Money

The Demand for Money

The demand for money is the desire to hold wealth in the form of money. Individuals demand money to facilitate transactions, as a precaution for emergency expenditures, and to have it available to purchase financial assets.
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.
The demand for money takes three forms. The transaction demand for money is the demand people have to exchange money for goods and services. The precautionary demand for money is the demand people have to hold some money in case of emergencies, such as medical emergencies or for car repairs. The speculative demand for money occurs when people wish to hold some wealth in the form of money in the hopes that they can do more with it later, such as getting better prices when goods and services go on sale or getting better interest rates when investing in bonds.
When individuals choose to hold their wealth in the form of money, there is an opportunity cost attached: they must forgo earning a rate of return. Therefore, the quantity of money demanded is inversely related to the interest rate. As the interest rate rises, individuals will choose to hold less money, and as the interest rate falls, individuals will choose to hold more. To graph the money demand curve, place the price of money, which is the interest rate, on the vertical axis and the quantity of money demanded on the horizontal axis. The demand for money is downward sloping, reflecting the inverse relationship between price and quantity demanded. While the interest rates causes changes in the quantity demanded of money, there are other factors that shift the entire demand curve for money: real GDP, overall price level, and expectations.
The demand for money shows the inverse relationship between the interest rate and the quantity of money demanded. At higher interest rates, people choose to invest rather than hold money, lowering the demand for money. At lower interest rates, people choose to hold money rather than investing it, increasing the demand for money.