Money demand refers to the amount of cash that people willing to hold at a certain point of time. People demand money to accomplish different motive. The three motive behind money demand as suggested by Keynes are transaction motive, precautionary motive and speculative motive. Transaction motive suggests people willing to hold money to make different kind of transaction at present (Goodwin et al. 2015). It gives rise to transaction demand for money. The precautionary motive explains willing to hold money to incur spending during unforeseen events. This kind of money demand related to uncertainties. The most important form of money demand is the speculative motive mostly guided by the nominal interest rate.
The money demand is considered to be a function of income and interest rate. income has a positive influence on money demand. Interest rate on the other hand is inversely related with money demand (Bernanke, Antonovics and Frank 2015). The essay discusses different determinants that explain a connection between money demand and interest rate.
In the monetary economics, the money demand is defined as the desire of people to hold financial assets in form of money. Money can be hold in form of bank deposit or liquid cash rather than investment. There are different definition of money depending on its liquidity. The most liquid form of money is the cash deposit (Heijdra 2017). This is the narrow definition of money and is denoted as M1. This form of money is directly spendable. The broader sense of money is defined as M2 and M3.
Money defined in terms of M1 is considered as the store of value in the form of interest bearing assets. M1 is necessary for transaction as it provides liquidity. There is a trade-off between holding the money at present to carry put different transaction or store it for future and enjoy interest rate from future holding. People have to choose between money holding at present and advantage of interest rate in future. In fact, the demand for narrowest form of money or M1 is the result of the trade-off that individual faces while deciding money demand. The motivation of individual behind holding a certain sum of money is divided between transaction and precautionary motive. The demand of broader money or M2 bearing a non-trivial interest rate is subject to the asset demand.
The general consensus is that nominal demand for money increases with increase in nominal output. In contrast, demand for money decreases with an increase in interest rate. Money demand in real term is defined as nominal money demand divided by the corresponding price level (Mankiw 2014). The typical money demand function is given as
Md denotes the nominal amount of money demand
P is the price level prevailing in the nation
R is nominal interest rate
Y is the real income of the nation
The real money demand function is denoted by L (.). Alternatively, L (R, Y) is also known as liquidity preference function.
The relation between money demand and interest rate can be explained with the help of different motives of holding money.
The transaction motive behind demand for money resulted from need for day to day transaction in near future. The transaction motive is more relevant in situation where income is earned occasionally while expenditures occur continuously. The two theories explaining the transaction motive of money include quantity theory of money and inventory model. The quantity theory of money does not pay any attention on interest rate as a determinant of money demand. It explains the money demand in terms of nominal income and velocity (Keynes 2018). Given a constant velocity, money demand is function of only price and income. The inventory model however explains the link between nominal interest rate and money demand.
Inventory model states that amount of money that people willing to hold also depend on the nominal interest rate. Interest rate here plays an important role in determining money demand at a certain point of time. The importance of interest rate in money demand arises due to the fact that there is considerable lag between when purchasing decision are made and when payment is given to the production factors at some later date (Jonung 2017). For example, workers receive salary only once in a month and hence, they wish to make their purchase using money to spend the entire course of month.
Baumol-Tobin model provides a well-known example of this fact. The economic model developed by Baumol and Tobin explains the link between real money demand and prevailing interest rate. In the model, individual is assumed to receive a periodic income. That is individual earns income only once in a month but desire to spend continuously. The individual can carry out the entire income at all times and use the income to make the desired purchase. In this case, the person has to give up the nominal interest rate that could have been earned if the money is put as bank deposit. The optimal solution here is to hold part of the income in liquid forma and part of it in bank. Higher the portion put in the bank lower the portion hold as direct liquidity and lower is the money demand. The amount of money put into the bank depends on the nominal interest rate. Higher the interest rate, higher is the bank deposit and lower is the money demand. This explains the inverse association between money demand and interest rate (Ragot 2014). The Baumol-Tobin model of money demand and interest rate is given as
t denotes the cost of one trip to the bank. R denotes the nominal interest rate. All the variables denote the same thing as before. As shown from the above equation there is an inverse association between nominal interest rate and real demand for money.
The link between demand for money and interest rate can be understood in depth in terms of speculative demand of money
John Meynard Keynes laid out the argument of speculative motive for money demand. Keynes developed a revolutionary theory stressing on speculative motive of holding money. Keynes made money demand as an inverse function of the rate of interest (Serletis and Gogas 2014). In the money market speculative motive arises from volatility in interest rate and related uncertainty of future interest rate. Keynes was particularly interested in evaluating the choice between money and bond.
Holding money does not provide any interest income to the holder. The value of money is always fixed in terms of capital valuation. In contrast, bond yields interest income in future. All the benefits however are wiped out if prices of bond decline in future. The gain or loss from transaction of bond is termed as capital gain or loss.
One factor affecting choice of individual related to portfolio is the expected change in the interest rate. The expected change in interest rate results in capital gain or capital loss. Keynes suggested that in case the interest rate is higher than the nominal level then people generally expect that interest rate would fall in future. The decline in the interest rate in future implies capital gain on bonds (Friedman 2017). Keynes stressed that relative to a high level of interest there would be a lower demand for money. There are two main reasons explaining this
The first is corresponding to a high interest rate, people face a higher opportunity cost of holding money. This is because, if the interest rate is high, then the foregone interest income that could be earned is also high. This raises the opportunity cost and hence lowers the demand for money.
In addition, relative to a high rate of interest the capital gains on bond likely to fall in future following an expected decline in interest rate in future. This is due to the fact that price of bond is inversely related to the interest rate (Lucas and Nicolini 2015). Therefore, if current interest rate is high then people expect that interest rate would fall increasing the possibility of capital gains from the purchased bonds.
As money demand fall at a high interest rate and increases at a low interest rate asset or speculative demand for money has an inverse relation with interest rate. The Keynesian money demand function also include transaction and precautionary motive of money demand where increase in demand for money is proportionate to increase in income.
The Keynesian money demand function thus is given as
Y denotes income
i denotes nominal interest rate
L is the liquidity preference
In explaining speculative demand for money Keynes assumed that different people in the economy have different rate of interest expectation. Therefore, at a very high interest rate, all the people can expect bond price to be very high in future (Alvarez 2017). In this situation money demand is zero. However, at a very low level of interest rate some people might expect bond price to fall in the future resulting in positive money demand.
Figure 1: Speculative demand for money
(Source: Berentsen, Huber and Marchesiani 2015)
Keynes also considered a possible situation known as liquidity preference. This indicates a certain situation in the economy where money demand become perfectly elastic at certain level of interest. This occurs at the rate where no one in the economy willing hold bond anymore and all desires to move to cash holding (Wen 2015). In such a situation no amount of monetary expansion can further lowers the prevailing interest rate.
The equilibrium interest rate in the money market is determined from money supply and money demand. The supply of money is fixed as it is determined by the central bank. The money demand following the inverse relation between money demand and interest rate slopes downward (Chen 2018). The equilibrium in the money market corresponds to the intersection point of money demand and money supply. Now, change in either money supply or money demand changes equilibrium in the money market and corresponding interest rate. The money demand curve shifts due to an increase in nominal income. An increase in money demand increases equilibrium interest rate while a fall in money demand cause interest rate to fall as well.
Figure 2: Changes in money demand and interest rate
(Source: Linnemann and Schabert 2015)
The above figure above illustrates the impact on interest rate following a change in the demand for money. The initial equilibrium in the market is obtained from the intersection of money demand curve D1 and money supply curve S. Consequently, the equilibrium interest rate in the market is given i1*. Now consider impact of an increase in money demand following an increase in income. The increase in money demand shifts the demand curve rightward to D2. Given the money supply, an increase in money demand shifts the money market equilibrium up increasing the interest rate. to i2*. Opposite is the case for a decline in money demand (Cohn 2015). A fall in money demand following a decline in income shifts the money demand curve leftward. Consequently, there is a decline in interest rate.
Conclusion:
Interest rate is the opportunity cost of holding money. When people hold a certain sum of money they had to forgo the interest rate that could have earned. Higher interest rate means higher opportunity cost and hence, a lower demand for money. Lower interest rate means lower opportunity cost resulting in a higher money demand. Keynes explains the inverse association between demand for money and interest rate using the speculative motive for money. This states higher interest rate means a lower expected interest rate in future resulting in a capital gain in the bond market. This lowers money demand. Lower interest rate means lower gain in the bond market and hence a higher demand for money. Keynes also explained the possibility of liquidity trap where money demand is perfectly elastic at the given interest rate. Money demand also influences equilibrium interest rate. An increase in money demand increase equilibrium interest rate and vice-versa.
References:
Alvarez, F., 2017. Monetary Economics. Journal of Political Economy, 125(6), pp.1825-1830.
Berentsen, A., Huber, S. and Marchesiani, A., 2015. Financial innovations, money demand, and the welfare cost of inflation. Journal of Money, Credit and Banking, 47(S2), pp.223-261.
Bernanke, B., Antonovics, K. and Frank, R., 2015. Principles of macroeconomics. McGraw-Hill Higher Education.
Chen, X., 2018. A Simple Classroom Experiment on Money Demand. Journal of the Scholarship of Teaching and Learning, 18(1), pp.115-135.
Cohn, S.M., 2015. Reintroducing Macroeconomics: A Critical Approach: A Critical Approach. Routledge.
Friedman, M., 2017. Quantity theory of money. The New Palgrave Dictionary of Economics, pp.1-31.
Goodwin, N., Harris, J.M., Nelson, J.A., Roach, B. and Torras, M., 2015. Macroeconomics in context. Routledge.
Heijdra, B.J., 2017. Foundations of modern macroeconomics. Oxford university press.
Jonung, L., 2017. Demand for money: an analysis of the long-run behavior of the velocity of circulation. Routledge.
Keynes, J.M., 2018. The general theory of employment, interest, and money. Springer.
Linnemann, L. and Schabert, A., 2015. Liquidity premia and interest rate parity. Journal of International Economics, 97(1), pp.178-192.
Lucas Jr, R.E. and Nicolini, J.P., 2015. On the stability of money demand. Journal of Monetary Economics, 73, pp.48-65.
Mankiw, N.G., 2014. Principles of macroeconomics. Cengage Learning.
Ragot, X., 2014. The case for a financial approach to money demand. Journal of Monetary Economics, 62, pp.94-107.
Serletis, A. and Gogas, P., 2014. Divisia monetary aggregates, the great ratios, and classical money demand functions. Journal of Money, Credit and Banking, 46(1), pp.229-241.
Wen, Y., 2015. Money, liquidity and welfare. European Economic Review, 76, pp.1-24.
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