Demand for money represents the total money that people want to hold, rather than keeping in the other assets such as stocks and bonds. Central banks try to match the money supply with their demand to control inflation.
Reasons demand money
Three motives for holding money:
- Transaction motive
- Precautionary motive
- Speculation motive
People need money to pay for various transactions. They prefer cash over financial assets for reasons of liquidity and security.
By holding money, people can use it whenever they need it. It’s different when they hold financial assets, which require time to cash in because they cannot pay directly with the asset.
In aggregate, money demand for transactions positively relates to GDP size and average transaction size. The higher the two, the greater the demand for money.
People hold extra money for unexpected needs or circumstances that require a cash outlay. In general, individuals hold cash to deal with uncertainties regarding their income, life span, out-of-pocket medical expenses, and imperfect insurance coverage. In this case, demand correlates positively with total transaction volume, average transaction size, and overall GDP.
Speculative demand is related to the trade-off between holding cash or investing it in several assets. By keeping cash, people can indeed immediately use it for transactions. But that also means they missed the opportunity to get more money from the return on investment.
In general, speculative demand is inversely related to the return of various assets such as time deposits, stocks, and bonds. At the same time, demand is positively related to the perceived risk in those assets. The higher the risk, the more reluctant people are to invest in the assets and are more likely to choose to hold cash.
Take the case of a time deposit. When interest rates are high, the opportunity cost of holding cash is high. People prefer to save since they could get high returns. The opposite condition applies when interest rates are low. Therefore, money demand has a negative correlation with interest rates.
Factors affecting the demand for money
Economists explain that the demand for money is a function of income and prices, ceteris paribus. When income rises, the demand will increase. Likewise, when prices rise (inflation), people need more money to buy the same amount of goods and services.
Frequency and the average size of transactions affect the demand. When both increase, people need more money for purchases.
Most people save their money in the bank, especially when other financial assets such as stocks and bonds have not yet developed. Therefore, interest rates are a crucial determinant of the demand for money. When interest rates rise, people prefer saving rather than holding cash.