Demand for Money

 John Maynard Keynes, in his theory of demand for money, which he called liquidity preference theory, asked the question, why do individuals hold money? He postulated that there are three motives behind the demand for money:

 

i) The transaction motive,

 

ii) The precautionary motive, and iii) The speculative motive.

i)  Transactions Motive: Individuals are assumed to hold money because it is a medium of exchange that canbe used to carry out current everyday transactions Keynes emphasized that thiscomponent of the

demand for money is primarily determined by the level of people'stransactions. The transactions component of the demand for money is proportional toincome.

 

ii)   Precautionary Motive: Besides holding money to carry out current transactions, people hold additionalmoney as a cushion against unexpected needs. Precautionary money balances come inhandy if you are hit with an unexpected bill, say for major car repair orhospitalization. Keynes believed that the amount of precautionary money balancespeople want to hold is determined primarily by the level of transactions they expect tomake in the future and that these transactions are proportional to income. Therefore,he postulated that the demand for precautionary money balances is proportional toincome.

 

iii)  Speculative Motive:Keynes did not end his theory with the transaction and precautionary motives, ratherhe added that money can be used as a store of wealth and called this motive forholding money as the speculative motive. Keynes, however, looked carefully at thefactors that influence the decisions regarding how much money to hold as a store ofwealth. Unlike classical (Cambridge) economists, Keynes believed that interest rateshave an important role to play here and he concluded that as interest rate rises. Thespeculative demand for money falls and vice versa.