Money Demand

Why do people want / demand money?  As you will recall from our earlier discussion of the Classical economists (1930s), money was traditionally viewed as simply a medium of exchange. Money had no intrinsic value so people demanded money simply to facilitate their transactions - if they had money they would spend it, and if the volume or price of their transactions increased, they would need more money. This transactions demand is described in the Transactions Demand schematic below where more income leads to more transactions which leads to demand for more money.   

Transactions Demand for Money

Keynes, took a somewhat different view of money, a more general view where he specified three reasons for holding money - transactions, precautionary, and speculative motives.  The first of these was simply the old Classical view - more transactions means more money demand - while it was the last of these that was the real innovation. Money should be viewed as an asset similar to the other assets people own - bonds, stock, and real estate.  Furthermore, individuals would be expected to continually alter their portfolio of assets to maximize the expected return.  If you read the financial press you will always hear the financial gurus telling investors how much of their wealth to keep in stocks, how much in bonds, gold, and cash.  Keynes was anticipating this literature.

The logic behind Keynes' speculative demand is simple: if interest rates are low people will not lose much money in foregone interest by holding a portion of their wealth as cash. If you happen to have $1,000 and hold it as cash, then you will be giving up the opportunity to earn $100 when the interest rate is 10%. If the interest rate falls to 5%, then by holding cash you will be giving up the opportunity to earn $50. You would expect as interest rates rise people will tend to hold less of their wealth as money and more as interest earning assets.  The "demand" for money will thus be lower at the higher rates, which is what you see in the Speculative Demand schematic below.

Speculative Demand for Money

If we combine the two effects we will have money demand being dependent on interest rates and the level of transactions, which is assumed to be related to the level of income.  Money demand is positively related to the level of income and negatively related to interest rates.  The demand for money can be demonstrated with a traditional demand curve that captures the negative relationship between interest rates (price of money) and money demand [Diagram 1].  As the interest rate rises from i* to i**, the demand for money will fall from M* to M**.

Diagram 1
Keynesian Money Demand

This is not the end of the story. Money demand for transactions purposes depends on income and an increase in transactions resulting from an increase in income, possibly the result of the economy moving out of a recession into the expansion phase of the business cycle, will show up as an outward shift in the money demand curve (D to D*).

Diagram 2
Increase in Money Demand

Now that we have looked at the demand-side of the market, we need to examine the supply-side and then put them together to discuss the price of money.