Many factors influence our total demand for money balances. The four main factors are
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the level of prices
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the level of interest rates
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the level of real national output (real GDP)
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the pace of financial innovation
KEYNESIAN DEMAND FOR MONEY - LIQUIDITY PREFERENCE
TRANSACTIONS DEMAND - this is money used for the purchase of goods and services. The transactions demand for money is positively related to real incomes and inflation. As an individual's income rises or as prices in the shops increase, he will have to hold more cash to carry out his everyday transactions. The quantity of nominal money demand is therefore proportional to the price level in the economy.
(note: the real demand for money is independent of the price level)
PRECAUTIONARY BALANCES - this is money held to cover unexpected items of expenditure. As with the transactions demand for money, it is positively correlated with real incomes and inflation.
SPECULATIVE BALANCES - this is money not held for transaction purposes but in place of other financial assets, usually because they are expected to fall in price.
Keynes demonstrated that there was an inverse relationship between the price of a bond and the rate of interest. For example, suppose a bond is issued for �200 and its annual return (coupon) is �20. The annual rate of interest is 10%. If the market rate of interest falls to 5% the price of the bond will increase to �400. The rationale behind this is that in order to secure the same return of �20 in any other financial asset �400 would have to be invested.
Conversely, if the rate of interest increases, the price of bonds will fall
There is an inverse relationship between interest rates and the market prices of fixed interest government securities
Keynes argued that each individual has a a view about an 'average' rate of interest. If the current interest rate was above the average rate then a rational individual would expect interest rates to fall. Similarly, if current rates are below the average rate then obviously interest rates would be expected to rise.
At high rates of interest, individuals expect interest rates to fall and bond prices to rise. To benefit from the rise in bond prices individuals use their speculative balances to buy bonds. Thus when interest rates are high speculative money balances are low.
At low rates of interest, individuals expect interest rates to rise and bond prices to fall. To avoid the capital loses associated with a fall in the price of bonds individuals will sell their bonds and add to their speculative cash balances. Thus, when interest rates are low speculative money balances will be high.
There is an inverse relationship between the rate of interest and the speculative demand for money.
The total demand for money is obtained by summating the transactions, precautionary and speculative demands. Represented graphically, it is sometimes called the liquidity preference curveand is inversely related to the rate of interest.
THE DEMAND FOR MONEY AND THE RATE OF INTEREST
MONEY DEMAND AND INCREASES IN REAL GDP
Consider a period of sustained economic growth in the economy. Rising real incomes and increasing numbers of people employed will increase the demand for money at each rate of interest. Therefore higher real national income causes an outward shift in the demand for money. This is shown in the diagram below
FINANCIAL INNOVATION AND THE DEMAND FOR MONEY
The pace of change in financial markets is rapid and this affects our demand for money balances in order to finance our purchases. In recent years the demand for cash balances (M0) has declined relative to the demand for interest-bearing deposit accounts. Most people can finance their purchases using debit cards and credit cards rather than carrying around large amounts of cash. Financial innovation has reduced the demand for cash balances at each rate of interest - represented by an inward shift in the money demand curve.
