The Demand for Money by Individuals

The Demand for Money by Individuals
Having discussed the functions of money and the definition of the money supply, we now
examine the factors that determine the amount of money an individual desires to hold. The
determinants of individual money demand can be derived from the theory of asset demand
discussed in the last chapter.
We saw in the last chapter that individuals base their demand for an asset on three
characteristics:
1. The expected return the asset offers compared with the returns offered by other assets.
2. The riskiness of the asset’s expected return.
3. The asset’s liquidity.
While liquidity plays no important role in determining the relative demands for assets
traded in the foreign exchange market, households and firms hold money only because of
its liquidity. To understand how the economy’s households and firms decide the amount of
money they wish to hold, we must look more closely at how the three considerations listed
above influence money demand.
Expected Return
Currency pays no interest. Checking deposits often do pay some interest, but they offer a
rate of return that usually fails to keep pace with the higher returns offered by less liquid
forms of wealth. When you hold money, you therefore sacrifice the higher interest rate you
could earn by holding your wealth in a government bond, a large time deposit, or some
other relatively illiquid asset such as vintage baseball cards or real estate. It is this last rate
of interest we have in mind when we refer to “the” interest rate. Since the interest paid on
currency is zero while that paid on “checkable” deposits tends to be relatively constant, the
difference between the rate of return of money in general and that of less liquid alternative
assets is reflected by the market interest rate: The higher the interest rate, the more you
sacrifice by holding wealth in the form of money.2
Suppose, for example, that the interest rate you could earn from a U.S. Treasury bill is
10 percent per year. If you use of your wealth to buy a Treasury bill, you will be
paid by Uncle Sam at the end of a year, but if you choose instead to keep the
as cash in a safe-deposit box, you give up the interest you could have
earned by buying the Treasury bill. You thus sacrifice a 10 percent rate of return by holding
your as money.
The theory of asset demand developed in the last chapter shows how changes in the rate
of interest affect the demand for money. The theory states that, other things equal, people
prefer assets offering higher expected returns. Because an increase in the interest rate is a rise
in the rate of return on less liquid assets relative to the rate of return on money, individuals
will want to hold more of their wealth in nonmoney assets that pay the market interest rate
and less of their wealth in the form of money if the interest rate rises. We conclude that, all
else equal, a rise in the interest rate causes the demand for money to fall.
$10,000
$10,000 $1,000
$11,000
$10,000
2Many of the illiquid assets that individuals can choose from do not pay their returns in the form of interest.
Stocks, for example, pay returns in the form of dividends and capital gains. The family summer house on Cape
Cod pays a return in the form of capital gains and the pleasure of vacations at the beach. The assumption behind
our analysis of money demand is that once allowance is made for risk, all assets other than money offer an expected
rate of return (measured in terms of money) equal to the interest rate. This assumption allows us to use the
interest rate to summarize the return an individual forgoes by holding money rather than an illiquid asset.
358 PART THREE Exchange Rates and Open-Economy Macroeconomics
We can also describe the influence of the interest rate on money demand in terms of the
economic concept of opportunity cost—the amount you sacrifice by taking one course of
action rather than another. The interest rate measures the opportunity cost of holding
money rather than interest-bearing bonds. A rise in the interest rate therefore raises the
cost of holding money and causes money demand to fall.
Risk
Risk is not an important factor in money demand. It is risky to hold money because an unexpected
increase in the prices of goods and services could reduce the value of your
money in terms of the commodities you consume. Since interest-paying assets such as
government bonds have face values fixed in terms of money, however, the same unexpected
increase in prices would reduce the real value of those assets by the same percentage.
Because any change in the riskiness of money causes an equal change in the riskiness
of bonds, changes in the risk of holding money need not cause individuals to reduce their
demand for money and increase their demand for interest-paying assets.
Liquidity
The main benefit of holding money comes from its liquidity. Households and firms hold
money because it is the easiest way of financing their everyday purchases. Some large purchases
can be financed through the sale of a substantial illiquid asset. An art collector, for
example, could sell one of her Picassos to buy a house. To finance a continuing stream of
smaller expenditures at various times and for various amounts, however, households and
firms have to hold some money.
An individual’s need for liquidity rises when the average daily value of his transactions
rises. A student who takes the bus every day, for example, does not need to hold as much cash
as a business executive who takes taxis during rush hour. We conclude that a rise in the average
value of transactions carried out by a household or firm causes its demand for money to rise.