Money, Demand For

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Money, Demand For







Money exists because there is a demand for it, and that demand creates its own value (like any other asset). The intrinsic value of money may be zero; still, the nominal value of money is equal to its face value. An intrinsically worthless paper acquires value because it performs the role of the medium of trade. People demand money because they believe that most people demand it. In other words, they know that they can exchange money for goods and services or other assets now or in the future. If people know that there will be no demand for money in the future, then nobody will demand it now, so there must be a belief system that money will be demanded in future for indefinite periods. Hence a medium of exchange necessarily becomes a store of value, though not every store of value is a medium of exchange. The liquidity of an asset makes it money. The degree of liquidity is defined as the easiness with which the asset is converted to any other commodity or service. If an asset can be exchanged seamlessly for another asset, then it fulfills the ideal definition of money. Similarly, if money is exchanged for another asset or goods or services and if no transaction cost is involved, then the money is perfectly liquid.


Demand for money is not exactly like demand for any other commodity. Money does not give any direct utility to a consumer, nor is it used as an intermediate good in the production process. However, it facilitates transactions in the processes of production, consumption, and distribution. Money has purchasing power whereby one can purchase any marketable good or service. Further in a sense money gives more utility than a set of goods or services of the same value because it provides a generalized purchasing power. An infinite set of choices of goods and services are possible if money exists. Hence demand for money is an indirect demand for goods and services, both in current and in future periods. If more money is chasing the same amount of goods or services, then value of money goes down; this is an inflationary situation. For the holders of money, it is the purchasing powerthat is, the real money balancesthat matters.

According to John Maynard Keynes, an asset possesses three properties: a yield, a liquidity premium, and a carrying cost. He defined money as an asset that has zero yield but a positive liquidity premium in excess of its carrying cost.

The most common form of money in the early twenty-first century world is the liabilities of central banks. The almost universal requirement that taxes be paid to the governments in the form of liabilities of a central bank ensures that there is a demand for such liabilities (see Jordan 2006).


Demand for money arises from medium of exchange and store of value functions. Because people need money to smooth transactions, they hold it for future needs. Money as a medium of exchange is a facilitator of transactions and hence an essential lubricant to the mechanism of exchange. In fact these two roles of money are interrelated. Unless money is a store of value, it cannot be a medium of exchange and vice versa. However, the transaction demand is more fundamental. There are other assets besides money that are competing and even better stores of value but no better medium of exchange. In developing countries, though, moneys store of value role is particularly significant. Money generally serves as the unit of account and the standard of deferred payment because it is convenient as well as efficient. However, the medium-of-account role is not logically tied to the medium of exchange (Wicksell 1906).

Keynes in The General Theory of Employment, Interest, and Money (1936) identified three motives for holding money: the transaction motive, the precautionary motive, and the speculative motive. The transaction motive and precautionary motive relate to moneys role as the medium of exchange, whereas the speculative motive relates to moneys role as a store of value. The transaction motive arises for exchanging money for goods and services, as it is extremely unlikely to have double coincidence of wants, especially in a modern economy. It may not be possible for me to exchange a few pages of my research paper for a meal in a restaurant because my want and the want of the restaurant owner need not coincide. Holding money involves a trade-off between forgoing the interest that can accumulate with savings and bearing the inconvenience of not holding money for transaction purposes. People may hold money to meet future payments, which are uncertain; this is the precautionary motive for holding money (see Whalen 1966). Money is also held for speculative purposes, that is, to avoid the risk inherent in other assets, which may pay higher returns (see Tobin 1958).

Demand for money varies between developed and developing countries because the former have relatively advanced financial systems, states of technology, and degrees of enforceability of contracts. The volume of transactions also influences demand for money. In less developed countries cash is used more often for transactions; in more developed nations the use of credit cards reduces the demand for cash.

There are several economic variables that affect the demand for money, including gross domestic product (GDP), interest rates, inflation rates, financial innovations in the economy, degree of monetization in the economy, exchange rates, structure and level of external trade, and so on. Various theories explain the relationships between these variables and money. The original quantity theory of money (Fisher 1911) was followed by the Keynesian theory of liquidity preference (Keynes 1936) and later by more modern variants of both (Friedman 1956; Tobin 1956, 1958; Baumol 1952). The Keynsian approach makes interest rate an explicit determinant of the demand for money.

Technical progress in the financial sector introduces two competing influences on the trend behavior of velocity, each of which dominates a different stage of development in a particular country. During the first stage of development, the economy is characterized by increasing monetization and expansion of bank branches. Cash and demand deposits are increasingly used for transactions, replacing earlier reliance on barter trade. The income velocity of money falls. In the second phase of development, new securities are introduced as an alternative store of value. The change in technology and regulatory mechanisms in the financial sector and the resultant rapid transfer of funds across time, space, and economic agents economizes on money balances. This results in a rise in velocity, giving rise to a U-shaped function for the velocity with respect to time. Money has an inherent tendency to instability through the development process as the velocity varies (see Bordo and Jonung 1987).


Money demand is one of the most extensively studied relationships in economic literature. Innumerable articles were published in the last decades of the twentieth century on empirical money demand estimations for numerous countries and time periods. Empirical research on the demand for money progressed as theory evolved, and econometric techniques improved in order to posit a plausible validation for the theoretical relationships (or lack thereof). The growing arsenal of time-series econometric techniques, such as cointegration and error correction, has permitted more sophisticated examinations of demand for money functions.

There is a vast amount of empirical literature examining the stability of demand for money. This is explained by the ever-changing technology, innovations, and regulatory mechanisms in the financial markets. Further the large fluctuations in the interest rates can render a large amount of instability to the velocity of circulation of money.

Markus Knell and Helmut Stix (2003) performed a meta-analysis of almost 500 empirical money demand studies to investigate whether different study characteristics might play a role in variations. They showed that the estimations for the income elasticity of money demand are systematically and significantly higher if broader definitions for monetary aggregates are used; the inclusion of variables such as wealth and financial innovation tend to be associated with lower estimates. The results for the use of different scale variables, the use of different econometric methods, and various additional details of the specification are less clear-cut. Surprisingly they also found that some of these results are similar to observations made in previous surveys, despite the facts that they use a completely different sample of papers and that in their sample most studies use modern cointegration techniques, whereas older surveys (see Laidler 1993) were dominated by partial adjustment models, and so on.

In an international sample of studies, income elasticities between14.11 and 44.79 (or corrected for outliers between .01 and 2.46) were observed; sometimes substantial differences can be found even within the same country and time period (Knell and Stix 2003). Most surveys show divergence of empirical findings in terms of coefficient values. However, this is to be expected because macroeconomic environment varies across countries and across sample periods.

During the 1970s and 1980s most studies looked at Organization for Economic Cooperation and Development (OECD) countries and particularly the United States and the United Kingdom, but since the 1990s a number of papers on developing countries have become available. The literature on developing countries suggests that the models on narrow money work better, reflecting weak banking systems and low financial sector development (Pradhan and Subramanian 2003). Automatic teller machines, for example, allow withdrawals from savings accounts, so the narrow money changes but not the broad money. Hence financial innovation has made narrow money relatively more unstable in advanced economies (see Hetzel and Mehra 1989; Hafer and Jansen 1991). Generally currency, demand deposits, and other checkable deposits constitutes the narrow money; broad money includes some more financial assets in addition to the narrow money.

Despite the numerous efforts to estimate the demand for money functions, there is little agreement among the authors of this literature. The range of estimated income and interest-rate elasticities is wide, and although some papers maintain that money demand is stable, others come to the opposite conclusion.


The long-run relationship between real money balances, real output, and interest rate has immense policy implications. If demand for money is stable, then output and price level are predictable to a given supply of money. A monetary policy that seeks to limit the supply of money to its demand facilitates the task of macroeconomic management and tries to ensure price stability in the economy. The rate of growth of money supply should be in conformity to the expected growth rate of output in order to constrain the price level from rising to an unacceptable level. The relation between the demand for money balances and its determinants is a fundamental building block in most theories of macroeconomic behavior and is a crucial component in the formulation of monetary policy. This requires a stable demand for money. Furthermore if the growth of money supply increases at a much faster rate than the real GDP, then the currency becomes unstable; this works against the Hayekian requirement of a stable currency for a proper market economy (Jordan 2006). If the demand function itself is not stable, then generally the interest rate rather than the money supply is targeted.

We saw that stability of demand for money has implications for policy. One can see this through the famed IS-LM framework as well. An unstable money demand function generates an unstable LM curve, which renders the IS-LM equilibrium unstable, making the policy impact on income and interest rates unpredictable.


Stability of demand for money is one of the most important issues in macroeconomic policy analysis. However, money demand functions are found to be not robust. Stability and reliability of estimates of parameters of demand functions of money for many countries have been found wanting for various time periods. Unusual economic conditions, including severe bouts of inflation, record-high interest rates, and deep recessions, are responsible for instability of money demand function. This happens across countries due to business cycles. Also the adoption of floating exchange rates and substantial institutional changes brought about by financial innovation and financial deregulation create instability. These changes, which occurred earlier in developed countries, are now affecting many emerging market economies, such as India and China.

There are measurement problems relating to the determinants, such as transaction variable, opportunity cost variable, and wealth variable. In fact measurement and definition problems arise with respect to the money variable itself. What we call money also keeps changing across time and geography. Improving the specifications and/or using improved econometric techniques helps matters to an extent. In fact these developments provide opportunities to explore new relationships and to use modern time-series techniques of cointegration and error correction and beyond.

However, statistical techniques are only tools to summarize data; therefore, they cannot always answer difficult questions that need deeper economic insights. More explorations are needed on the conceptual aspects of demand for money.

SEE ALSO Friedman, Milton; Interest Rates; Keynes, John Maynard; Liquidity; Liquidity Premium; Liquidity Trap; Money; Neutrality of Money; Quantity Theory of Money; Tobin, James


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Basanta Kumar Pradhan