Why Is Money Demanded?

We know that money in hand does not earn any income. On the other hand, there are always certain competing non-money assets which give some returns to their holders. The fundamental question that arises, therefore, is: what is the motive of holding assets in the form of money? Its genera! explanation is that, money being the only commonly acceptable means of payment, it has the advantage of being perfectly liquid, which is not there in case of other assets. 

Keynes put this idea in more concrete form when he classified the motives for holding money into three categories: a) transactions motive, b) precautionary motive, and c) speculative motive.

In order to meet current transactions of all kinds, people hold some cash, known as transactions demand for money; while they demand money for precautionary purposes when they hold it to provide for contingencies and unforeseen profitable opportunities. Cash held over and above that needed for transaction and precautionary purposes is known as speculative demand for money. The detailed discussion of these three motives is given below.

The Determinants of Demand for Money

1) The transactions motive

The time of receiving income and the time of incurring expenditure by an individual firm generally do not coincide. In order to meet the needs of transactions during this time gap some money is kept aside, known as the transactions demand for money. The smaller the time gap between a person's receipts and payments, lesser will be the transaction demand for money. Let us understand this with the help of an illustration. Two individuals, A and B who had the same salary per month say Rs. 4,000. Individual A is paid Rs. 4,000 on first day of every month, while B is paid Rs. 1,080 on first day of every week (making an aggregate of IPS. 4,000, assuming exactly four weeks in a month). Assuming that each individual spends his income each day in such equal amounts that at the end of the income-period they are left with zero cash balance.

The above assumption implies that the average transactions balance during the income-period would be equal to half of the income of that period. Individual A would therefore, have a transactions balance of Rs. 4,000 X 112 = Rs. 2000, while transactions balance of individual B would be Rs. 1,000 X 112 = Rs. 500.

However, the assumpt3on of an even distribution of expenditure over the income period seems very simplistic. Certain payments like the monthly bills for electricity, water, telephone, house rent, children's school fee, etc., and other lump sum payments are generally made at the beginning of the month Cash holdings, therefore, decline rapidly during the early part of the income period. Business firms also need cash for meeting their day-to-day transactions. But them receipts and payments are not as regular as those of the households. Compared to households, therefore, the firms must keep relatively larger cash balances at any point of time. Apart from income. certain other factors are also relevant to the transactions demand for money in the long run. For example, if a particular society decides to change its payment period from monthly to weekly, the average amount of cash held per day will decline significantly. In a similar manner, the level of monetisation- in developing countries is yet another factor to be taken into account. As barter transactions decline. more cash is needed to facilitate transactions.

Keynes treated transactions demand for money as a function of income alone. However, later economists attempted to show that the transactions demand is affected by the changes in interest rate also. A t higher rates of interest, transactions demand is interest-elastic, a s a high rate of interest implies higher opportunity cost of holding money, i.e., higher sacrifice in terms of interest income. I t is a t very low rates of interest that transactions demand is interest-inelastic. However, Keynes believed that money for transactions purposes is held mainly, for the sake of convenience and not for earning interest.


2) The Precautionary Motive

The precautionary demand for money arises mainly due to the uncertainty of future I receipts and expenses. The cash held by an individual firm helps in meeting unexpected fall in receipts or rise in expenditure or both in future.

Like transactions demand, precautionary demand for money also is related to the level of income, and varies directly with it Compared to a small firm, a firm having high turnover needs more cash in hand in a similar manner, a rich man generally needs a larger amount of cash for precautionary purposes. A firm's precautionary, demand for money is influenced not only by the level of income of the firm but also by factors like political situation and business conditions prevailing the economy. If the political situation is unstable or the business conditions look bleak, there will be greater demand for precautionary balances, a n d vice versa, It may be noted that since precautionary demand for money is generally found to be directly. Related to the level of income, Keynes clubbed such demand for money with the transactions demand for money.


3) The Speculative Motive

The Keynesian proposition that the money is held for transactions and precautionary purposes does not conflict with the classical theory: a transactions balance is nothing but money giving as the medium of exchange. Same can be said for the precautionary balances also. However, the third motive introduced by Keynes, viz., the speculative motive for holding money, represents a distinct break from the classical theory. The speculative demand for money also sometimes called the 'asset demand for money'.

According to the speculative motive, money is demanded as an asset to make speculation in bonds which are long-dated government securities. The speculative demand for money comes from the people who desire to make capital gains by buying bonds when their prices are low and selling them when their prices rise. People holding speculative balances keep anticipating about the behaviour of bond prices in future. If they expect bond prices to fall in future, they hold speculative balances so as to be able to buy the bonds when their prices actually fall and sell them when their prices actually go up.

The bond prices (or the capital value of bonds) are inversely related to the rate of interest. A fall in the interest rate will lead to an increase in the bond prices, and vice vena Suppose a Rs. 100 bond yields an annual return of 5%. Let us say the market rate of interest goes up to 10%. Since the return on this bond has reduced to half compared to the market interest rate, the price of bond (or the capital value of bond) will naturally reduce to Rs. 50. Since the bond prices are affected by the interest rate changes, the speculative demand also becomes a function of the interest rates and there is an inverse relationship between the two. There are two reasons for this inverse relationship:

1) As mentioned earlier Keynes considered holding bonds as an alternative to holding cash. Given a choice between bonds and money, the higher the rate of interest, the greater is the opportunity cost of holding cash Hence, at higher interest rates more bonds and less cash are held

2) A n important reason for the inverse relationship is the existence of expectations. At high interest rate it is expected that the interest rate will fall. A fall in interest rate would mean an increase in the price of bonds. If the price of bonds is expected to go up in future, people buy more bonds now, resulting in d cline in cash balances.

Another important element in the Keynes' Theory of speculative demand is the concept of 'normal rate of interest'. According to Keynes, at any particular time period, there exists a certain 'r' which the speculators consider as 'normal', i.e., the rate of interest which will prevail in the market under normal conditions. It is in relation to this normal rate that the current rate of interest is judged as low or high. A rate higher than the normal rate of interest will produce expectations of its fall in future, and vice-versa. Hence, the speculative demand for money depends on the current rate of interest in relation to the normal rate.

It will be relevant here to make distinction between active and idle cash balances, as given by Keynes. The active balances are those which are used as means of payment for meeting transactions, while the rest are idle balances. The transactions and precautionary demand for money are sometimes called the demand for active balances, while money demanded for speculative purposes is called the demand for idle balances.

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