The Demand For Money Is Purely A Transactionary Demand

Money and banking

The demand for money

Exam question: "The demand for money is purely a transactionary demand." Discuss

The objective of this question is to discuss the statement: "The demand for money is purely a transactionary demand." This essay will begin by with determination of money. It will show that it is usual to distinguish three reasons why people want to hold their assets in the form of money. And these reasons are: the transactions motive, the precautionary motive and the asset or speculative motive. These motives are known as theories of money demand.

Money - anything which is generally acceptable as a means of payment and which fulfil the four key 'functions of money', namely acting as a medium of exchange, unit of account, store of value and standard of deferred payment. In other word, money is a stock. It is the quantity of circulating currency and deposits held at any given time. We hold money now to spend it later. People can hold their wealth in various forms - money, bills, bonds, equities and property.

The demand for money refers to the desire to hold money: to keep your wealth in the form of money, rather than spending it on goods and services or using it to purchase financial assets such as bonds or shares. People choose to hold their assets in the form of money because of three motives: the transactions motive, the precautionary motive and speculative motive.

Transactions demand for money

Individuals need to hold money in order to meet daily transactions such as buying petrol, paying for groceries or purchasing a newspaper. Everyone will hold a certain amount of money. The average amount held for transactions purposes depends upon the level of money income, the price level and the frequency of pay days. In terms of money income, the higher the money income, the greater the average expenditure on goods and services over the time period, hence the higher the level of transactions balances required. If the price level increases, then it is also likely that the demand for money for transaction purposes will be higher. In the case of the frequency of pay days, the less frequent the pay days over any given time period, the higher the transaction demand for money. The transaction demand for money will contrast as interest rates rise and expand as interest rates fall. It is easier to hold some money than put our income into interest-earning assets, to be resold later when we need money for purchases, because of brokerage and bank charges, time and effort.

The precautionary demand for money

The demand for money is also based on the desire to provide for the unexpected. The precautionary demand for money allows the individual to cover unforeseen events, such as the car breaking down, a lengthy period off work through illness, or an unexpected redundancy. The higher the income received per time period, the more costly any unforeseen event (e.g. loss of employment) is likely to be, and therefore the greater the precautionary demand for money to hold. As the rate of interest rises, the precautionary demand for money will contract.

Transactions (T) and precautionary (P) demands for money are shown here as inversely related to the rate of interest, with T + P rising as the interest rate falls, and vice versa. At any given rate of interest (e.g. r1) arise in the level of income will shift the T + P curve to the right, raising the quantity of money demanded from M1 to M2.

The speculative demand for money

This demand for money differs from the other two. The transactions and precautionary motive relate to the function of money as a medium of exchange, whereas a speculative demand for money is based on the expectation of making a speculative gain and avoiding a speculative loss. The speculative demand refers to the desire to hold either money or fixed income bonds. The price of bonds and the rate of interest are inversely related. For example, the price of the bond is Ј100 which yields Ј10 per year, and then the effective rate of interest from holding the bond for one year is 10%. If the rate of interest were to rise to 20% then the market price of this nominal Ј100 bond would fall to Ј50, since Ј50 invested in an income earning asset at 20% would yield Ј10. It can be seen that if the interest rate rises then the price of such fixed return bonds fall, making bonds less attractive proposition to investors than money. When the price of such fixed return bond rises, then they are more attractive for an investor than money. Some investors will expect the rate of interest to rise, while others will expect it to fall. When the rate of interest is realised to be unduly high by individuals, most will assume that the next move is in a downward direction. When the rate of interest falls, the price of bonds increases and so there are capital gains to be made. When the rate of interest is high there will be a substantial demand for bonds and hence a low speculative demand to hold money. If, however, the rate of interest is perceived to be unduly low then most individuals will assume that the next move is upwards, resulting in a fall in bond prices and, therefore, a capital loss for those who own bonds. The speculative demand for money to hold will be high when people owing bonds are looking to sell them before the price falls.

This is a speculative demand (SD) for money. A fall in the rate of interest from r1 to r2 leads to an expansion in the speculative demand for money. At a low rate of interest r3, the speculative demand for money is perfectly elastic. And everyone believes that this rate of interest must rise. At this position no one wants to hold bonds and everyone wants to hold cash. On the other hand, the rate of interest can be seen so high, such as r4, that everyone expects the rate of interest to fall, leading to an increase to capital gain. Then the speculative demand for money is zero, nobody wants to hold money and everyone wants to hold bonds.

The demand for money: prices, real income and interest rates

The transactions, precautionary and speculative motives suggest that there are benefits to