Money is the main measure of the value of material wealth, a tool for purchasing goods and services, accumulating wealth. People and companies always need cash - that is, there is a constant demand for them. But there is no infinite amount of money. Accordingly, there is a limited supply of them.
What is the demand for money
Several definitions can be found in the economic literature. Thus, the Finam dictionary gives the following:
The demand for money is the amount of liquid assets that people want to keep in their possession at the moment. The demand for money depends on the size of the income received and the opportunity cost of owning this income, which is directly related to the interest rate.
In some definitions, the demand for money is linked to the size of the gross national product (GNP). There is no contradiction here: when production grows, incomes of citizens and companies also increase, and vice versa.
What does it consist of
The demand for money breaks down into two components. They come from two functions of money: to be a means of payment and to act as an instrument of accumulation.
First, there is transactional demand. It reflects the desire of citizens and companies to have the means to conduct current transactions, purchase goods and services, and settle their obligations.
Second, they highlight the demand for money from assets (or speculative demand). It appears because funds are needed to purchase financial assets and can themselves act as an asset.
What determines the demand for money: different theories
Each of the major economic theories puts forward its own understanding of the demand for money and differently identifies the main factors of its formation. So, in the classical quantitative concept, the formula is derived:
MD = PY / V
This means that the demand for money (MD) directly depends on the absolute level of prices (P) and the real volume of production (Y) and is in inverse proportion to the speed of money circulation (V).
Representatives of the economic classics took into account only the transactional component of the demand for money. But over time, new models have emerged that look at the issue from different angles.
Keynesianism attaches great importance to the accumulation of cash by people. Also in this theory, the motives for which people keep money are important:
- Transactional motive. It is driven by the desire to have funds for constant purchases or transactions.
- Precautionary motive. It is related to the need of people to have a cash reserve for unforeseen expenses and payments.
- Speculative. It occurs when people prefer to keep funds in money rather than other assets. This motive determines the speculative demand for money.
Keynesians established the dependence of speculative demand and the interest rate on securities in inverse proportion. The high cost of money makes investments attractive and the need for cash is reduced. At low rates, on the contrary, the attractiveness of keeping money in cash in highly liquid form increases.
Total demand was defined as the sum of transactional and speculative demand. Its size is directly proportional to income and inversely proportional to the interest rate. A graph reflecting this pattern can be found in any textbook on economics. It is also cited in articles specifically devoted to this issue.
It is now believed that the demand for money is influenced by many more factors than previously thought. So, are important:
- nominal current income;
- percentage of income;
- the amount of accumulated wealth: with its positive dynamics, the demand for money also increases;
- inflation (rise in the price level), the growth of which also directly affects the demand for money;
- expectations about the economy. Negative forecasts cause an increase in the demand for cash, while optimistic ones provoke a reduction.
What is money supply
The money supply is the sum of all the money in the economy. With the monetary base unchanged, this indicator depends on the volume of banknotes in circulation and the size of the interest rate.
Today, the money supply is provided by the banking system, which is made up of the Central Bank and commercial financial structures. The Central Bank has a regulatory role in this area. First, it issues banknotes (banknotes, coins). Secondly, the Central Bank regulates the issuance of loans to financial structures, as it sets the refinancing rate.
If the demand for money becomes the same as the volume of supply, they speak of reaching equilibrium in the money market.
