Economics- The Demand For Money
The demand for money is he quantity of monetary assets, such as cash and checking accounts, that people choose to hold in their portfolios. Choosing how much money to demand is thus a part of the broader portfolio allocation decision. In general, the demand for money – like the demand for any other asset – will depend upon the expected return, risk and liquidity of money and other assets.
There are two features of money that are particularly important. First, money is the most liquid asset. This liquidity is the primary benefit, of holding money. Second, money pays a low return (indeed, currency pays a zero nominal return). The low return earned by money, relative to other assets, is the major cost of holding money. People’s demand for money is determined by how they trade off their need for liquidity against the cost of a lower return.
There are some key macroeconomic variables effect the demand for money. Although we primarily consider the aggregate, or total, demand for money, the same economic arguments apply to individual money demands. This relationship is to be expected, as the aggregate demand for money is the sum of all the individual money demands.
The macroeconomic variables that have the greatest effects on money demand are the price level, real income and interest rates. Higher prices or incomes increase people’s needs for liquidity and thus raise the demand for money. Interest rates affect money demand through the expected return channel. The higher the interest rate on money, the more money people will demand, however, the higher the interest rate paid on alternative assets to money, the more people will want to switch from money to those alternative assets.
The Price Level
The higher the general level of prices, the more dollars people need to conduct transactions and thus the more dollars people will want to hold. For example, sixty years ago, the price level in the United States was about one tenth of its level today. Less money was needed for transactions and the number of dollars that the people back then held was also less. So, the nominal demand for money was probably much smaller than the amount of money that we hold today. The conclusion is that a higher price level, by raising the need for liquidity, increases the nominal demand for money. In fact, because prices are ten times higher today than they were in the past, an identical transaction takes ten times as many dollars today as it did back then. Thus, everything else being equal, the nominal demand for money is proportional to the price level.
The more transactions that individuals or businesses conduct, the more liquidity they need and the greater is their demand for money. An important factor determining the number of transactions is real income. For example, a large, high-volume supermarket has to deal with a large number of customers and suppliers and pay more employees than a corner grocery. Similarly, a high-income individual makes more and larger purchases than a low income individual. Because higher real income means more transactions and a greater need for liquidity, the amount of money demanded should increase when real income increases.
Unlike the response of money demand to changes in the price level, the increase in money demand need not be proportional to an increase in real income. Actually, a 1% increase in real income usually leads to less than a 1% increase in money demand. One reason that money demand grows more slowly than income is that higher income individuals are firms typically use their money more efficiently. For example a high income individual many open a special cash management account in which money needed for current transactions is automatically invested in nonmonetary assets paying a higher return. Because of minimum balance requirements and fees, such an account might not be worthwhile or a lower-income individual.
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