Money
just like every other commodity has its own demand and supply. However, money
has certain qualities, or characteristics,
or attributes, which distinguishes it from other commodities. Money does not
need to be converted to any
other thing before it is used to pay for other goods and services. It is the
most
liquid of all commodities.
Money confers to the holder a general purchasing power. Once you hold money,
you can get other commodities.
The most distinguishing feature of money is that it is a medium of exchange. It
is generally accepted in
settlement of financial obligations. Now, we know that money serves as a medium
of exchange and a store of value.
People, therefore, demand to hold money in order to utilize these services.Broadly speaking, there are three motives or reasons why people prefer to hold money instead of other
assets. They are the
Transactionary Motive, the Precautionary Motive and the Speculative Motive.
This unit,
therefore, presents a
detailed discussion of the demand for money.
Demand for Money
Each individual or
person tries to hold his wealth in any of two broad forms. It is either held as
idle cash
balances which yield
no income or held as non-cash assets such as securities, houses, bags of rice,
vehicles
and other
commodities. These other commodities yield some income, appreciate or
depreciate in value over
time. Wealth held as
idle cash balances guarantees no income, instead it reduces in value during
inflation. The
decision to hold
money as cash balances instead of spending it immediately in buying other
assets is called the
demand for money.
Demand for money, therefore, refers to the total amount of money balances that
people
want to hold for
certain purposes.
The Liquidity Preference Theory
If an individual
decides to hold all his wealth in the form of other wealth-creating or
financial assets, he faces
the danger of
illiquidity (that is, having no cash to settle his immediate illiquidity
obligations). To avoid the
danger of
illiquidity, he may prefer to hold money instead of other assets. This is what
Lord J. M. Keynes
called Liquidity
Preference. Liquidity Preference is the extent to which a person prefers to hold
cash balances
instead of parting
with it or keeping his wealth as other assets. Keynes propounded the Liquidity
Preference theory, which states that “the stock of money held by the public will vary inversely with the rate
of interest (price of
money).” The higher the return on income-yielding assets, the less likely it is
that cash
will be held. There
is a level to which interest rate will reach and people will no longer be
willing to invest at
all. This level is called the Liquidity trap level.
Apart from the level of income and rate of interest generated by other assets, there are other determinants
of how much a person
will be willing to hold as cash. These other factors include interval between
pay days,
general price level,
level of expenditure, and availability of credit. These factors are, however,
influenced by
the level of income.
Other factors such as a person’s attitude towards risks and expectations are
equally
influenced by the
rate of return (or Interest Rate). When interest rates are high, more people
will be willing
to take risk.
Motives for Holding Money (DD for money)
Whoever is holding
money is holding it to enable him get something else. Each person has his own
reasons for
holding money, and
not because he wants to chew the paper called money. The demand for money is,
therefore, said to be
a derived demand.
Lord John Maynard
Keynes who propounded the Keynesian theory identified three reasons that prompt
people to hold money.
These reasons are transactions, precautionary and speculative.
i
Transactions Motive
The first reason
people hold money balances is to enable them pay for their normal day-to-day
transactions.
People hold money as
a medium of exchange. It is generally accepted by individuals and firms in
payment for
goods and services.
Keynes observed that
the level of transaction undertaken by individuals and society as a whole has a
stable relationship
with the level of income. Keynes, therefore, confirmed that “the demand for
money for
transactionary
purposes was proportional to the level of income”. This means that the higher
the income
level, the larger the
amount held for transaction purpose.
The Monetarists led by Milton Friedman also agreed
The Monetarists led by Milton Friedman also agreed
that “the demand for
money will be proportional to the level of income for each individual and hence
for the
aggregate economy.
Therefore, money is held for the purchase of goods and services because of the non-synchronization
of the periods of
income receipts and their disbursements. This is determined directly by the
level of income.
ii Precautionary
Motive
The term
“Precautionary Motives” refers to the desire to hold cash balances in order to
meet expenditures
which may arise due
to unforeseen circumstances such as sickness and accidents. Uncertainties are a
reality
of life. We can never
be quite certain what payments we have to make in the future. Lacking certainty
we,
therefore, arm
ourselves with money against emergencies. Like the transaction motive, it is
relatively interest-
inelastic unless the
rate of interest is really very high.
As the case of transactions motive, the amount of money an individual holds for precautionary purposes is
also dependent on the
level of Income. The higher the level of income, the more the amount held for
precautionary purposes. Both Keynesians and monetarists agree on this point.
iii
Speculative Motive
The third reason why
people hold money is to enable them speculate on the possible outcome of
business
events. If people
expect prices to fall in the near future, for instance, they can suspend
further purchase now,
and hold more money
waiting to buy when prices will fall. In the same way, if people think that
prices are
relatively low now
and expect prices to rise in the near future they will use their money to buy
financial
assets which they
will sell later when prices will rise. The amount of money for speculative
purpose is not
based on the level of
income. It is determined by what people expect to gain or to lose by holding
other
assets. This expected
gain or loss depends on the interest rate.
Lord Keynes used
movement in bond prices to illustrate the speculative motive for holding money
and how
this is influenced by
interest rates.
(i) Transaction Motive: The
desire to keep or hold money for the day-to-day transactions;
(ii)
The Precautionary Motive: Necessary in order to meet up with
unforeseen circumstances or
unexpected
expenditure;
(iii)
Speculative Motive: People also keep money with the hope of using such money kept in
making
quick money.
Determinants of Money Demand
Apart from the
factors identified by Keynes, other factors were later identified by Professor
Milton Friedman
in his modern
quantity Theory of Money. These include the price level, the rate of change of
prices or
inflation real
permanent income or wealth and return on bonds and equities. Therefore, the
determinants of
money could be seen
as
(a) Income
Demand for money
varies directly with the level of income, that is, the higher the level of
income, the higher the level
of income, the higher the level of money demand.
(b) Interest Rate
Demand for money
varies inversely with the interest rate.
(c) Price level
There is direct
positive relationship between money demand and the price level.
(d) The Rate of
Price Changes
Inflation rate varies
inversely with money demand. This is a weak determinant of money.
(e) Real Permanent
Income
Real permanent income
or wealth varies directly with money demand.
(f) Return on
Bonds and Equities
The higher the return
on bonds and equities the lower the demand for money.
Quantity Theory of Money
The classical
quantity theory of money was developed by Irwin Fisher in 1911 and was
generally accepted
view until the 1930’s
about the relationship between the amount of money in economy or circulation
and the
level of prices. It
is a theory about how much money supply is needed to enable the economy to
function.
The quantity theory
took the view that money was used only as a medium of exchange to settle
transactions
involving the demand and supply for goods and services. The theory is based on
the simple identity between
total money spend and the price level in the economy. This is illustrated with
an equation.
Where M – is the
money supply
MV = PT
V – is the velocity
of circulation i.e. the rate at which money changed hands in the society.
P – is the Price
level
T – rate of
Transaction
Given the assumption that ‘V’ and ‘T’ are constant, the price level ‘P’ varies directly with the amount of
change in money
supply i.e. P = MV/T
Criticisms of Quantity Theory of Money
Today, no one accepts
that the influence which money has on the economy can be explained in terms of
a
simple quantity
theory. To a lesser or greater extent, they would question the three key
assumptions necessary
to convert the
equation of exchange into a theory of the determination of prices. As we have
seen, these
three key assumptions
were:
· the
velocity of circulation of money is constant.
· the
stock of money is an instrument which can be controlled.
· Say’s
Law (supply creates its own demand) will operate.
The validity of these three assumptions is critically on the grounds that
(a) prices cannot
respond quickly to changes in money supply;
(b) an increase in
the distribution of wealth might result from an increase in the money supply
and
price levels;
(c) if people expect
price to rise, they might decide to hold more of their wealth in physical asset
and
less in money and so
the velocity of circulation will fall;
(d) people must be
fooled by inflation.
Conclusion
Money is such an
important asset in the asset market and this is why people choose to hold it. A
person’s
decision about how
much money to hold (his or her money demand) is part of a broader decision
about how
to allocate wealth
among the various assets that are available. This analysis demonstrate that the
price level
in an economy is
closely related to the amount of money in the economy.
Summary
In this unit, we have
succeeded in stating that The Demand for Money is the total amount of money
that
people choose to hold
in their portfolios. The principal macro-economic variables that affect money
demand
are the price level,
real income and interest rates. The Quantity Theory of Money is an early theory
of money
demand that assumes
that velocity is constant, so that money demand is proportional to income.
The motive for
holding money can be divided into three motives namely: Transactional motives,
Precautionary
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