CHAPTER 3

Demand for Money

The demand for money comes from the desire to hold liquid assets, of which money is the only perfect example. It may be noted that money is not demanded for its own sake but because it can be used to purchase economic goods and avail needed services. The behavior of individuals and businesses is important in deciding the level of money balances they wish to hold to understand the demand for money. The demand for money is a key variable to explain links among money, the financial system, output, and prices.

Concept of Demand for Money

In economics, the demand for money is the desired holding of financial assets in the form of money: that is, cash or bank deposits rather than investments. Money is not desired for its own sake. Rather, people demand money because it serves indirectly as a lubricant to trade and exchange. Money serves many functions; the most obvious reason that households and businesses demand money (currency, checkable deposits, and other close substitutes) is for use in making transactions. To conduct everyday transactions, households and businesses require money to hold. Demand for money means the amount of money the public desires and is willing to hold at any point in time. Money is a stock variable. Money stock is the quantity of money at a point of time. As an asset, money is demanded because of the public desire to hold it. The motive for holding money and the time period for which it is held may differ from individual to individual.

Money is necessary to carry out transactions; in other words, it provides liquidity. This creates a trade-off between the liquidity advantage of holding money and the interest advantage of holding other assets. The demand for money is a result of this trade-off regarding the form in which a person’s wealth should be held. Holding money entails some cost. The cost of holding assets in the form of money is not the storage cost. Rather it is the opportunity cost—what the money could earn if it were converted into so-called earning assets, such as stocks and bonds, real estate, machines, consumer durables, and personal belongings. The return from stocks and bonds can be easily measured in terms of dividends and interest. The cost of holding money has commonly been approximated by the interest return on securities, such as stocks and bonds. The higher the interest return on securities, the higher the cost of holding money.

Motives for Holding Money

There are five theories of demand for money¹:

As per these theories, the demand for money is affected by several factors. The way in which these factors affect money demand is usually explained in terms of three motives for demanding money:

Together, they provide good reasons for people to hold some money in their portfolio in spite of the opportunity cost of foregone interest. How much of income or resources will a person hold in the form of ready money (cash or non-interest-paying bank deposits), and how much will he part with or lend depends on what Keynes calls his “liquidity preference” for the demand for money to hold or the desire of the public to hold cash.

Keynes argued that there are three motives for holding money. First, individuals will demand money to finance their daily purchases of goods and services. This is known as the transactions motive. Second, people will demand money as a contingency against unforeseen expenditures. This is known as the precautionary motive. Third, people will hold money as a store of wealth. This is known as the speculative motive.

Generally, the higher the income, the greater the demand for money for transactions purposes. However, some individuals place a high value on holding currency because it gives them anonymity. People who are involved in drug trade, tax evasion, and other illegal activities may value currency because cash transactions are difficult to trace. Hence, the demand for money may be affected by changes in the volume of illegal activity or the tax code. The transactions demand for money depends on the volume of transactions, which are directly related to the level of income and business.

A precautionary motive to hold money arises as people prefer to hold a little in reserve as a precaution against unforeseen contingencies—the desire to keep extra money in the case of an unforeseen situation. Money is held not only by individuals for precautionary purposes; similar motives for holding money are applicable to business firms. Precautionary demand is the demand for money people want in case of emergency. This demand is assumed to be positively related to income.

Speculative Motive

Keynes hypothesized that individuals allocate their wealth between two assets—money and “bonds” (representing all other financial assets)—assuming that the expected return on bonds is determined by the interest rate on bonds adjusted for expectations of capital gains or losses. The demand for money balances is negatively related to the interest rate on non-money assets. The speculative demand for money is affected by expectations as to the future course of the prices of financial assets, and thus interest rates. This behavior is an example of a simplified portfolio allocation decision.

Friedman relied more generally on the determinants of asset demand that depends on permanent income, interest rate on money, interest rate on bonds, return on equities, rate of inflation, ratio of human-to-nonhuman wealth, and other factors. His analysis of demand for money is based on three important ideas:

Although most people prefer to hold a part of their assets in the form of money, no one would want to hold all of his or her assets in this form. All people must decide what part of their wealth, or income equivalent, they will hold as money and what part they will hold as so-called earning assets, such as securities (stocks and bonds), or directly usable items, such as house, car, appliances, and personal belongings. In making this decision, a person must balance the benefits of holding money (convenience and security) against the cost of holding money. An individual will choose to hold a greater proportion of his or her wealth in the form of money only if the added return outweighs the cost.

To sum up the discussion, it is important to note that the demand for money is not at all constant. There are quite a few factors that influence the demand for money:

Demand for Money and Demonetization

In the context of demonetization in India, it is important to first understand what is it that cash does in the economy? There are broadly four kinds of transactions in the economy (Rao et al. 2016):

The first two categories relate to whether transactions and the corresponding incomes are reported for tax purposes or not. The third category would consist largely of agents who earn incomes below the exemption threshold and therefore do not have any tax liabilities. The uses that cash is put to for these various segments of the economy can be summarized in the form of Table 3.1. Finally, there would be demand for cash for illegal purposes, like bribes in elections, spending over sanctioned limits, dealings in crime, and corruption. Kavita Rao et al. (2016) study points out that if one takes a snapshot of the location of cash at any given point of time, it is difficult to predict what the breakup of the cash according to these categories would be, but it would be safe to say that each of these components would be represented in that snapshot.

Table 3.1 Demand for cash by various agents in the economy

Sources: Rao (2016).

The role of currency notes as a medium of exchange and as a store of value is very high for the common citizen of India, which is still predominantly unbanked. A document by the RBI, published in 2012, observed:

Cash remains the predominant payment mode in the country. Reflecting this tendency, the value of banknotes and coins in circulation as a percentage of GDP (12.04 percent) is very high in the country when compared to other emerging markets, like Brazil, Mexico and Russia. The cash-to-GDP ratio in India has remained range-bound over the last three years. Similarly, the number of non-cash transactions per citizen is very low in India (6 transactions per inhabitant) when compared to other emerging markets. While no specific study has been carried out, the presence of a well established network of treasuries/currency chests and over 1,200 clearing houses across the country may have contributed to the slow turn around and adoption of modern electronic payment products.²

The continued relevance of currency notes as a medium of exchange and as a store of value is important for more than 90 percent of India’s workforce who continue to earn their wages in cash. These consist of hundreds of millions of agriculture workers, construction workers, and so on. Cash is the bedrock of the lives of these people. Their daily subsistence depends on their cash being accepted as a medium of valid currency. They save their money in cash, which, as it grows, is stored in denominations of 500 and 1,000 notes. The vast majority of Indians earn in cash, transact in cash, and save in cash. Indeed India’s cash-to-GDP ratio (an indicator of the amount of cash in the economy) is 12 to 13 percent: much higher. Money is, metaphorically, the blood that makes the economy live and function. India is a particularly cash-heavy economy, with almost 78 percent of all consumer payments being effected in cash.

In the aftermath of demonetization, a fresh question arises as to “who wants to hold cash?” It is simple common sense that everybody prefers to keep cash. If the cash holdings of an average Indian are far in excess of what he/she needs to buy, it creates problem for the RBI. In this context, Hyder and Khan (2016) have observed that some people intentionally hold cash balances, while the following category of people simply hold cash because they see no viable alternative:

Those people who intentionally hold cash balances are forced to deal in cash because either their underlying business is illegal, or the source of money is bribery or corruption. Such category of people are as follows:

Endnotes