Demand for money theory (20TH CENTURY)

Also known as liquidity preference, demand for money theory deals with the desire to hold money rather than other forms of wealth (for example stocks and shares).

It is particularly associated with the work of English economist John Maynard Keynes (1882-1946).

Keynes distinguished three motives for holding money: the transaction motive (to meet day-to-day needs); the speculative motive (in anticipation of a fall in the price of assets); and the precautionary motive (to meet unexpected future outlays).

The amount of money held is determined by the interest rate and the level of national income.

Monetarists argue that the demand for money is no longer a function of the interest rate and income but that the RATE OF RETURN on a wider spectrum of physical and financial assets influences demand.

Also see: quantity theory of money

Source:
J M Keynes, The General Theory of Employment, Interest and Money (New York, 1936);
D Fisher, Money, Demand and Monetary Policy (Hemel Hempstead 1989)

In monetary 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. It can refer to the demand for money narrowly defined as M1 (directly spendable holdings), or for money in the broader sense of M2 or M3.

Money in the sense of M1 is dominated as a store of value (even a temporary one) by interest-bearing assets. However, M1 is necessary to carry out transactions; in other words, it provides liquidity. This creates a trade-off between the liquidity advantage of holding money for near-future expenditure and the interest advantage of temporarily holding other assets. The demand for M1 is a result of this trade-off regarding the form in which a person’s funds to be spent should be held. In macroeconomics motivations for holding one’s wealth in the form of M1 can roughly be divided into the transaction motive and the precautionary motive. The demand for those parts of the broader money concept M2 that bear a non-trivial interest rate is based on the asset demand. These can be further subdivided into more microeconomically founded motivations for holding money.

Generally, the nominal demand for money increases with the level of nominal output (price level times real output) and decreases with the nominal interest rate. The real demand for money is defined as the nominal amount of money demanded divided by the price level. For a given money supply the locus of income-interest rate pairs at which money demand equals money supply is known as the LM curve.

The magnitude of the volatility of money demand has crucial implications for the optimal way in which a central bank should carry out monetary policy and its choice of a nominal anchor.

Conditions under which the LM curve is flat, so that increases in the money supply have no stimulatory effect (a liquidity trap), play an important role in Keynesian theory. This situation occurs when the demand for money is infinitely elastic with respect to the interest rate.

A typical money-demand function may be written as

{\displaystyle M^{d}=P\times L(R,Y)\,}

where {\displaystyle M^{d}} is the nominal amount of money demanded, P is the price level, R is the nominal interest rate, Y is real income, and L(.) is real money demand. An alternate name for {\displaystyle L(R,Y)} is the liquidity preference function.