The modem concept of demand for money is associated with the Keynesian analysis of the demand for money. In his General Theory of Employment, Interest and Money (1936), J.M. Keynes expounded his theory of demand for money.
Essentially, Keynes' theory of demand for money is an extension of the Cambridge cash-balances approach and stresses the asset role (i.e., the store of value function) of money.
In contrast to the Fisherian view of what people 'have to hold', the Keynesian view stated that the demand for money is determined by what people 'want to hold'.
To Keynes, demand for money does not mean the actual money balances held by the people, but what amount of money balances they want to hold.
Keynes states that the demand for money means demand for money to hold the demand for cash balances.
Money is not just meant for spending. It can be held as a form of wealth or asset which commands other forms of wealth in exchange, all the time.
Thus, money being the most liquid asset, can serve as an efficient store of value; so it is demanded for its own sake. In this sense, the demand for money is the inverse of the velocity of circulation.
We can say either that the demand for money has increased or that the velocity of circulation, the rate of spending, has diminished, and vice versa.
In short, the Keynesian approach to the demand for money stresses the public's need for cash or money balances as a store of value at a particular point of time.
In this context, it involves evidently the reason for the people's preference to hold liquid cash or money, rather than other assets, as a store of value. This desire for money is described by Keynes as liquidity preference.
Thus, the demand for money, in the Keynesian sense, is a demand for liquidity or "liquidity preference." Hence the modern approach to the demand for money has been designated as the cash balance or liquidity preference approach.
Now, viewing the demand for money in its modern terminology, the question may be asked: Why should there be demand for money to hold, or why do people prefer to keep idle cash balances?
An obvious answer is provided by the subjective considerations of individuals regarding liquidity motives for the satisfaction of which they desire to hold money balances.
Keynes distinguished three such motives which induce people to hold money. These are: (1) the transactions motive; (2) the precautionary motive, and (3) the speculative motive.
Corresponding to these motives, thus, Keynes separated the demand for money into three parts: (i) the transactions demand, (ii) the precautionary demand, and (iii) the speculative demand for money.
He further holds that, the total demand for money implies total cash balances. Analytically, total cash balances may be classified into two parts:
(i) Active Cash Balances; and
(ii) Idle Cash Balances.
1. Active Cash Balances:
Active cash balances relate to the demand for money held under transactions and precautionary motives. In other words, transactions demand for money and precautionary demand for money together constitute active cash balances held by the people.
Transactions Demand for Money:
Money being a medium of exchange, the primary demand for money balances arises directly out of its use for carrying on ordinary trade and business affairs of the economy.
The transactions-prompted demand for money arises on account of the lack of synchronisation between receipts and payments. Individuals, in general, do not receive money income as frequently as they make payments.
Thus, when income is received at discrete intervals of time, but is paid out more or less continuously against the exchange of goods and services, it is inevitable that people should need a certain stock of money all the time in order to carry out their transactions.
Keynes' Analysis of Transactions Motive:
Keynes defines transactions motive for holding money as "the need of cash for the current transactions of personal and business expenditure."
Thus, both households and firms hold money balances under the transactions motive. Their respective transactions motives may be referred to as income motive and business motive.
(a) The Income Motive
This refers to the transaction motive of the households, i.e., consumers' class. Consumers hold money balances to facilitate their day-to-day purchases of consumption goods. By keeping cash-balances they tend to bridge the gap of time interval between receipt of incomes and its disbursement. the consumer's/individual's demand for money, thus, depends upon:
(i) The level of income:
Usually, the amount of consumption oriented transactions increases with the rise in an individual's income. Thus, a rich man tends to hold more money balances for transactions purposes than a poor man does.
(ii) The price level:
With the rising prices, more money is required to buy a given quantity of goods.
During inflation, thus, the consumers' transactions demand for money tends to rise, corresponding to the rising price level.
(iii) The spending habits:
People's tendency to spend on consumption depends on their habits. A spendthrift obviously needs more transactions demand for money than a saver does.
(iv) The time-interval:
The time gap involved between the receipts of successive income flows and the corresponding expenditure is very important in determining an individual's transactions demand for money.
The longer the time-interval involved, the larger will be the money balances required to be held for transactions purposes and vice versa.
In other words, the transactions demand for money tends to be high when there -is lesser frequency of income receipts over a period of time, and it will tend to be low in case of more frequent income receipts.
Assuming, given the habit of spending, the price level, and the length of time interval between the flow of incomes and outlays, the consumer's/individual's transactions demand for money is an increasing function of his level of income.
That is to say, the transactions demand for money rises with the increase in income and vice versa.
(b) The Business Motive:
This refers to the transactions motive to the entrepreneur class or business community. Businessmen require money balances in order to meet business expenses like payment for new materials and transport, payment of wages and salaries, and allied current expenditure.
Thus, money held by producers for these purposes is said to be held to satisfy the business motive.
Money balances held under this motive will depend on the turnover of the firm. The larger the turnover, the larger will be the demand for money.
It follows, therefore, that the amount of money balances held under the transactions motive will depend: (i) on the time and size of firms' incomes, and (ii) on the turnover of business. As income rises and the business becomes more prosperous, the amount of money demanded for the transactions motive will rise.
It is commonly stated that the transactions motive for holding money fluctuates with the level of money income. This is justified by the assumption that transactions and hence, transactionary demand for money, fluctuate in proportion to change in money income.
It should be noted, then, that the transactions demand for money is income-determined, and is relatively stable because income does not change all of a sudden.
Moreover, changes in the rate of interest have no such influence in changing the transactions demand which is determined by the level of income. Thus, the transactions demand for money is interest-inelastic.
There may be seasonal variations in the demand for money held under the transactions motive. For instance, during festive seasons, like Diwali and Christmas, or during vacation periods, it may tend to increase at micro as well as macro levels.
Similarly, in the busy season, after the harvest, the business community's transactions demand for money tends to increase, while in the slack season, it decreases.
Nevertheless, the trend of a community's aggregate demand for money, under the transactions motive, depicts a high degree of correlation of proportionality to the size of money of national income.
Precautionary Demand for Money:
Apart from transactions purposes, people generally desire to hold some additional money balances against unforeseen contingencies. Thus, the second reason for holding money balances is the precautionary motive.
The money balances which people hold under the precautionary motive will be devoted to fulfilling the function of a store of value.
Out of prudence, people keep some liquid reserves or cash balances to provide for unexpected contingencies for events such as illness, accidents, unemployment, or some ceremonial occasions.
The precautionary demand for money depends largely on the uncertainty of future receipts and expenditures. This demand is very sensitive to the anticipation of the level of income.
However, future uncertainty is an important factor determining the precautionary demand for money. Therefore, when uncertainty is present, people tend to hold money balances to act as a buffer against unforeseen contingencies.
Naturally the precautionary demand for money varies with the type of emergency envisaged.
The increased desire for liquidity, related to the precautionary motive, is described by Keynes as "the desire for security as to the future cash equivalent of a certain proportion of total resources."
Thus, the precautionary demand for money is income- determined and is relatively stable. Obviously, the larger the income of the individual, the larger the cash balance set aside for future contingencies.
Moreover, the estimate of future contingencies is normal under normal circumstances, which do not fluctuate suddenly. Thus, the precautionary demand will be relatively stable.
Though money is held under the precautionary demand as a store of value, it is not affected by the interest rates.
Therefore, the precautionary demand for money is also interest-inelastic, and is income-determined, but, by and large, it changes in response to the changes of uncertainties.
In symbolic terms, by denoting the precautionary demand for money as Lp, we can represent the money- demand function as follows:
Lp = f(Y)
In practice, however, it is difficult to bifurcate the transactions demand and the precautionary demand for money. And, it must be remembered that both are income-determined.
The combined sum of money balances, held under the transactions and precautionary motives, is however, and referred to as "active balances" by Keynes. In symbolic terms, the demand for active balances may be stated as:
L 1 = L t + L p .
Since L t = f(Y), and L p = f(Y), it follows that L 1 = f(Y), that is to say, the demand for active balances is a function of income. It has been represented graphically.
It can be seen that at income level of OY 1 , OA is the demand for money held under the transactions and precautionary motives, i.e., the demand for active balances. At higher income level OY 2 , it becomes OB. Thus, there is a proportionate relationship between income and the demand for active balances.
2. Idle Cash Balances (The Speculative Demand for Money):
Keynes pointed out that a section of people in the community hold cash balances for speculative purposes. This demand for money held under the speculative motive is referred to as the demand for "idle balances".
The speculative motive for holding cash balances arises from uncertainty about the future rates of interest. More precisely, the speculative demand for money represents the demand for cash for being invested rapidly, as and when attractive opportunities for monetary investments appear.
The speculative motive, in fact, confines itself to the store of value property of money. Money held under the speculative motive constitutes a store of value, a liquid asset, which the holder intends to use for gambling or to make a speculative gain, e.g., investment in securities at a opportune moment.
To Keynes, people make capital gains by speculating in securities or bonds hoping to gain from knowing better than others in the market what the future holds in store for them.
Thus, the speculative motive concerns an increase in the demand for money balances as a means to realising a gain, possibly, in anticipation of likely changes in the value of bonds (a form of security asset), but also, most generally, in expected changes in the value of a variety of assets.
It must be remembered that people hold cash balances just to preserve liquidity. But the holding of cash, by itself, does not provide a yield, nor does it satisfy any want directly.
Real assets like jewellery, ornaments, etc. give the pleasure of snob appeal. A car is meant for riding; a house provides shelter or can yield rent, if let out to a tenant; shares earn dividend; bonds and time deposits receive interest and so on.
Whilst money kept idle begets nothing. One has, therefore, to pay an opportunity cost for preserving liquidity in terms of the yield forgone. The yield-forgone in keeping cash balances is usually measured in terms of prevailing market rate of interest.
The rate of interest is, thus, the cost of being liquid. Thus, at any time, when people have a desire for liquidity they are supposed to consider the cost element involved.
But in holding the active balances, there is the main consideration of convenience and prudence which induces them to have the least consideration for the rate of interest.
In the holding of idle balances, however, much attention is paid to the rate of interest, because these balances are held for income-earning purposes or speculative activity.
Thus, the amount of money held under speculative motive depends upon the rate of interest. There is always an inverse relationship between the speculative demands for idle cash balances and the rates of interest.
When people expect the prices of fixed income-yielding assets, like bonds, to fall, more balances will be held in cash, than what are just required to satisfy the other two motives (transactions and precautionary).
If people expect the rate of interest to fall and prices of bonds to rise, there will be an increased tendency to hold bonds, and other near-money assets, than cash. Thus, the speculative demand for money will be less.
To express it symbolically, thus, the speculative demand for money or the demand for idle balances (L s or L 2 ) may be stated as under:
L 2 = f(i)
Where, i stands for the rate of interest. It implies that the demand for idle balances is a decreasing function of the rate of interest. An inverse relationship between the speculative demand for money and the rate of interest is depicted.
It can be seen that the demand for idle cash balance is inversely related to the rate of interest. When the rate of interest falls the demand for speculative balances rises and vice versa.
Thus, it is highly interest-elastic. According to Hicks, it is a demand for money which acts as a liquidity reserve.
Therefore, the amount of money held under the speculative motive, as Hicks puts it, or rather, for a liquidity reserve purpose will be a matter of the relative advantage, at the margin, of holding money as against the holding of an interest yielding asset (near-money asset).
It has been observed that at low rates of interest, people prefer to hoard their money rather than use it to buy securities and vice versa. This is because the bond or securities price and interest rates always move in opposite directions.
When interest rates rise, bond or security prices fall, when interest rates fall, bond or securities prices rise, so that accordingly, the capital value of the assets change.
The reason for this inverse relationship lies in the fact that securities prices (and also of all capital values) actually are the present (capitalised) value of the future flow of income, discounted at the market rate of interest for the type of investment involved.
This may be illustrated with the help of capitalisation formula, as provided by Hamberg:
Where, V denotes the present value of the future income generated from the security. Y stands for the future income per annum, and i is the market rate of interest.
Now, suppose an investor has invested Rs. 1,000 in government bonds, yielding 6 per cent annual interest and that, at that time, the market rate of interest was 6 per cent. This means that the investor earns Rs. 60 as interest.
Now, suppose the market rate of interest increases to 10 per cent. Then, if this investor has to sell his bond, no one will pay Rs. 1,000 for it. Because now Rs. 1,000 in cash can fetch an annual income of Rs. 100.
Therefore, in order to sell the bonds he should offer them at less than Rs. 1,000, namely, at a price that would make the annual income of Rs. 60 by the interest on bond exactly 10 per cent of the purchase price.
Thus, the capitalised value of the bonds would become 60/0.1 = 600, that is, if the interest rate were to rise from 6 to 10 per cent, bond price would fall from Rs. 1,000 to Rs. 600. Thus, the investment will be a capital loss.
Therefore, any individual who expects the rate of interest to rise in the near future will not invest his money in bonds, etc. but will have a strong liquidity preference for money for the present. Similarly the reverse will take place when the rate of interest is expected to fall.
Briefly, therefore, the speculative demand for money is a function of the rate of interest. It is very much interest elastic. When the interest rate is high, speculative cash balances are minimal, and when the rate of interest is low, the demand for speculative balances may become insatiable.
Moreover, the speculative demand for money, as against transactions and precautionary demand, is income determining. The purpose of holding money under the speculative motive is to use it for speculation for earning income.
Thus, when the rate of interest is expected to rise, people prefer to hold more money balances at the current rate of interest so that they can take advantage of a rise in the interest rate in future and earn more.
Thus, it is the magnitude of money balances held under speculative motive that determines one's income from it when it is invested at an opportune moment.
Increased speculative demand for money represents increased preference for liquidity. It is, thus, sometimes called as liquidity proper.
It indicates preference for money as the most liquid asset rather than other assets. It is most sensitive because it depends upon speculation or expectations, and is interest elastic.