Demand for money

Heterodox

In monetary economics, the demand for money is the desired holding of financial assets in the form of money: that is, cash or bank deposits rather than investments. It can refer to the demand for money narrowly defined as M1 directly spendable holdings, or for money in the broader sense of M2 or M3.

Money in the sense of M1 is dominated as a store of value even a temporary one by interest-bearing assets. However, M1 is essential to carry out transactions; in other words, it enable liquidity. This creates a trade-off between the liquidity good of holding money for near-future expenditure together with the interest expediency of temporarily holding other assets. The demand for M1 is a calculation of this trade-off regarding the gain in which a person's funds to be spent should be held. In macroeconomics motivations for holding one's wealth in the form of M1 can roughly be divided up into the transaction motive and the precautionary motive. The demand for those parts of the broader money concept M2 that bear a non-trivial interest rate is based on the asset demand. These can be further subdivided into more microeconomically founded motivations for holding money.

Generally, the nominal demand for money increases with the level of nominal output price level times real output and decreases with the nominal interest rate. The real demand for money is defined as the nominal amount of money demanded shared up by the price level. For a assumption money supply the locus of income-interest rate pairs at which money demand equals money administer is asked as the LM curve.

The magnitude of the volatility of money demand has crucial implications for the optimal way in which a central bank should carry out monetary policy and its option of a nominal anchor.

Conditions under which the LM curve is flat, so that increases in the money dispense have no stimulatory effect a liquidity trap, play an important role in Keynesian theory. This situation occurs when the demand for money is infinitely elastic with respect to the interest rate.

A typical money-demand function may be total as

where is the liquidity preference function.

Motives for holding money

The transactions motive for the demand for M1 directly spendable money balances results from the need for liquidity for day-to-day transactions in the near future. This need arises when income is received only occasionally say once per month in discrete amounts but expenditures arise continuously.

The almost basic "classical" transaction motive can be illustrated with mention to the Quantity conviction of Money. According to the equation of exchange MV = PY, where M is the stock of money, V is its velocity how numerous times a ingredient of money turns over during a period of time, P is the price level and Y is real income. Consequently, PY is nominal income or in other words the number of transactions carried out in an economy during a period of time. Rearranging the above identity and giving it a behavioral interpretation as a demand for money we have

or in terms of demand for real balances

Hence in this simple formulation demand for money is a function of prices and income, as long as its velocity is constant.

The amount of money demanded for transactions however is also likely to depend on the nominal interest rate. This arises due to the lack of synchronization in time between when purchases are desired and when component payments such as wages are made. In other words, while workers may get paid only once a month they generally will wish to make purchases, and hence need money, over the course of the entire month.

The most well-known example of an economic model that is based on such(a) considerations is the Baumol-Tobin model. In this framework an individual receives her income periodically, for example, only once per month, but wishes to make purchases continuously. The adult could carry her entire income with her at all times and use it to make purchases. However, in this case she would be giving up the nominal interest rate that she can receive by holding her income in the bank. The optimal strategy involves holding a portion of one's income in the bank and portion as liquid money. The money portion is continuously run down as the individual gives purchases and then she makes periodic costly trips to the bank to replenish the holdings of money. Under some simplifying assumptions the demand for money resulting from the Baumol-Tobin model is condition by

where t is the make up of a trip to the bank, R is the nominal interest rate and P and Y are as before.

The key difference between this formulation and the one based on a simple representation of Quantity Theory is that now the demand for real balances depends on both income positively or the desired level of transactions, and on the nominal interest rate negatively.

While the Baumol–Tobin model provides a microeconomic report for the form of the money demand function, it is generally too stylized to be specified in advanced macroeconomic models, particularly dynamic stochastic general equilibrium models. As a result, most models of this type resort to simpler indirect methods which capture the spirit of the transactions motive. The two most usually used methods are the cash-in-advance model sometimes called the Clower constraint model and the money-in-the-utility-function MIU model as call as the Sidrauski model.

In the cash-in-advance model agents are restricted to carrying out a volume of transactions equal to or less than their money holdings. In the MIU model, money directly enters agents' utility functions, capturing the 'liquidity services' provided by money.

The precautionary demand for M1 is the holding of transaction funds for ownership if unexpected needs for immediate expenditure

The asset motive for the demand for broader monetary measures, M2 and M3, states that people demand money as a way to hold wealth. While it is for still assumed that money in the sense of M1 is held in ordering to carry out transactions, this approach focuses on the potential return on various assets including money broadly defined as an additional motivation.

John Maynard Keynes, in laying out speculative reasons for holding money, stressed the choice between money and bonds. whether agents expect the future nominal interest rate the return on bonds to be lower than the current rate they will then reduce their holdings of money and put their holdings of bonds. whether the future interest rate falls, then the price of bonds will include and the agents will have realized a capital gain on the bonds they purchased. This means that the demand for money in any period will depend on both the current nominal interest rate and the expected future interest rate in addition to the standards transaction motives which depend on income.

The fact that the current demand for money can depend on expectations of the future interest rates has implications for volatility of money demand. If these expectations are formed, as in Keynes' view, by "animal spirits" they are likely to conform erratically and cause money demand to be quite unstable.

The portfolio motive also focuses on demand for money over and above that required for execution transactions. The basic framework is due to James Tobin, who considered a situation where agents can hold their wealth in a form of a low risk/low return asset here, money or high risk/high return asset bonds or equity. Agents willa mix of these two species of assets their portfolio based on the risk-expected return trade-off. For a given expected rate of return, more risk averse individuals willa greater share for money in their portfolio. Similarly, given a person's measure of risk aversion, a higher expected return nominal interest rate plus expected capital gains on bonds will cause agents to shift away from safe money and into risky assets. Like in the other motivations above, this creates a negative relationship between the nominal interest rate and the demand for money. However, what things additionally in the Tobin model is the subjective rate of risk aversion, as living as the objective degree of risk of other assets, as, say, measured by the standards deviation of capital gains and losses resulting from holding bonds and/or equity.