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The Demand for Money

The Demand for Money

The demand for money otherwise referred to as liquidity preference means the desire of people to hold their resources or wealth in the form of cash i.e. currency notes and coins, instead of interest-yielding assets. The British economist, John Maynard Keynes (1883 – 1946) identified three reasons for demand for cash balances or why people hold money. These are:

  1. The Transaction Motive: This represents cash balances held in order to carry out ordinary, everyday transactions. For example, individual persons need to hold money to buy food, and so on. Similarly, business organisations need money to pay wages and electricity bills, buy raw materials, vehicles and equipment, etc. The transactions demand for money is directly related to income.
  2. The Precautionary Motive: This refers to holding cash balances as a precaution against unexpected expenses. For instance, people hold money to provide them with some degree of security against sudden illnesses, accidents, fire or flood disasters, etc., while firms hold money against unpredictable occurrences such as sudden breakdown of vehicles, equipment, and so on. The main factor influencing this motive is the level of income.
  3. The Speculative Motive: This refers mostly to the desire to hold cash balances in order to make speculative dealing in the bond or securities (interest-yielding assets) markets. The demand for money for speculative purposes is interest-elastic. The higher the rate of interest, the lower the demand for speculative cash balances. Thus, there is an inverse relationship between the price of bonds and interest rate. This motive for holding money is a decreasing function of the rate of interest and it is also influenced by incomes.

Lord Keynes refers to the money held for transactions and precautionary motive as active balances, and that which is held for speculative motive as idle balances. The total demand for money is found by the summation of transactions, precautionary, and speculative demands.

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