Money demand in monetary economics

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Money demand in monetary economics

In monetary economics, the demand for money is the desired holding of financial assets in the form of money: that is, cash or bank reserves rather than investment. It can refer to the demand for money, which is briefly defined as M1 (directly expendable holdings), or to money in the broader sense of M2 or M3.

Money in the sense of M1 is dominated by interest-bearing assets as a store of value (even a temporary one). However, M1 is necessary for carrying out transactions. In other words, it provides liquidity. This creates a trade-off between the liquidity advantage of holding money for near-term expenses and the interest advantage of holding other assets temporarily. The demand for M1 is the result of this trade-off with respect to the form in which a person's funds should be spent. In macroeconomics, the motives for holding one's wealth in the form of M1 can be roughly divided into the transaction motive and the precautionary motive. The demand for those parts of the broader money concept M2 that bear abnormal interest rates is based on the demand for the asset. These can be further divided into the motives for holding money on microeconomic grounds.

In general, the nominal demand for money increases with the level of nominal output (price level times real output) and decreases with the nominal interest rate. The real demand for money is defined as the nominal amount of money divided by the price level. The location of the income-interest rate pairs for a given money supply at which money demand equals money supply is known as the LM curve.

The magnitude of fluctuations in money demand has important implications for the best way in which a central bank should choose monetary policy and its nominal anchor.

Conditions under which the LM curve is flat, so that an increase in the money supply has no stimulating effect (a liquidity trap), plays an important role in Keynesian theory. This situation occurs when the demand for money is infinitely elastic with respect to the interest rate.

The transactional motivation for the demand for M1 (the balance of expendable money) is the result of the need for liquidity for everyday transactions in the near future. This need arises when income is received only occasionally (say once a month) in discrete amounts but expenditures are continuous.

John Maynard Keynes, in explaining speculative reasons for holding money, emphasizes 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 reduce their holdings of money and increase their holdings of bonds. If interest rates fall in the future, the price of bonds will rise and agents will realize capital gains on the bonds they have purchased. This means that the demand for money in any given period will depend on both the current nominal interest rate and the expected future interest rate (except for standard transaction purposes which depends on income).

The fact that the current demand for money may depend on expectations of future interest rates has implications for the volatility of the demand for money. If these expectations are, as Keynes believed, established by “animal spirits”, they are likely to change randomly and the demand for money will become quite volatile.

The portfolio objective also focuses on the demand for the money needed to carry out transactions. The basic framework is due to James Tobin, who considered a situation where agents could hold their wealth in the form of a low-risk/low-return asset (here, money) or a high-risk/high-return asset (bonds or equities). Agents will choose between these two types of assets (their portfolio) based on a trade-off between the expected return and the risk. For a given expected rate of return, more risk-averse individuals will choose a larger share of money in their portfolio. Similarly, given a person's degree of risk aversion, a higher expected return (the interest rate on bonds plus the expected capital gain) will cause agents to move away from safe money and into risky assets. Like the other motivations above, this creates a negative relationship between the nominal interest rate and the demand for money. However, what is of additional importance in the Tobin model is the subjective degree of risk aversion, as well as the objective degree of riskiness of other assets, as measured by the standard deviation of capital gains and losses resulting from holding, say, bonds and /or stocks. Equation