The Transaction Motive
A certain amount of money is needed for everyday requirements, the purchase of food and clothing and other ordinary expenses. How much is necessary to hold for these purposes will depend on 3 factors.
- A person’s income
- The interval between one pay-day and the next
Generally the higher the income the more money will be held. The weekly wage-earner will need to hold less than a person who receives his salary monthly, for in the first case, sufficient amount has to be held to cover expenses for only one week, whereas the other man has to make provision for four weeks.
The Precautionary Motive
People hold money in reserve to cover unanticipated contingencies which might arise in the period or sudden purchase of opportune advantage. The amount held will depend mainly on the outlook of the individual, how optimistic he is both as regards events and the possibility of borrowing at short notice should the need arise. But, taking the community as a whole, the amount set aside for the precautionary motive is, in normal times, likely to be tied fairly closely to the level of national income.
The Speculative Motive
Another major reason for holding money is in order to speculate on the course of future events. If one thinks prices are now very low and will soon rise, the tendency is to buy now and to put off selling until prices rise. If one thinks prices are high now and will soon fall, the tendency is to sell now and to postpone buying until prices have fallen.
This emphasizes the role of money as a store of wealth. Speculative Balances are wealth held in the form of money rather than interest earning assets because of expectations that the prices of those assets may change.
When households decide how much of their monetary assets they will hold as money rather than s bonds (and other interest earning assets) they are said to be exercising their Preference for Liquidity.
In contrast with the above view, monetarists tend to deny the importance of the speculative factor, claiming instead that the main factor is the transaction demand. They argue that the demand for money is interest inelastic and that people hold money largely to finance spending on goods and services. Any increase in the quantity of money can, they agree, produce some changes in interest rates but the main effect is not on investment and output but on prices as people spend their increased money holding mainly on goods and services. The effect of this additional spending is to bid up the price of goods. Monetarist explain this effect by reference to some version of the quantity theory of money summarized in the basic equation MV = PT
where M stands for stock of money; V is its velocity of circulation; P is the average price and t is the number of transactions taking place in a given period. Assuming V is relatively constant because the institutional features of an economy change only slowly and that T is fixed at its maximum once a situation of full employment is reached, then it is argued any change in the quantity of money M can only be accommodated by variations in prices.
Modern monetarists following the work of Milton Friedman have refined the quantity theory, pointing out that the demand for money depends on several factors such as total wealth, expected rates of return on wealth, the rate of inflation, the ratio of human to non-human wealth and tastes and preferences.