THE DEMAND FOR MONEY AND

OTHER ASSETS
• The objective of this unit is to examine the
demand side of money. It investigates how
money demand is determined. That is it
investigates the factors that determine how
much money does on individual wish to hold,
given that the more money one hold the less
you can hold of other assets.
• This unit examines the demand side of money.
One of the basic analytical tools for the study
of money and monetary theory is the theory
of asset demand.
• The theory of asset demand is useful to
examine many economic phenomena. The
demand for money is an essential building
block to our understanding of how monetary
policy affects the economy, because it
suggests the factors that influence the
quantity of money in the economy.
• This chapter develops in chronological order
the various theories that attempt to explain
the demand for money.
• We begin with the microeconomic
foundations of the demand for money where
Keynes and portfolio balance approach is
discussed.
• Latter the demand for money at a macro level
will be examined. We begin with the classical
theories and move to Milton Friedman's
modern quantity theory.
THE DETERMINANTS OF ASSET
DEMAND
• An asset is a piece of property that is a store
of value. Items such as money, bonds, stocks,
land, houses, farm equipment, manufacturing
machinery, and so on are all assets.

• The asset market are the markets in which

money, bonds, stock and other forms of
wealth are traded.
• Asset fall into two broad categories: Financial
assets and tangible assets. These are:

i) Money
ii) Bonds
iii) Equities or stocks
iv) tangible or real assets.
• Money: Assets that can be immediately
used for making payments. It includes
currency and deposits.
• Bonds: It is a promise by a borrower to pay
the tender a certain amount (the principal) at
a specified date, and 6to pay a given amount
of interest per year in the mean time.
• Equities or Stock: these are claims to share of an
enterprise. Share stockholders receive the return
on equity either in dividend form or retained
earnings. Thus the return on stocks, or the yield
to a holder of a stock is equal to the dividend plus
the capital gain.
• Real Assets or tangible assets: these are the
machines, land and structures owned by
corporations and the consumer durables (cars,
etc) and residences owned by households. These
assets are called real to distinguish them from
financial assets.
• Faced with the question of whether to buy
and hold an asset or whether to buy one asset
rather than another, an individual must
consider the following factors:
• Wealth, which is the total resources available
to the individual;
• The expected return on one asset relative to
the expected return on alternative assets;
• The degree of uncertainty or risk associated
with the return on one asset relative to
alternative assets;
• The liquidity of one asset relative to
alternative assets; that is, how quickly and
easily it can be turned into cash
 A) Wealth
• When a person finds that his wealth has increased, he
has more resources available with which to purchase
assets and so, not surprisingly, the quantity of assets he
demands increases.
• Note that the demands for different assets do have
different responses to changes in wealth. The degree of
this response is measured by a concept called the wealth
elasticity of demand (which is similar to the concept of
income elasticity of demand that you learned in your
introduction to economics course).
• The wealth elasticity of demand measures how much,
with everything else unchanged, the quantity demanded
of an asset changes in percentage terms in response to a
percentage change in wealth
• Assets can be sorted into two categories
depending on the value of their wealth
elasticity of demand. An asset is a necessity if
the percentage increase in the quantity
demanded of the asset is less than the
percentage increase in wealth—in other
words, its wealth elasticity is less than 1.
• Since the quantity demanded of a necessity
does not grow proportionally with wealth, the
amount of this asset that people want to hold
relative to their wealth falls as wealth grows.
• An asset is a luxury if its wealth elasticity is
greater than 1, and as wealth grows, the
quantity demanded of this asset grows more
than proportionally and the amount that
people hold relative to their wealth grows.
• Common stocks and bonds are examples of
luxury assets, and currency and checking
account deposits are necessities.
• The effect of changes in wealth on the
demand for an asset can be summarized as
follows.
• An increase in wealth raises the quantity
demanded of an asset, and the increase in the
quantity demanded is greater if the asset is a
luxury rather than a necessity.
B) Expected Returns
• The return on an asset measures how much
we gain from holding that asset. When we
make a decision to buy an asset, then we are
influenced by what we expect the return on
that asset to be.
• If the expected return on the bond rises
relative to expected returns on alter­native
assets, holding everything else constant, then
it becomes more de­sirable to purchase that
bond and the quantity demanded increases.
• This can occur in either of two ways:
• 1) when the expected return on that bond rises
while the return on an alternative asset—say,
stock in a particular corporation-remains
unchanged, or
• 2) when the return on that particular
corporations stock, falls while the return on the
bond remains unchanged.
• To summarize note that an increase in one
return relative to that of an alternative asset
raises the quantity demanded of the asset.
C) Risk

• The degree of risk or uncertainty on an asset’s

returns also affects the demand for the asset.
• Most people are risk averse. That is,
everything else being equal; they prefer to
hold the less risky asset. Hence, if an asset's
risk rises relative to that of alternative assets,
its quantity demanded will fall.
D) Liquidity
• Another factor that affects the demand for an
asset is its liquidity, that is, how quickly it can
be converted into cash without incurring large
costs.
• The more liquid an asset is relative, to
alternative assets, (holding everything else
unchanged), the more desirable it is and the
greater will be the quantity demanded.
 All the determining factors we have just
discussed can be assembled to­gether into the
theory of asset demand, which states that,
holding all of the other factors constant:
1. The quantity demanded of an asset is usually
positively related to wealth, with the response
being greater if the asset is a luxury rather
than a necessity.
2. The quantity demanded of an asset is
positively related to its expected return
relative to alternative assets.
3. The quantity demanded of an asset is
negatively related to the risk of its returns
relative to alternative assets.
4. The quantity demanded of an asset is
positively related to its liquidity relative to
alternative assets.
THE THEORY OF DEMAND FOR MONEY
• Introduction :
• Money is a stock variable. Its stock refers to its
quantity in the economy as a whole at a
particular point of time. The demand for
money arises from the fact that it is an asset
for its holders.
• Since it is acceptable to all, people hold it, not
only for paying debts, but as a particular form
of an asset-one which is easy to be converted
into other goods and services.
• A theory of demand for money is, therefore,
merely concerned with the questions:
- What are the constituents of the demand for
money?
• And why there is a public demand for money?
A number of explanations have been put
forward in this regard.
• Before taking up these explanations or
theories it would be helpful to clarify the
distinction between nominal and real cash
balances.
• Nominal cash balances are money or the
current purchasing power of a unit of money
(say, a birr in the case of Ethiopia, or a dollar
in the case of USA or a pound in the case of
UK).
• Real cash balances arc money of some base
year's purchasing power.
• Technically speaking, real cash balances mean
the nominal cash balances divided by the
price level.
• Symbolically, if M is the nominal money and P
is the price level then the real cash balances
will be M/P. Whenever P changes the
distinction be­tween nominal and real cash
balances would be more relevant.
• Thus, demand for money refers to real money
balance. This is because people hold money
for what it will buy.
Micro Economic Foundations of
the Demand for Money
 At an individual or micro level demand for
money balances will be a function of
• The differential between the perceived yield on
money and on other assets
• The cost of transferring between money and
other assets
• The price uncertainty of other assets and
• The expected patterns of expenditures and
receipts
• The following discussion illustrates these
cases in one way or another.
I) Keynes Theory of Demand for
Money
• According to him the demand for money
arises because of its liquidity or 'liquidity
preference' as he calls it.
• In this approach the demand for money arises
for three motives:
(i)transactions motive,
(ii)(ii) the precautionary motive, and
(iii)(iii) the speculative motive.
• According to Keynes the total demand for
money means total cash balances which may
be of two types:
(i) active and
(ii) idle;
• the former comprising transactions demand
and precautionary demand for money and the
latter comprising of speculative demand for
money. Let us examine the three motives in
detail
a)Transactions Motive:
• Money is a medium of exchange and
individuals hold money for use in transaction.
Thus the amount of money held for the
transaction purpose would vary positively
with the volume of transaction in which the
individual engaged.
• Thus, the transactions demand for money
depends upon
(i) the personal income, and
(ii) the business turnover.
• The demand for money for transactions
motive thus varies proportionately to the
changes in the money income.
• The higher the money in­come the greater the
demand for money and vice versa.
• Note that the rate of interest has no role to
play in determining the transactions demand
for money.
b)Precautionary Motive:
• According to Keynes people also hold some cash
for meeting unexpected contingencies such as un­
employment, sickness, accidents, etc.
• This is known as a precautionary motive. In the
case of households the decisions are affected by
these factors. Similarly, in the case of business
firms the decision is influenced by the element of
uncertainty of the future, i.e. economic
fluctuations.
• Keynes believed that the amount held for this
purpose depends positively on income.
• Note that for Keynes both the transactions and
the precautionary motives are fairly stable and
constant function of income and both are
interest-inelastic.
• The money balances under these two motives are
referred as 'active balances' by Keynes.
• This amount varies from one individual to the
other and from one business firm to another. It
will depend upon the frequency of income, credit
arrangements, and con­version of assets into
money, degree of insecurity and uncertainty of
future
• But, these factors do not normally change in
the short period. Relationship between the
demand for active balances and money
income is, therefore, proportionately positive.
C) Speculative Motive:
• Speculative motive is the third motive for
which people hold money balances.
• Keynes calls such balances as 'idle balances'.
Speculative demand for money is thus, the
demand for holding cash for making
speculative gains from the purchase and sale
of bonds and securities owing to changes in
the rate of interest/dividend.
• Obviously, this demand is determined by the
rate of interest and bond prices.
• Note that the rate of interest and the bond
prices are inversely related.
• High bond prices indicate low rate of interest
and low bond prices indicate high interest
rate.
• For deciding, whether wealth should be held
in the form of money or bonds, an individual
inves­tor compares the current rate of interest
with the future rate of interest (or the nor­mal
interest rate as called by Keynes).
• If people expect the future rate of interest to
rise, they will anticipate capital losses on
bonds. To avoid this people will sell their
bonds and keep cash holdings to lend it in
future at a higher rate of interest, because
when the rate of interest is low the bond
prices are high and when the rate of interest is
high the bond prices are low.
• Hence, the aggregate speculative demand for
money has an inverse relationship with the
current rate of interest. That is, when the
interest rate raises the speculative demand
for money falls and when it falls then the
speculative demand for money rises. Consider
the following figure
• Notice that the curve is smooth, reflecting the
gradual increase in the speculative demand for
money at successively lower interest rates.
• The curve flattens out at a very low rate of
interest, reflecting the fact that at this low rate,
there is a general expectation of capital losses
on bonds that outweigh interest earnings.
• At this rate increments to wealth would be held
in the form of money, with no further drop in
the interest rate. Keynes termed this situation
the Liquidity Trap
• Liquidity trap represents the subjective minimum
level of interest rates.
• An important characteristic of the speculative
demand for money is that when the current rate of
interest becomes very low people have no desire to
lend money but they want to keep the whole money
with them.
• This is the minimum critical level of the current rate
of interest at which everybody becomes a money
holder instead of a bond holder.
• In fact in such a situation the yield of bonds
becomes so low and the risk becomes so high that
the people do not want to keep bonds.
• Keynes held that cash balances held for
transactions and precautionary motives are
primarily determined by the level of income.
That is, LT= f(Y), and the speculative demand
for money is determined by the rate of
interest Ls= f(r). In this way, the total demand
for money is determined by both income and
interest:
• LT + Ls = f(Y) + f(r)

Or L = f(Y) + f(r)
Or L = f (Y, r) ……………… (3.1)

• where L is the total demand for money

II. The Post-Keynesian Approaches
(Portfolio Balance Approach)