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Q: I read the article "Why Don't Prices Decline During A Recession?" on inflation and the article "Why Does Money Have Value?" on the value of money. I can't seem to understand one thing. What is the 'demand for money'? Does that change? The other three elements all make perfect sense to me but 'demand for money' is confusing me to no end. Thanks.
A: Excellent question!
In those articles, we discussed that inflation was caused by a combination of four factors. Those factors are:
- The supply of money goes up.
- The supply of goods goes down.
- Demand for money goes down.
- Demand for goods goes up.
You would think that the demand for money would be infinite. Who doesn't want more money? The key thing to remember is that wealth is not money. The collective demand for wealth is infinite as there is never enough to satisfy everyone's desires. Money, as illustrated in "How much is the per capita money supply in the U.S.?" is a narrowly defined term which includes things like paper currency, traveler's checks, and savings accounts. It doesn't include things like stocks and bonds, or forms of wealth like homes, paintings, and cars. Since money is only one of many forms of wealth, it has plenty of substitutes. The interaction between money and its substitutes explain why the demand for money changes.
We'll look at a few factors which can cause the demand for money to change.
1. Interest Rates
Two of the more important stores of wealth are bonds and money. These two items are substitutes, as money is used to purchase bonds and bonds are redeemed for money. The two differ in a few key ways. Money generally pays very little interest (and in the case of paper currency, none at all) but it can be used to purchase goods and services. Bonds do pay interest, but cannot be used to make purchases, as the bonds must first be converted into money. If bonds paid the same interest rate as money, nobody would purchase bonds as they are less convenient than money. Since bonds pay interest, people will use some of their money to purchase bonds. The higher the interest rate, the more attractive bonds become. So a rise in the interest rate causes the demand for bonds to rise and the demand for money to fall since money is being exchanged for bonds. So a fall in interest rates causes the demand for money to rise.
2. Consumer Spending
This is directly related to the fourth factor, "Demand for goods goes up". During periods of higher consumer spending, such as the month before Christmas, people often cash in other forms of wealth like stocks and bonds, and exchange them for money. They want money in order to purchase goods and services, like Christmas presents. So if the demand for consumer spending increases, so will the demand for money.
3. Precautionary Motives
If people think that they will suddenly need to buy things in the immediate future (say it's 1999 and they're worried about Y2K), they will sell bonds and stocks and hold onto money, so the demand for money will go up. If people think that there will be an opportunity to purchase an asset in the immediate future at a very low cost, they will also prefer to hold money.
4. Transaction Costs for Stocks and Bonds
If it becomes difficult or expensive to quickly buy and sell stocks and bonds, they will be less desirable. People will want to hold more of their wealth in the form of money, so the demand for money will rise.
5. Change in the General Level of Prices
If we have inflation, goods become more expensive, so the demand for money rises. Interestingly enough, the level of money holdings tends to rise at the same rate as prices. So while the nominal demand for money rises, the real demand stays precisely the same. (To learn the difference between nominal demand and real demand, see "What's the Difference Between Nominal and Real?")
6. International Factors
Usually when we discuss the demand for money, we're implicitly talking about the demand for a particularly nation's money. Since Canadian money is a substitute for American money, international factors will influence the demand for money. From "A Beginner's Guide to Exchange Rates and the Foreign Exchange Market" we saw that the following factors can cause the demand for a currency to rise:
- An increase in the demand of that country's goods abroad.
- An increase in the demand for domestic investment by foreigners.
- The belief that the value of the currency will rise in the future.
- A central banking wanting to increase its holdings of that currency.
To understand these factors in detail, see "Canadian-to-American Exchange Rate Case Study" and "The Canadian Exchange Rate"
Demand for Money Wrap Up
The demand for money is not at all constant. There are quite a few factors which influence the demand for money.
Factors Which Increase the Demand for Money
- A reduction in the interest rate.
- A rise in the demand for consumer spending.
- A rise in uncertainty about the future and future opportunities.
- A rise in transaction costs to buy and sell stocks and bonds.
- A rise in inflation causes a rise in the nominal money demand but real money demand stays constant.
- A rise in the demand for a country's goods abroad.
- A rise in the demand for domestic investment by foreigners.
- A rise in the belief of the future value of the currency.
- A rise in the demand for a currency by central banks (both domestic and foreign).