08 January 2017

Why there is a Demand for Money ?

1

There are three motives underlying the demand for money i.e.

  1. Transaction demand for money
  2. Speculative demand for money
  3. Precautionary demand for money

Transaction demand : Transaction demand for money means that money is demanded to carry out certain transactions. It is likely to be positively related with income. This is simply because higher the income of an economic agent, higher is the expected volume of economic transaction. To facilitate higher volume of economic transactions, more money is required. However, the transaction demand for money is influenced by the prevailing rates of interest and the expected rate of return on alternative assets like shares. This is because money held in the form of idle cash provides liquidity and facilitates economic transactions but it does not give a positive return. Therefore, the economic agents will be facing a trade-off between the utility they derive from the liquidity of the available cash and the expected return they are forgoing on alternative assets. So, they will try to economize on their money holding, when the expected returns on alternative assets go up.

Speculative demand :  The demand for money arising out of speculative motive is called speculative demand for money. The speculative demand for money depends on people’s expectation of the future interest rate movements. 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. The speculative demand for money is low when people expect interest rates to fall in future and vice versa.

Precautionary demand for money : The precautionary demand for money arises because of uncertainty regarding future income. For example, one does not know when one would fall sick or have accident or need money for some unforeseen requirement. The money demanded to cover these expenses is called precautionary demand.

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