The Functions of Money: The Demand for Money

The Demand for Money Why do people desire to hold demand deposits and currency? After all, by holding these two forms of money they give up the opportunity to earn interest on the sum held. Similarly, when money is held in the form of interest-bearing checkable deposits, the interest earned is usually less than can be earned on near monies, bonds, and other less liquid assets that can be purchased with money. The opportunity cost of holding a dollar in money over the year is the interest income that is forgone. For example, if you can earn 8 percent per year in a savings account, the opportunity cost of holding a dollar in cash is 8 cents over the year assuming interest is computed once annually. The higher the interest rate you can earn is the next best alternative you have, such as investing in bonds or certificates of deposit, the greater the opportunity cost of holding money. People hold money because they receive benefits from doing so. In deciding how much to hold, people consider both the benefits and costs of holding money. In the following sections we analyze the benefits of holding money and look at various motives for choosing to hold money as an asset. Transaction Demand for Money At any given level of interest rates, people demand a certain amount of money to carry out the basic transactions associated with everyday business. The level of interest rates is an average of a broad array of interest rates that can be earned on a variety of assets. The greater the dollar volume of transactions during the year, the greater the sum of money each day over the year that is willingly held at each possible level. By holding money you avoid the inconvenience and possible embarrassment of settling your debts late. You also avoid the need to incur other costs involved in liquidating assets to make payments. For example, suppose you have both a savings account and a checking account. To pay for your periodic purchases, you must be sure to have at least a minimum amount of currency and checkable deposits on hand. Your savings deposits do you little good as a means of payment unless you go to the bank and transfer some of the funds to your checking account or withdraw them as currency. The transaction demand for money is the sum of money people want to hold per day as a convenience in paying their everyday bills. The benefit of holding money in this form is the avoidance of transaction costs of converting other assets to currency and checkable deposits. Suppose you're paid once a month, your expenses require daily expenditure of money, and you don't borrow to meet any of your expenses. You can deposit all of your monthly money income in a savings account on the day you're paid to avoid the loss in interest income associated with holding it. However, every time you need to pay for an item, you'll have to go to the bank and wait in line to convert some of your savings deposits to checkable deposits or currency. In some cases you may incur penalties for early withdrawal that will reduce your interest income. The time (the trip to the bank, for example) and the money costs involved in liquidating these savings deposits are your transaction costs. In managing the money you keep for transactions, you must weigh these transaction costs against the income you forgo by holding money instead of interest-bearing assets. You may decide always to keep a certain sum each month as checkable deposits and currency rather than as less liquid assets. The interest you forgo by doing so is worth less to you than the inconvenience of having to liquidate those assets to make payments every day. The yearly transaction demand for money at any given level of interest rates depends on the dollar volume of transactions over the year. In general, the greater the level of nominal GNP over the year, the greater the transaction demand for money. After all, if your monthly bills increase from $1,000 to $1,500 this year, you'll need to hold more money to make payments. Similarly, when nominal GNP increases from $6,000 billion to $7,000 billion per year, the transaction demand for money in the economy will also increase even if interest rates don't change.