Money Demand Definition and Three Motives of Demand for Money
Money demand definition
The money demand means the aggregate amount of money that firms and individuals of an economy keep with them. There are three main motives of money demand. They are transaction motive, precautionary motive, and speculative motive.
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1. Transaction motive of demand for money
People demand for money with the transactive motive to use them as a medium of exchange (There are three main functions of money. Medium of exchange is the main function of the money).
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What are the main three functions of money?
In other words, consumers demand for money with the transactive motive to pay food, education, clothes, transportation. Business firms demand for money with the transactive motive to pay factors of production, taxes, and other expenses. People hold money in the form of cash, or checkable or demand deposits (current account) to conduct daily transactions.
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What are the four factors of production?
Usually, people keep in their hands average amount of money that they wish to spend for a given period of time. The amount of money that they wish to spend depends on the number things they wish to purchase and the size of their income. If people have to buy a large number of things and if they have higher level of income, they demand more money with transaction motive.
Beyond the above-mentioned microeconomic factors, macroeconomic factors (the economy of a country as an overall) directly influence the transaction motive demand for money.
It is rational to predict that consumer spending will increase as macroeconomic conditions, such as stronger nominal GDP growth, reduced unemployment, or higher earnings. Increased demand for the money needed to fund the acquisition of goods and services is determined by the circumstances.
2. Precautionary motive of demand for money
The precautionary motive of demand for money means keeping some amount of money against unforeseen events. For example, keep money for unexpected situations such as repairs in cars and medicines.
Due to uncertainty around the date of their receipt and payment, businesses also maintain precautionary funds as extra liquidity. For example, a customer who was expected to make a payment after seven days is unable to do so, or a supplier who once extended credit for one month has no inventory to provide.
Demand for money based on precautionary motive depends on the income level of the people and business firms. If the level of income is high, people and firms demand more money with the precautionary motive.
An increase in economic activity and GDP causes businesses’ and consumers’ precautionary reserve funds to rise.
Active money balances
Active money balances are the money balances are kept with the transaction motive and precautionary motive. People demand for money with the transactive motive and precautionary to use them as a medium of exchange (There are three main functions of money. Medium of exchange is the main function of the money). Interest rates does not influence the active money balances because people keep these money balances for the everyday transactions or to pay emergencies. The four major determinants of active balances are aggregate income, frequency of pay, use of credit cards and price level.
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What are the main three functions of money?
3. Speculative motive of demand for money
The speculative motive of demand for money means people demand money to buy financial assets such as stocks and bonds for profitable opportunities. Money, when used for this purpose, is a means of temporarily storing wealth.
Individuals and firms hold the cash in their hands and wait until that they feel the prices of the financial assets going to fall. After that, they purchase financial assets such as bonds, shares, and securities. For example, people buy shares after the prices drop and sell them when their prices rise to make capital gains.
When people demand money with a speculative motive, it is called idle or passive money balances
They is a negative relationship between money demanded speculative purposes and interest rates.
Relationship between interest rate and money demand
When interest rates are high, there is a high opportunity of holding money. Because people have to sacrifice a higher percentage of interest income that is received from investment opportunities such as bonds, shares, and securities. Hence this will reduce the speculative balances. However, when interest rates fall, the opportunity cost of holding money will decrease and people will hold more money for speculative purposes.
Following money demand curve shows the negative relationship between interest rate and money demand.
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Money Market Graph with Demand, Supply and Equilibrium
Reasons of money is used as a speculative instrument
There are several cases in which money is used as a speculative instrument
• When deflation is occurring or is anticipated to occur. If prices fall, the money you have saved today will be worth more in the future.
• When circumstances in other markets are unfavorable and likely to get worse. For instance, investors may prefer maintaining speculative cash balances to wait for better market conditions if the bond market doesn’t give attractive yields.
• When people seek to make predictions about changes in exchange rates. For instance, if someone anticipates a big decline in the value of their domestic currency relative to a foreign currency. They can purchase foreign currency, store it, and wait for it to gain value in relation to their domestic currency. Hedging is the name given to this tactic.
