What is the Demand for Money?

The demand for money is an economic concept that theorizes that individuals prefer holding money over other terms of investments, such as stocks or bonds. British economist John Maynard Keynes developed three motives associated with this theory: transaction, speculation and precautionary. While Keynes believed these elements create the demand for money, monetarist economists believe that the rate of return achieved on money places more influence on demand.

Under Keynes' theory, transaction motives drive people to hold money for daily needs. This money represents the consumption side of economics, where individuals must have money derived from an income stream to pay for food, shelter, clothing and other basic necessities, not to mention the discretionary income for non-necessary items. The speculative motive allows individuals to hold income in case the prices of assets begin to fall in the economy. Through this price reduction, individuals can purchase more goods or purchase big ticket items previously deemed too expensive. Precautionary motives lead to saving money in case of unexpected future cash outlays, such as health emergencies or major repairs to homes or cars.

Keynes developed his theory based on macroeconomics. This economic study focuses more on the aggregate effects of supply and demand in regards to money. Through his theory, government interactions is a necessary force that drives the economic transactions of individuals and businesses.

When the demand for money increases, nations must increase the supply to match this demand. Most nations use a central bank or other government agency to help control the supply of money. This agency is necessary because countries that continue to print money to meet demand will have rampant inflation, which is classically defined as too many dollars chasing too few goods. The most common way to control money supply is through the use of interest rates charged to banks. Lowering rates will tend to increase money supply while raising rates will decrease the supply.

The alternate theory for the demand of money states that the rate of return earned from invested capital dictates demand, and lies in the fact that individuals who make money will want to earn more. This creates an increase in the demand for money and also forces individuals to takes into account opportunity costs, which are the value given up when selecting one investment over another. In order to earn the highest rate of return, individuals must be judicious in selecting investments. This furthers the demand for money, as good investment opportunities will create a significant short-term demand so individuals can maximize investment income.