International Finance Theory and Policy
by Steven M. Suranovic

Finance 40-6

Money Demand

The demand for money represents the desire of households and businesses to hold assets in a form that can be easily exchanged for goods and services. Spendability, or liquidity, is the key aspect of money that distinguishes it from other types of assets. For this reason, the demand for money is sometimes called the demand for liquidity.

The demand for money is often broken into two distinct categories: the transactions demand and the speculative demand.

Transactions Demand for Money

The primary reason people hold money is because they expect to use it to buy something sometime soon. In other words, people expect to make transactions for goods or services. How much money a person holds onto should probably depend upon the value of the transactions that are anticipated. Thus, a person on vacation might demand more money than on a typical day. Wealthier people might also demand more money because their average daily expenditures are higher than the average person.

However, in this section we are not interested so much in an individual's demand for money, but rather in what determines the aggregate, economy-wide demand for money. Extrapolating from the individual to the group, we could conclude that the total value of all transactions in the economy during a period of time would influence the aggregate transactions demand for money. GDP, the value of all goods and services produced during the year, will influence the aggregate value of all transactions since all GDP produced will be purchased by someone during the year. GDP may be an underestimate since people will also need money to buy used goods, intermediate goods and assets. Nonetheless, changes in GDP are very likely to affect transactions demand.

Anytime GDP rises, there will be a demand for more money to make the transactions necessary to buy the extra GDP. If GDP falls, then people demand less money for transactions.

The GDP that matters here is nominal GDP. This means GDP measured in terms of the prices that currently prevail, (GDP at current prices). Economists often break up GDP into a nominal component and a real component, where real GDP corresponds to a quantity of goods and services produced after eliminating any price level changes that have occurred since the price level base year. To convert nominal to real GDP, simply divide nominal GDP by the current US price level, P$, thus

Real GDP = Nominal GDP / P$

If we use the variable Y$ to represent real US GDP, and rearrange the equation we can get,

Nominal GDP = P$ Y$

By rewriting in this way we can now indicated that since the transactions demand for money rises with an increase in nominal GDP, it will also rise with either an increase in the general price level or an increase in real GDP.

Thus, if the amount of goods and services produced in the economy rises while the prices of all products remain the same, then total GDP will rise and people will demand more money to make the additional transactions. On the other hand, if the average prices of goods and services produced in the economy rises, then even if the economy produces no additional products, people will still demand more money to purchase the higher valued GDP, hence the demand for money to make transactions will rise.

Speculative Demand for Money

The second type of money demand arises by considering the opportunity cost of holding money. Recall, that holding money is just one of many ways to hold value or wealth. Alternative opportunities include holding wealth in the form of savings deposits, certificate of deposits, mutual funds, stock, or even real estate. For many of these alternative assets interest payments, or at least a positive rate of return, may be obtained. Most assets considered money, such as coin and currency and most checking account deposits do not pay any interest. If one does hold money in the form of a NOW account (a checking account with interest) the interest earned on that deposit will almost surely be less than on a savings deposit at the same institution.

Thus to hold money implies giving up the opportunity of holding other assets that pay interest. The interest one gives up is the opportunity cost of holding money.

Since holding money is costly, i.e., there is an opportunity cost, people's demand for money should be affected by changes in it's cost. Since the interest rate on each person's next best opportunity may differ across money holders, we can use the average interest rate, i$, in the economy as a proxy for the opportunity cost. It is likely that as average interest rates rise, the opportunity cost of holding money for all money holders will also rise, and vice versa. And, as the cost of holding money rises, people should demand less money.

The intuition is straightforward, especially if we exaggerate the story. Suppose interest rates on time deposits suddenly increased to 50% per year (from a very low base). Such a high interest rate would undoubtedly lead individuals and businesses to reduce the amount of cash they held, preferring instead to shift it into the high interest yielding time deposits. The same relationship is quite likely to hold even for much smaller changes in interest rates. This implies that as interest rates rise (fall) the demand for money will fall (rise). The speculative demand for money, then, simply relates to component of the money demand related to interest rate effects.

International Finance Theory and Policy - Chapter 40-6: Last Updated on 1/11/05