Define payment system. What are the motives behind the demand for money? Briefly describe the ‘Demand for Money’ with an example

 Payment System: Payment systems are the means by which funds are transferred among financial institutions, business and individuals, and are considered to be the critical factor for the proper functioning of a country’s financial system. The payments system is the set of institutional arrangements through which purchasing power is transferred from one transactor in exchange to another. For efficient exchange, a common medium of exchange or means of payment is necessary. The payment system is organized around the use of money. An efficient organization of the monetary system is the sine qua non of an efficient payment system.

The organization and running of the payment system involves costs to transactors and to the economy. The more efficient the payment system, the lower the cost of transfer of funds per. The gain of lower costs accurses to the whole economy.

Broadly stating, there are three main motives, for which money is wanted by the people:

a)     Transaction Motive;

b)    Precautionary Motive;

c)     Speculative Motive;

a)     Transaction Motive: It refers to the demand for money for conducting day-to-day transactions. This motive can be looked at from the perspective of consumers, who want income to meet their household expenditure (income motive) and from the perspective of businessmen, who require money to carry on their business activities (business motive).

The transaction motive relates to demand for money to meet the current transactions of individuals and business units. The income, which a person gets, is not continuous whereas, expenditure is continuous, So, to bridge the gap between receipt of income and its expenditure, people hold cash.

 

According to Keynes, transaction demand for money is positively associated with the level of income, i.e. higher the level of income, the larger would be the size of money holdings for transactions.

 

b)    Precautionary Motives: It refers to the desire of people to hold cash balances for unforeseen contingencies. People wish to hold some money to provide for the risk of unforeseen events like sickness, accident, etc. The amount of money held under this motive, depends of the nature of individual and on the conditions in which he lives. The demand of money for precautionary balances is also closely related to the level of income. Higher the level of income, more will be the cash balances for contingencies.

c)     Speculative Motives: It refers to desire of the holder to keep cash balance as an alternative to financial assets like bonds. Under speculative motive, it is presumed that people can hold their wealth either in the form of bonds or in the form of cash balances. The decisions regarding holding of bonds or cash balances depend upon the expectations about changes in the rate of interest or capital value of assets (bond) in future.

The interest rate varies inversely with the market value of securities (bonds), i.e. when interest rate rises, market value of bonds falls. Hence, demand for money for speculative motive becomes less at high interest rates and becomes large at low interest rates.