As with “What is money?,” answering “Do you have enough money?” seems obvious. Your behavior, however, indicates that at times you have too much money, so you spend it; at other times you try to acquire more money because you have too little. Ambiguity arises because people use money, income, and wealth interchangeably. You might easily justify answering no if asked if you had enough income or wealth. But money, though related to both, is identical to neither income nor wealth. Money is the device used to buy goods and by which we measure income, wealth, and prices paid.

 

Most people spend in fairly predictable ways and receive money at regular intervals. If you try to secure more money income by selling your time or goods, or by saving more money from your income, you have temporary shortages of money relative to your time or goods. But when you spend money, you see your purchases as more desirable than their monetary costs; relative to these goods, you have temporary surpluses of money.

 

Individual demands for money are fairly complex. It would be fruitless to break up our demand for cars into “vacation,” “work,” “commuter,” or “shopping” motives. Some economists, however, find it useful to compartmentalize reasons we hold money instead of consuming more or investing in other assets. The functions money performs were addressed previously: money is a medium of exchange, a unit of account, a store of value, and a standard of deferred payment. One trivial way to explain your demand for money is to say that you desire money for the functions it performs. You can gain more insight into how money works by looking at three basic motives for holding money: the transactions, precautionary, and asset demands for money.

Transactions Demands

Before the Great Depression, classical reasoning focused on spending as the sole rational motive for holding money.

The transactions demand for money arises because people anticipate spending it.

 

This is usually the dominant reason for holding money. You can predict many if not most transactions fairly accurately. You know how much your monthly rent and car payment will be and roughly how much you will spend on utilities, gasoline, and meals. You probably also have a good idea about how much money you will receive in the near future. Most workers receive their paychecks regularly: daily, weekly, biweekly, or monthly. Students may receive money monthly or once or twice a semester.

 

Predictable transactions flows of money to and from an individual paid $2,000 monthly are reflected in the blue line in Figure 1. The vertical rise of the area shaded in green shows money-holding patterns for someone with an identical $2,000 monthly income, but paid $1,000 at the middle and again at the end of each month. Notice that this person’s average holdings of money are much lower than for the individual paid monthly. We have shown more rapid declines in money holdings right after a payday than toward the end of the pay period. You are typical if you write a lot of checks right after you get paid, and then find yourself almost broke before you are paid again.

 

Precautionary Demands Even people who hold enough money to cover their planned spending feel uncomfortable with no extra money in reserve. There always seem to be little—and sometimes big—emergencies that require money. For example, you may have the hard luck of a flat tire or lost textbooks, or you may be pleasantly surprised to find a tape you want on special in a store at your local mall. People hold precautionary balances of money on hand to meet unexpected expenditures. The precautionary demand for money arises because people know that unanticipated spending is required at times. Transactions and precautionary demands for money differ in the predictability about future spending. Both motives, however, suggest that your average of money balances held will be positively related to your income; you probably hold more money now than when you were ten years old, and far less than you will hold when you put your student days behind you and find a good job. Figure 2 stacks the precautionary demand for money on top of the transactions demand to show how the total of these two

demands is related to income. One of Keynes’s innovations in monetary theory is the idea of the precautionary motive. While earlier classical writers ignored this motive in their writings on money, they would have had little difficulty accepting this idea because, like transactions balances, precautionary balances of money are closely related to income.

 

Early classical theorists argued that no one will hold money as an asset because they could earn interest on stocks or bonds if they made these financial investments instead. Keynesians argue that a desire to hold some wealth in the form of money originates from (a) expectations that the prices of stocks or bonds will fall in the near future, (b) reluctance to hold only assets that tend to swing widely in value, or (c) a belief that transaction costs are higher than any expected return from investments in stocks or bonds.

Asset Demands Keynes’s major innovation in monetary theory is the concept of an asset demand for money, an idea that clashes with early classical theory. The asset demand for money arises because people sometimes want to hold part of their wealth in the form of money. • Speculative Balances  Suppose you intend to buy stocks, bonds, or real estate out of funds you have saved. People hold speculative money balances if they expect the prices of alternative assets to fall in the near future. If it required a 10% return to persuade you to buy this bond, you would be willing to pay $1,000 for it, because 10% times$1,000 equals $100, which is the annual payment. If you required a20%

return on your financial investment, the bond would be worth only $500 to you: 0.20($500) = $100. Thus, higher interest rates imply lower bond prices (20% > 10% and $500 < $1,000).

A general formula for this type of bond (called a perpetuity) is     Bond prices (the present value of the bond) drop If interest rates rise, and falling interest rates drive bond prices up. If you and other potential bond buyers expect interest rates to rise soon, you will speculate against bonds and hold money while waiting for bond prices to fall.

• Risk Avoidance  Keynes emphasized the speculative aspect of the asset demand for money. Other economists have developed other reasons why people may hold money as an asset. Assets yielding relatively high average rates of return tend to be relatively risky. Most people are risk averse, so they buy various kinds of insurance. We invest only if the assets we buy with money are expected to yield returns that compensate us for our reduced liquidity (less money held) and the increased risk of loss.

 

Newspapers occasionally profile eccentrics who seemed destitute, but who left their heirs hoards of cash hidden in mattresses. Risk-averse people will hold money when expected rates of return from other assets are viewed as too low to overcome their riskiness. Consider, for example, two financial investments: (a) $10,000 in cash, with a zero return or (b) $10,000 worth of ZYX stock, which has a 96% probability of yielding a 6% rate of return, but a 4% chance of losing the $10,000. Buying ZYX stock is probabilistically more valuable than holding the cash (0.96 ¥ $10,600 = $10,176 > $10,000), but many people would hold the cash in preference to risking the 4% probability of losing the entire $10,000.

• Costs of Illiquidity  Money is the most liquid of all assets. If you have so little wealth that the costs of investing overshadow any potential gains, you will hold money instead of investing. For example, if you have only $50 to invest and expect a $50 share of stock to generate a $5 profit, it is better to hold money if the stockbroker’s fee is more than $5.

All these reasons for people to hold money as an asset lead to the conclusion that money holdings are negatively related to the interest rate. Transactions demands are related to time, as suggested in Figure 1. But neither precautionary nor asset demands for money are systematically related to time. It is impossible to compartmentalize chunks of money precisely, but the transactions, precautionary, and asset motives are reasonable explanations for why most of us keep positive balances of money handy. Typical total money holdings for a person paid $2,000 once a month are depicted in Figure 3.