The Demand For Money

The demand of money is not similar to the need for money. The demand refers to keeping your money in other forms such as assets or bonds instead of cash.

There are 3 motives for the demand of money:

1. Transaction motive

2. Speculative motive

3. Precautionary motive

Yet generally Economist only focus on the first two motives (Transaction and speculative motive).

Transaction motive

As individuals, as consumers, we get into transaction on the daily basis, purchasing goods and services to satisfy or maximize our utility. Bread and Milk, for instance are our daily consumption and we should not drive even 5 miles to be able to purchase these necessities. Presume you had to go to town to withdraw money so that you can buy merely Airtime and bread, that is preposterous. This concludes that the demand for money for transaction motive is not determined by interest rates, rather by disposable income. The demand for money for transaction motive is not kept with the bank, but in your pocket or under mattresses, hence it is not determined by interest rates. It is also money categorized under the the conventional measure of money (M1), referring to all the coins and banknotes in circulation as injections to the economy. The aggregate demand of money for transaction motive is determined by the aggregate income. Given the income or your budget constraints, there is a proportion of money that is going to be spent (MPC) and another proportion of money that is going to be saved (MPC). For instance, taking into account your monthly needs such as data and grocery, there is an amount you have to reserve for those needs from your income. As the income increases the transaction demand for money also increases. For instance, presume John's income increased from $500 to $1 000. Previously John had to save more because his income was lower, but now he can increase his spending because his budget constraints had been lifted.

Summing up that the demand for money for transaction is independent of interest rates; categorized under M1 and active balance; and serving as a medium of exchange.

Speculative motive

Demand for money for speculative motive refers to money as an asset (interest rate bearing goods). Suppose instead of keeping money under your mattresses and in your pocket as explained under transaction motive, that you could loan it to someone else or save it in the bank. Before that, understand that the money with you do not hold any interest, while the money you loan to someone else or save with the bank has interest.

For instance, the interest rate is 5%, and planning on saving $100 for 3 years with the bank.

Fv = P ((1 + i) × (1 + i) × (1 + i))

Fv = $100 ((1 + 0.05) × (1 + 0.05) × (1 + 0.05)

Fv = $100 (1.157625)

Fv = $115.76

Suppose interest rate was 12%

Fv = $100(1 + 0.12)^3

Fv = $100(1.404928)

Fv = $140.49

Note: The lower the interest rate lower the earnings from savings.

This also indicates reason why the demand of money for speculative motive is has a negative relationship with interest rates. Suppose the Central Bank increases repo rates, interest rates will also increase encouraging people to save hoping for higher earnings in the future. On the contrary, repo rates decreases, people spend more and save less because even one saves they going to receive lower earnings. This explains the contractionary and the expansionary monetary policy.

Interest rate and bond price

The inverse relationship between bond and interest rates can be used to explain this. When interest rates goes down, bond prices increases, instigating bondholders such as commercial banks to give loans, while when interest rates increases and bond prices decreases, commercial banks are not encouraged to give loans. For instance if interest rates are relatively low today and projected to rise, people would prefer holding cash instead of bonds, hence banks give more loans during recession than when the economy is stabilized.

As now banks are involved, this moves to the broader definition of money (M2) and the most comprehensive definition of money (M3), no longer serving just as a medium of exchange but more of store of value, computed under the passive balance.