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Understanding the Factors that Affect the Demand for Money

Understanding the Factors that Affect the Demand for Money

Money can be defined as an asset used as a means of exchange. Money has a narrow and broad definition. Narrow definition includes checking deposits, currency in circulation, and debit card accounts while broad definition of money includes deposits of currency. Money is also a liquid asset used to pay for goods and services or used to settle down debts. According to Murphy, (2009, 102-3), assets can be grouped into liquid assets and illiquid assets. Assets such as checking deposits, currency in circulation, savings deposits, debit card accounts, and time deposits are more liquid than assets such as loans, bonds, real estate, stocks, and other assets. The circulation of money in the economy is controlled by the central bank. In the United States, the central bank is a Federal Reserve System charged with the responsibility of regulating the circulation of money in the economy. The central bank influences the amount of debit card accounts, checking deposits, and other monetary assets.

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Monetary demand refers to the amount of monetary deposits that individuals are willing to hold instead of non-liquid assets (Murphy, 2009, 78-9). Demand for money is the desire to hold financial assets in monetary forms; in the form of cash or monetary deposits. Money is required for purposes of carrying out transactions (provides liquidity). This brings about a trade-off between the advantage of holding money (liquidity advantage) and the advantage of holding other assets (interest advantage). The demand for money comes about because of such kind of trade-off with regards to where an individual chooses to place his wealth. An individual’s motivation to hold his wealth in monetary form can be divided into asset motive and transaction motive.

There are several factors that influence people’s demand for money. This aspect can be considered in terms of aggregate demand for money and individual demand for money. The first factor that influences individual demand for money is interest rates or the expected rate of return on money. The next factor is the risk involved in holding money arising from unexpected inflation; thereby reducing the purchasing power of money (Cesaran, 2007, 89). The last factor that influences individual demand for money is the aspect of liquidity, which occurs when transaction prices increases. On the other hand, the factors that influence the aggregate money demand include interest rates or rates of return associated with holding monetary assets. The next factor in this aspect is the price, which involves the cost involved in purchasing of goods and services. Such prices will dictate people’s willingness to hold or not hold money. Higher prices would mean a greater need to hold more money for transaction purposes. The last factor in this aspect is income. High income means that more goods and services can be purchased; thereby implying that more money is required for transaction purposes. Higher real national income implies that there is more production of goods and services, thereby increasing the demand for money for transaction purposes. The other factor influencing the demand for money is the aspect of consumer spending. It is often observed that when consumer spending is high; such as during Christmas, individuals prefer to cash in other forms of their wealth like bonds and stocks in exchange for cash. They need money to buy goods and services. This implies that if consumer spending increases, there would be a likely increase in the money demand. The other factor is the transaction costs for bonds and stocks. If it becomes expensive or difficult to buy and quickly sell bonds and stock, they become undesirable thus making people to desire to hold more of the wealth in form of money (Cesarano, 2007, 78-9). This leads to increase in the demand for money.

The equations representing aggregate demand for money can be represented as:

Md= P x L (R, Y)

Where:

P-Price level

Y-Real national income

R-Interest rates for non-monetary assets

L (R, Y) – Aggregate demand for monetary assets

Alternatively:

Md/P=L(R, Y)

Aggregate demand for money is a function of interest rates and national income

Graph showing the relationship between interest rate and the aggregate demand for money

From the diagram above, it is observed that there is an inverse relationship between the aggregate real money demand and the interest rates. At lower interest rates, there is high demand for monetary assets since individuals would demand more money for transaction purposes. On the other hand, at high interest rates, few individuals would be willing to hold money for transaction purposes thereby lowering the aggregate real demand for money.

Graph showing the effect on the aggregate demand schedule of an increase in real income

From the graph above, it can be observed that increase in income levels would result into a shift in the aggregate demand for money from point L (R, Y1) to point L (R, Y2). This is because increase in the levels of income for individuals will increase their purchasing power, thereby leading to increase in the aggregate real demand. On the other hand, increase in income levels would also lead to increased interest rates (Kaushik, 1987, 78-9). This results in the positive shift of the graph as shown in the diagram.

References

Cesarano, F., 2007. Monetary theory and Bretton Woods: The construction of an international monetary order. New York: Cambridge University Press.

Kaushik, S. K., 1987. International banking and world economic growth: The outlook for the late 1980s. New York [u.a.: Praeger.

Murphy, A. E., 2009. The genesis of macroeconomics: New ideas from Sir William Petty to Henry Thornton. Oxford: Oxford University Press.

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