand for real money decreases when interest rates increase. Additionally, as real income rises, the marginal benefit of each pound of real money increases. This is due to an increase in transactions and the need for precautionary balances. Therefore, a fixed quantity of real money does not provide the same level of ease as it did at lower levels of transactions and real income.
The increase in real income results in a greater benefit of having a little more money, as demonstrated by the upward shift of the MB schedule to MB’.
