The demand for money refers to holding of cash deposits and liquid assets, or the desire to hold wealth in the form of money. The decision to hold money rather than other types of assets is a matter of liquidity, which is the degree to which an asset can be readily converted to spendable cash without a significant loss in value. If an individual holds the majority of their investments in nonliquid assets, they must first sell the assets in order to purchase other items. Therefore, individuals want to hold money to purchase goods and services, which is known as the transaction demand for money. The greater the value of transactions a person makes, the more of her wealth that person needs to hold in the form of money. In today's modern economy, many consumers choose to hold very little money and instead use credit and debit cards to purchase goods and services.
The precautionary demand for money, the desire to hold money in order to pay for emergency expenses, occurs because money is the most liquid asset in the economy. Because money is a liquid asset, people can use it to pay for emergency expenses without incurring additional losses in value. If people store all their wealth in stocks, real estate, or jewelry, they would first have to sell these assets to obtain money before they can make other purchases. Thus, individuals choose to hold some of their wealth in the form of money in case unexpected expenses arise. If an emergency occurs, a person will likely want money available to purchase the needed goods or services. If individuals do not diversify their wealth holdings and are forced to convert less-liquid assets to money in a hurry, this may result in a significant financial loss for the individual. For instance, if a person must sell off valuable real estate in short period of time, he may have to accept a price that is well below market value and incur a loss to gain the money he needs. Therefore, to avoid risk, people often keep some of their wealth in the form of money as a precaution.
The speculative demand for money is the desire to hold money to be able to purchase financial assets at the appropriate time or to hedge certain current financial risks. Individuals may hold some of their wealth in the form of money, waiting to make purchases of other financial assets as the opportunity arises. For example, an individual may hold money when interest rates are low and speculate that the rates will increase over time. However, when interest rates are high, this encourages more bond holding because an increased amount of interest can be earned.