The demand for money is the total amount of money that the population of an economy wants to hold.
The three main reasons to hold money, as opposed to bonds, equity, or other financial asset classes, are as follows:
A transactions-relatedreason – People need money on a regular basis to pay bills and finance their discretionary consumption;
A precautionaryreason, as an unexpected need, can often arise; and
A speculativereason if they expect the value of such money to increase versus other asset classes.
Money Held for Transactions
The amount of money held for such a reason is called transaction money balances. Transaction money balances depend on several factors, but mainly:
The overall conditions in the economy analyzed. When macroeconomic conditions improve, in the form of higher nominal GDP growth, lower unemployment, or higher salaries, it’s reasonable to assume that spending in the economy will improve. The conditions determine an increase in the demand for money needed to finance the purchase of goods and services.
The citizens’ propensity to spend. Regardless of the overall macroeconomic conditions, the citizens of an economy may possess a higher propensity to spend on goods and services than another economy with similar characteristics, which would create, other conditions held equal, a higher demand for money.
Money Balances Held for Precautionary Reasons
Precautionary money balances are held to moderate the impact of unexpected spending needs that can occur in the future. The factors that drive the demand for precautionary money balances are similar to those analyzed for transaction money balances.
As the level of economic activity and GDP rises, companies and consumers will increase the level of precautionary money balances for unforeseen spending needs.
The availability of credit and the level of interest rates affect the level of precautionary money balances. Other conditions held equal, when credit is easily (hardly) available and interest rates are low (high), such money balances are expected to rise (decline).
The balances held for precautionary reasons must be consistent with the level of spending of a company, family, or individual. For example, a precautionary balance of $500 would not be enough for a family that is spending $5,000 per month.
Money Held for Speculative Reasons
Money held for speculative reasons is also known as the portfolio demand for money. The money is held to take advantage of speculative opportunities or for covering/offsetting risks in other assets or the economy. There are several cases in which money is used as a speculative instrument:
When there is deflation or when it is expected in the future. If prices decline, the money stored today will be more valuable tomorrow.
When conditions in other markets are not favorable and are expected to deteriorate. For example, if the bond market doesn’t offer good returns, investors may prefer holding speculative cash balances to wait for better market conditions. In addition, if the prices of certain assets are expected to go down, investors may increase their cash positions for speculative purposes.
When people want to speculate on changes in currency rates. For example, if somebody expects its domestic currency to depreciate significantly against a foreign currency, they can buy the foreign currency and store it and wait for its appreciation against the domestic currency, the strategy is known as hedging.
Such a practice is common in emerging and frontier markets characterized by volatile currency and high inflation, where some people try to store money in U.S. dollars, euros, or other relatively stable currencies for speculative reasons.
Speculative Demand for Money and Asset Prices
We said that speculative demand also depends on the conditions in other markets, such as the bond market and the expectations of returns in those markets.
In general, an investor who chooses to hold money instead of financial instruments, such as bonds, is giving up the return he/she can earn holding such instruments.
That is why:
The demand for money tends to increase when the potential returns in other asset classes decline or when the perceived risk of such investments increases.
The demand for money tends to decline if the potential returns in other asset classes increase or when the perceived risk of such investments declines.
As a general rule, we can say that there is:
A direct relationship between speculative demand for money and returns in other financial assets.
An inverse relationship between speculative demand for money and risks in other financial assets.
CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful: