22 August 2012

Day 75: The Demand for Money - Part 1

Within the previous blogs, we've looked at the Supply side of Money [Day 71: The Money Supply - Part 1, Day 72: The Money Supply - Part 2]. Within this blog we'll be looking at the demand side of things.

At any point in time, people can hold their wealth in various different forms, such as 'real assets' with include things such as property, "valuable items" such as paintings, rare carpets, antiques, etc. and 'financial assets'. Within financial assets we can further distinguish between money and bonds.

Bonds are a financial tool where the debtor promises to regularly repay the owner interest and will pay back the capital amount at a certain date. Governments for instance work with bonds to finance some of its expenditure.

Within this context, the demand for money is the amount that the different members in the economy plan to hold in the form of money balances. Remember that the demand for money is not the same as the ‘want’ for money. So within the context of the ‘demand for money’ – we are only looking at those members of the economy who have an income / possess wealth. You can read up on the concept of Demand within Day 49, 50 and 51.

When looking at the demand of money we are looking at a few factors:

·         Money for the purpose of transactions
·         Money for the purpose of precaution
·         Money within speculation

These three points refer to functions money can have. Money is a universal tool for transactions, you need money readily available for you to do your groceries, for companies to pay their workers, etc. People also save their money for unseen events and expenditures.

When looking at the speculation point within money, we are basically looking at the trade-off between holding wealth as money, which is a flexible form as it can be exchanged at any time for something else– and holding bonds – which are more inflexible, but on which one can gain interest. The demand for money is thus directly related to the function it performs, and what function the wealth owner prefers best.

So depending and the person, and their circumstance – they will either prefer to hold some/most of their wealth as cash and demand deposits – or as bonds on which they can gain interest.
Within this, the particular interest rate which is being applied plays a role. A person might want to keep their wealth in the form of cash / demand deposits because he/she values the liquidity of money in this form more than bonds at an ‘x’ interest rate – but if the interest rate suddenly goes up, the person might change their mind as they can see that they could be making more money through having bonds, and so will forego the liquidity of cash for bonds (until the interest rate drops again). Within the concept of ‘supply and demand’ – we saw that prices are the main determinants which direct supply and demand for goods and services. Within this context, we can view the ‘interest rate’ as a price being put on loanable funds. And so, as the price goes up (high interest rate being paid out) – the more people will be willing to move some of their wealth in in the form cash/demand deposits – to holding it in the form of bonds.

(There are various interest rates, such as the repo rate, interbank lending rate, prime rate of banks, rates on deposits, mortgage rates, government stock rates,… and so the list goes on. At this point you do not require to know what all these different interest rates do/mean – all you need to know is that there are different ones. And that although there are different ones, they will follow the same pattern in their movement (up or down). So when we speak of ‘the interest rate’, it should be seen as a ‘representative’ rate for all the individual rates which are in play.)

When I first heard about 'the demand for money' -- I immediately went within myself 'Oh cool, now we are going to learn how the money supply has to adapt to the amount of people and levels of poverty -- because if there's more people / a lot of poverty obviously a lot of money is demanded because these people require money so they can access basic resource in order to sustain themselves'. So I was in for quite a disappointment when I learned that the 'demand for money' has got nothing to do with people and them being able to take care of themselves. It only cares about those who have money and how they act within their self interest in terms of whether they want to be flexible with their money or want to make money out of money. No consideration whatsoever for real issues -- a very big disappointment indeed.

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