DEMAND FOR MONEY
Prepared By:
RAMANDEEP KAUR DHIR
MBA
DEMAND FOR MONEY
The demand for money is the
desired holding of financial assets in
the form of money: that is, cash or
bank deposits.
It can refer to the demand for money
narrowly defined asM1 (non-interestbearing holdings), or for money in the
broader sense of M2 or M3.
Individuals Demand for
Money
An individuals quantity of money
demanded is the amount of wealth
that the individual chooses to hold as
money, rather than as other assets.
When you hold money, you bear an
opportunity cost - the interest you
could have earned.
Individuals Demand for
Money
Simplifying Assumption:
Individuals choose how to
wealth between two assets:
divide
money, which can be used as a means
of payment but earns no interest, and
bonds, which earn interest but cannot
be used as a means of payment.
Motives for holding money
Transaction motive
Asset motive
Speculative motive
Portfolio motive
Transaction motive
The transactions motive for money
demand results from the need for
liquidity for day-to-day transactions
in the near future.
This need arises when income is
received only occasionally (say once
per month) in discrete amounts but
expenditures occur continuously.
Asset motive
The asset motive treats money, in the
broader sense of including interestbearing bank deposits, as a particular
type of a financial asset among many
others.
While it is still assumed that money is
held in order to carry out transactions,
this approach focuses on the potential
return on various assets (including
money) as an additional motivation.
Speculative motive
John Maynard Keynes, in laying out speculative reasons
for holding money, stressed the choice between money
and bonds.
If agents expect the future nominal interest rate (the
return on bonds) to be lower than the current rate they
will then reduce their holdings of money and increase
their holdings of bonds. If the future interest rate does
fall, then the price of bonds will increase and the agents
will have realized a capital gain on the bonds they
purchased.
This means that the demand for money in any period will
depend on both the current nominal interest rate and
the expected future interest rate (in addition to the
standard transaction motives which depend on income).
Portfolio motive
The portfolio motive also focuses on demand for money over
and above that required for carrying out transactions. The
basic framework is that agents can hold their wealth in a form
of a low risk/low return asset (here, money) or high risk/high
return asset (bonds or equity).
Agents will choose a mix of these two types of assets (their
portfolio) based on the risk-expected return trade-off.
For a given expected rate of return, more risk averse
individuals will choose a greater share for money in their
portfolio. Similarly, given a person's degree of risk aversion, a
higher expected return (nominal interest rate plus expected
capital gains on bonds) will cause agents to shift away from
safe money and into risky assets. Like in the other motivations
above, this creates a negative relationship between the
nominal interest rate and the demand for money.
Determinants of Demand for
Money
How much money an individual
will decide to hold is determined
by:
The Price Level
Real Income
The Interest Rate
Rate of Return
Determinants of Demand for
Money
1. Interest rates/expected rates of return:
monetary assets pay little or no interest, so
the interest rate on non-monetary assets like
bonds, loans, and deposits is the opportunity
cost of holding monetary assets.
A higher interest rate means a higher opportunity
cost of holding monetary assets lower demand of
money.
Determinants of Demand
for Money
2. Prices: the prices of goods and services
bought in transactions will influence the
willingness to hold money to conduct those
transactions.
A higher level of average prices means a greater
need for liquidity to buy the same amount of goods
and services higher demand of money.
Determinants of Demand for
Money
3. Income: greater income implies more
goods and services can be bought, so
that more money is needed to conduct
transactions.
A higher real national income (GNP)
means more goods and services are
being
produced
and
bought
in
transactions, increasing the need for
liquidity higher demand of money.
Key Determinants of demand
for money (By Friedman)
Some of the key determinants of
demand for money specified by
Friedman are:
1. Total wealth
2. The division of wealth between human
and non-human forms
3. The expected rates of return on
money and other assets
4. Other variables
Total wealth
It is the total wealth that must be divided among various
forms of assets. In practice, estimates of total wealth
are rarely available, more so when total wealth is
defined to include not merely non-human or physical
wealth but also human wealth, that is, the present value
of the expected flow of labour income.
So income is generally used as a substitute for wealth.
Income, as we know, includes both property income and
labour income.
But to serve as a good substitute for wealth, a longerterm concept of income, concept of permanent income,
should be used in place of current income.
The division of wealth between
human and non-human forms
Since total wealth is assumed to include human
wealth and institutional constraints limit
narrowly the conversion of human into nonhuman wealth or the reverse, Friedman
hypothesises the fraction of total wealth that is
in the form of non-human wealth to be an
additional important variable. In particular, he
hypothesises the demand for money to be a
declining function of the aforesaid fraction, as it
is much easier to sell or purchase non-human
than human wealth.
The expected rates of return
on money and other assets
The nominal rate of return on money may be zero as on
currency or positive as it is on savings deposits, a large part of
which is counted as demand deposits, or even negative, if
current-account deposits are subject to net service charges.
The nominal rate of return on other assets consists of two
parts: first, any currently paid cost, such as interest on bonds,
dividends on equities and storage costs on physical assets, and
second, expected changes in their nominal prices.
It is through the second part (of expected capital gains or
losses) that Keynes had introduced his speculative demand for
money. Keynes, however, had considered only bonds as the
competing non-money asset. Or, more correctly speaking, he
had treated bonds as representing all long-term financial
assets.
Economic Stability in Future
This variable suggested by Friedman is the degree of
economic stability expected to prevail in the future.
According to him, wealth-holders are likely to attach
considerably more value to liquidity when they expect
economic conditions to be unstable than when they
expect them to be highly stable. However, it is difficult to
express this variable quantitatively.
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