3.1 Demand for Money

The Following Graph Shows The Market For Real Money Balances Without
The Following Graph Shows The Market For Real Money Balances For A

Figure 25.10 An Increase in the Money Supply. The Fed increases the money supply by buying bonds, increasing the demand for bonds in Panel (a) from D1 to D2 and the price of bonds to Pb2. This corresponds to an increase in the money supply to M ′ in Panel (b). The interest rate must fall to r2 to achieve equilibrium. The Real Balances Effect “Real balances” refers to the purchase power of a given amount of money in circulation. We make the assumption that at any given point in time, there is a fixed amount of money in circulation. At higher price levels, the money in circulation can purchase fewer items.

The notion of a demand for money may strike you at first glance as bizarre. Don't you just want as much as you can get? Or isn't money what you use when you demand other goods? Here is where we have to remember that money is a stock not a flow, and that income and wealth are not money. Demand for money is a question of how much of your wealth you wish to hold in the form of money at any point in time. (Supply of money is also a stock concept.)

Your demand for money is how much of your wealth you wish to hold as money at any moment in time. It is thus a stock demand. Your wealth is a stock, and you must decide how to allocate that stock of wealth between different kinds of assets -- for example a house, income-earning securities, a checking account, and cash.

Why would you hold any of your wealth as money -- as cash or checking deposits? Those assets earn little or no interest. Wouldn't it be more sensible to hold all your wealth in the form of assets that yield income? Note that:

2. There is no intrinsic value in the money balances you hold except in their use as a medium of exchange. Generally, you acquire money in order to get rid of it -- to buy things. While you hold it, money does not keep you warm, entertain you, or provide any other benefit.

Economists identify two reasons why people will demand money balances, or desire to hold a certain stock of money even if there is no intrinsic value for the money balances they hold.

3.2 Transactions Motive for Holding Money
The most obvious answer is that we hold some money because it's convenient to buy stuff with. We'll call this first reason the transactions motive. Essentially, it's convenient to hold a certain average amount of money at any given time, depending on the kind of purchases you make and the size of your income.

One of the most important functions of money is that it is the universally accepted medium of exchange -- this is the main reason you hold money. Thus, one reason to hold money is to use it as a means of payment in transactions in the future. Now, if there was a perfect match between the moments you receive money in transactions and the moments you use money, you would not need to hold any money at all. If I were paid every Friday, and I could pay all my bills on the same day, then I would need to hold very little money.

Unfortunately, in the real world, there is not going to be an exact match between when I receive money and when I need to make payments. Let us say that as a work study student, you receive $500 every month as payment for your work. This payment comes once a month. But you need to pay for rent, food, movies, books, copying, pens etc. This is spread out over the month. So, on the first of the month, you deposit $500 in you bank account at Fulton bank, and then you withdraw this money and run your account down to zero over the course of the month. In the course of the month, you hove an average money holding of $250. Same thing happens the next month, and the next, over the year.

Your average holding of money then, is $250: this is how much you have on average in your bank account over the course of a year.

If instead, you were paid $250 every two weeks, then you would hold $250 at the beginning of the two weeks, and run it down to zero over the course of two weeks, repeat this the next two weeks, and so on.

Can you see that on average, you would be holding $125 in your account?

In other words, the need you have for holding money balances will depend on the smoothness with which the time you get paid and the time you use the money to make payments mesh. Thus, the need to hold money balances is in part a result of the institutional payments mechanisms in the economy. An agrarian day laborer in India does not hold very much cash balances because she will get paid on a daily basis in small amounts and then use up the money she receives to pay for her transactions of purchasing food almost immediately. She will have a near zero holding of money balances. But in a system where people are paid with longer term contracts, regularized wages and salaries, and where they get paid in intervals of a week, a fortnight or a month, and where incomes are relatively stable, the need to hold money balances will be higher.

Even if there was not a perfect match between my receipts of cash and the moments in which I use it as a means of payments for transactions, if I could costlessly and immediately convert any bonds I hold into money, then there is no reason to hold money. I would hold all wealth as bonds, and sell a bond for money the moment I need to make a purchase, holding money for only an instant.

So for example, you are paid $500 per month. You hold an average balance of $250 as you start out the month with a $500 bank balance, and then run to down over the month. But what if you find that you can buy a $250 bond at the beginning of the month, and sell it in the middle of the month, earning an interest for half the month? When you get paid, you could put $250 in your checking account as a money holding, and buy a bond for $250. At the end of two weeks, when your $250 has been used up, you can sell the bond and deposit another $250 in your account. Your average money holdings have just dropped to $125, and you earn interest on $250 bonds every fortnight.

You can take this further an further. Why not deposit only $125, and buy $375 worth of bonds? Sell $125 of bonds every week, and earn interest for three weeks. In effect, the question is:

Why hold any money balances at all? Why not always hold bonds and only get hold of money the moment you need it to pay for transactions?

It is costly, in terms of time and resources, to keep moving in and out of bonds or other assets and money. Since this is the case, I will desire to hold a certain level of money balances on average, to meet my needs to pay for transactions. This is called the transactions demand for money.

If the interest payments I receive on bonds and other assets is high, then it is worth my while to move in and out of stocks and bonds and money, so that I can earn this interest payment instead of holding money balances. If the interest rate is not that high, then it is not worth it to move in and out of money and bonds in order to receive this interest payment.

Another way to look at it is that the interest rate describes the cost of holding money balances. This is because the interest rate tells you the amount of interest income you have to forego by holding money balances instead of lending out that money and holding an asset like a bond.

This is enough to generate a curve which plots the demand for money -- the amount you wish to hold as opposed to holding wealth as bonds -- as a function of r. This curve will slope downward.

Caution: This looks like the kind of demand curve you're used to in micro. It isn't. Those represent demand for a flow of a good. This shows what stock of money people wish to hold as part of their asset portfolios.

We emphasize the way that r affects transactions demand because it's important to our money market story. But two other things will also affect transactions demand. If income changes, transactions demand should change with it. As your income rises so do your expenditures, and hence the amount of wealth you might want to hold as money at any instant in time. Similarly it's reasonable to assume that at a national level, demand for money will grow as national income grows, and decline if national income declines. Additionally, as the overall price level of goods and services changes, transactions demand will cha

The Following Graph Shows The Market For Real Money Balances