Three Reasons Why People Hold Money
We can now move on to money demand (denoted by Md or L), and the question of why people hold money?
Economists have identified three broad motives:
a. The transactions motive: People need to make day-to-day transactions (buy food, Clothes etc.) and therefore need to hold cash in their hands. Of course, the increasing Spread of plastic money (credit cards) has considerably reduced the transactions incentive for holding money. Assuming no plastic money, an individual’s transactions demand for money is likely to increase with his/her income, as s/he is more likely to make more transactions if he feels richer.
b. Precautionary motive: In addition to money held for making transactions, people sometimes hold money for precautionary purposes as well: i.e. to meet any urgent or unexpected expenditure needs, or to “snatch a bargain” that might be taken by someone else. Again, precautionary demand for money is likely to increase with income
c. Assets motive (also called speculative or investments motive): In addition to a and b, people might wish to keep some cash to switch between various investments. So consider a person who owns some land, holds some bonds, and has some stock market investments. Let’s say he spots a good investment opportunity on the stock market but doesn’t have instant buyers for the land or bonds he holds. In this situation some spare cash in hand would have helped him acquire the equity asset. The assets demand for money is likely to increase with income (for reasons similar to those for a and b) and decrease with interest rates (because the interest rate is the opportunity cost of holding cash in your hands).
DEMAND FOR MONEY
Generally, then, money demand Md increases with income levels and falls with interest rates. Note that we refer to real income (which measures purchasing power) and real interest rates (which measure real return on invested money), and not their nominal counterparts. Thus the demand for money we refer to is the demand for real money. Contrast this with what have been talking about earlier: nominal money supply – i.e. what the central bank controls through
its various instruments. Whether nominal and real money supply is equal or not depends much on the assumption regarding prices. If prices are assumed fixed, then the two are equal, otherwise not.