Explain in detail the various determinants

that imply a link between the interest rate

and the demand for money?

Money, Banking & Finance

Mohammed H. Khan

08178887 G. Thomas
B.A Finance

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Änitially classical economists assumed that the average number of times per year that a dollar
was spent (velocity) in buying total amount of foods and services produced in the economy
was constant. Ät was not until the Great Depression, that economists realised that velocity was
not constant. Ät was thus after the Depression era that economists began to search for other
factors influencing demand for money that might explain the fluctuations in velocity. Keynes
abandoned the notion of a constant velocity and came up with the Liquidity Preference theory
which attempted to answer, why people held money.

The demand for money can be defined as ³the desire to hold money, in the form of cash or
bank deposits enabling the buying and selling of goods and services´ (Bain et. al, 2005). The
demand for money theory assesses the trade off between holding money rather than other
forms of wealth and elaborates on the fallacy that the main purpose of holding money is
purely for everyday transactions. This essay will explain the three motivational theories put
forward by Keynes as to why people hold money and suggest whether each motivation can be
used to imply a link between the interest rate and the demand for money.

Money is defined as the medium of exchange for buying and selling goods and services. The
value of money can fluctuate because its purchasing power depends on the price of the goods
and services for which it is exchanged which in turn is dependent on the supply and demand
of goods and services and their availability. (v
).

The rate of interest is the proportion of a sum of money that is paid over a specified period of
time in payment for its loan. Ät is the price a borrower has to pay to enjoy the use of cash
which he does not own, and the return a lender enjoys for deferring his consumption or
parting with his liquidity (
  


Having identified and defined key terms, the essay will now move onto analysing whether
the three motivations put forward by Keynes for holding money imply a link between the
demand for money and key interest rates. Keynes () distinguished three motives for
holding money which had a relationship with interest rates. These are the transaction motive
(to meet day-to-day needs), the speculative motive (in anticipation of a fall in the price of
assets) and the precautionary motive (to meet unexpected future outlays).
The motivations infer that the amount of money held is determined by the interest rates, for
when interest rates are low it is cheaper to borrow and therefore demand for money is high;
meaning there is an inverse relationship between money demand and interest rates. Also,
increases in real income usually cause an increase in the demand for money.(

)

The first motive, the transaction motive infers the value of money for everyday purchases of
goods and services must equal the value of the goods and service sold for the exchange to
occur. This is represented by the following equation identity 



MV = PT [1]

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where M is equal to the amount of money in the economy, V is the velocity of money , whilst
P is the average price and T represents transactions in goods and services over a specified
period of time.

Thus MV is the total value of money required for purchases over a period of time and PT
signifies the value of goods and services produced. Äf T is considered in terms of real
income, Y and V now represent the income velocity of circulation, and then the identity takes
the form of:

MV = PY [2]

We can further modify this relationship if the identity for M is solved which would make
possible the derivation of transactions demand MT:

1
 X c ,

 [3]

As V is constant, it can be replaced with a constant K, and when the money market is in
equilibrium,

Mt = K PY [4]

Thomas () states this follows the transactions demand for real money balances which is
equal to:



X  .  [5]

This shows that K is constant and the level of transactions is dictated by a fixed level of
income. Therefore, under the quantity theory of money as stated by Fisher () that money
demand is a function of income and does not depend on the rate of interest. He proposed the
demand for money was determined by two factors, firstly the level of transaction with regards
to nominal income PY and secondly changes that alter individuals behaviour with regards to
transactions.
The empirical evidence supports the theoretical argument that the demand for money is a
desire for real balances. To paraphrase, individuals are concerned with real money holdings,
which is the demand for a money stock deflated by the price system. Äf behaviour is
unaffected by changes in the price level then individual agents are free from money-illusion,
holding all real variables constant. Real demand for money and behaviour remain unchanged.
Äf they are affected in their behaviour from a change in the price level, then it is said that
agents are suffering from money illusion.

However, Thomas (2010) refutes the classical explanation of money demand that individuals
only hold money in the form of notes and coins and not in interest bearing accounts, this

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claim is clearly devoid of reality, as income from work is paid in the form of bank transfers;
therefore expression [5] is not a coherent explanation of the transaction demand of money.

Since the transaction demand suggests people hold money as a medium of exchange to carry
out everyday transactions. Ät would be rational to study the trade off between the amount of
interest individuals forgo by holding money and the cost/insolvencies of holding small
amounts of money.
Suppose, an individual earns a monthly income of Y which is paid into a savings account
earning 1% interest per month, if households withdraw (n) their income at regular intervals,
they withdraw Y/n each time. Z can denote the size of each withdrawal from the saving
account. This can be shown as:

X

, 
  X .  å

Assuming spending takes place during the period when individuals hold cash, the average
amount of withdrawals is: Y n 2 X Z 2, or, / 2 ().

Say an individual makes 3 withdrawals from the saving account. Än month 1 they will transfer
the first Y/3 into cash which they use up, subsequently, another Y/3 will be withdrawn and
transferred into cash. The interest they forgo for holding the money is the interest rate
multiplied by the average balance which is denoted by:

 
 or .  [7]
2 2

Equation [7] implies the greater the demand for money and the higher each transaction the
more interest the individual forgoes. Mishkin (), suggests the size and the amount of
times transactions take place decreases as interest rates increases; suggesting further interest
rates affect demand for money.

Equation [7] does not include the cost or inconvenience associated with withdrawals from the
bank. Äf c represents transaction costs, then individuals incur nc cost over the month. The
total cost of managing their portfolio is:


 X  U .  [8]
2

Equation [8] implies transactions costs rise as the number of withdrawals increases, whilst
interest costs decrease. The equation can be minimised and differentiated using the quotient
rule to show the optimal number of withdrawals the individual should make to lower total
cost of holding money to meet transaction requirements. This is represented below:


* X .  [9]
2

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 The optimal point occurs when the benefit of a withdrawal equals the cost of the withdrawal
from the saving account; as illustrated below:

The financial benefit from further transactions is represented by the MB curve which shows
the interest saved by making another withdrawal and having a smaller cash balance on
average during the month. Total interest costs decrease as bank withdrawals increase, and
decreases rapidly as the number of withdrawals increase, this is why the MB curve is
downward sloping.

As the average demand for transaction balances is given by MT = Y/2n, if expression [9] is
substituted for n, the optimal transaction balance (M*T) is obtained and can be represented as:

* 

X . [10]
2 
where MT*, is positively correlated with real income and inversely linked to the rate of
interest. The greater the transaction cost the greater the demand for money. The transaction
demand for real money balances are positively related to real income, but are inversely linked
to the interest rate.
The transaction demand advocates there is a greater demand for money when interest rates
are low and vice versa.
Another, motivation for the demand for money is the precautionary motive. The
precautionary motive proposes people hold money as a cushion against an unexpected need,
for example, car repairs (v
 ). Keynes stated ³the precautionary money balances
people hold are determined primarily by the level of transactions they expect to make in the
future´, and that transactions must be in proportion to real income.
Thomas ) suggests in holding additional money, individuals create a higher opportunity
cost as they must consider the amount of interest they may lose on the additional money
withdrawn. Therefore, the optimal amount of withdrawals depends on balancing the interest
costs against the benefits of not being illiquid which occurs when the increased liquidity is
equal to the marginal cost (MC) as the MC of the withdrawal involves the interest forgone (i).
Ät is clear that the optimal amount of precautionary balance will be related to the rate of
interest as depicted in the graph. Ät shows as the rate of interest increases, the cost of each
transaction will also rise as the individual forgoes interest. The precautionary demand for

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money thus becomes lower with the
MC curve shifting from MC0 to MC1.
Marginal benefit will shift from MB0
to MB1 if income increases as there is
an increase in money holdings.

Evidently, the precautionary motive

implies the link between interest rates
and the demand for money, for it
infers the higher the rate of interest the more expensive withdrawals resulting in lower
precautionary demand for money.
The final motivation for the demand for money is speculative demand. This suggests people
keep some wealth in cash to take advantage of unexpected financial opportunities e.g.
through the stock market or bonds. Speculative demand is determined by the relation of three
rates of interest, current, actual and the expected future rate. Keynes analysis of the
speculative demand for money posed a dilemma as he assumed individuals only held money
or bonds to acquire wealth, but why would anyone hold any of their wealth in the form of
cash instead of higher interest earning or profit bearing assets? (>
 This leads to the
notion of a portfolio. Due to uncertainty about returns on insecure assets it would be unwise
to hold entire portfolios in one risky asset. Thus rational investors have diversified portfolios
consisting of low and high risk assets and expect the high risk assets to provide high returns.
Risk averse investors usually invest in safer assets which tend to have lower rates of return
than insecure assets. Money is a safe asset in that its nominal value is known with certainty.
Tobin   outlines a portfolio choice that suggests money would be held as the safe asset
in the portfolio. Än Tobin¶s model individuals hold wealth either in money M or bonds B, or
some combination of the two. Money does not earn a rate of interest and is an assured asset
(i.e. no real risk involved) where as bonds are assets which are susceptible to constant
changes in their price/value which suggests that an individual may gain or lose wealth by
holding bonds.

Bonds have an interest payment i, a bond in perpetuity has a price, pb which is equal to the

total yield A, divided by the rate of interest, which is p B X i . Also, pB is the purchase price.
The expected selling price is dependent on the expected interest rate that is p eB X A i e . Hence,
the expected gain or loss (ð) would be:

  ! !
M
" M"    !  

#X 

 X X . M 1 X M 1.
[11]
" !  ! 




This equation is important as it states the expectations of gain or loss (ð), in line with the
actual and expected interest.
Total earnings on the bond denoted by , will be the interest rate at the time of purchase plus
capital gains/loss in the form of
=i+ð [12]

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where is the bond, i is the interest and ð is the gain or loss.

The graphs below can be used to interpret the speculative demand for money.

At interest rate, i1, equilibrium is at point E1. At lower interest rate, i2, equilibrium is E2,
where the demand for money increases from M1 to M2. From this it is possible to derive the
speculative demand for money, which is a downward slope and shows an inverse relationship
between the demand for speculative money balances and the rate of interest.
Tobin¶s attempt to improve on Keynes study of speculative demand for money was not
entirely successful. There is still the problem of whether speculative demand for money
exists, as there are assets which have no risk but earn a higher return such as government
bonds which poses the question will there still be speculative demand for money? Mishkin
(2006) suggests no because investors are risk averse; therefore why would an investor want
to hold money balances as a store of wealth in terms of speculative demand for money.

The three motives for holding money can be amalgamated into one money demand
equation. Keynes suggested that people want to hold a certain amount of real money balances
(money in real terms) which in his three motives indicated would be related to real income 
and to interest rates
Keynes put forward the demand for money equation or the liquidity
preference function which states demand for real money balances Md/P is a function of i and
Y, that is:

 X $ ( , ). [13]
" M U

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where the minus below i means the demand for real money balances is negatively related to
the interest rate and the positive sign below  means demand for real money balances and
real income are positively related. Mishkin ) suggests in the Keynes theory of the
demand for money velocity is not constant but fluctuates with movements in the interest rate.
The liquidity preference equation can be rearranged as:

c 1

X .  [14]
 $ (, )

Multiplying both sides of the equation by Y and as Md = M in money market equilibrium,

velocity is equal to:

c

X X .  å

 $ (, )

A rise in interest rates encourages people to hold less real money balances for a given level
of income. Thus the rate at which money turns over (velocity) must be higher. This implies
interest rates haves substantial fluctuations, the liquidity preference theory of the demand for
money indicates velocity has substantial fluctuations too.

The speculative model provided another reason for why velocity fluctuated substantially. Äf
people expected future normal interest rates to be higher than current normal interest rates,
then more people would expect price of bonds to fall and expect capital losses. The expected
returns from holding bonds would decline and money will become more attractive relative to
bonds; resulting in increase demand for money. This means that —(i,Y) will increase and
velocity will fall. Velocity will change as expectations change about future normal interest
rate changes. Unstable expectations about the future movements in normal interest rates can
lead to instability of velocity. (!)

Overall, Keynes three motivations for why people held money was the transaction motive,
the precautionary motive and the speculative motive. The transaction motive outlined that
holding money is solely for transaction purposes and has a sensitive inverse relationship with
the rate of interest. Precautionary demand for money suggests people hold money because of
the uncertainty of the future where unpredictable purchases may take place; precautionary
demand has an inverse relationship with the interest rate. Speculative demand for money
states that money is held for wealth purposes and suggests people who have wealth will want
to hold it in specific assets other than cash. Speculative demand has an inverse relationship
with interest rates as when interest rates are low people abandon buying bonds because they
are expensive and prefer to borrow money because it is cheap.

Keynes demand for money theory suggested velocity is not constant but is positively related
to interest rates. This is because changes in people¶s expectations about normal level of
interest rates causes shifts in the demand for money causing velocity to change as well.

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Overall, all three demands for money motives are positively related to real income and
inversely related to the interest rate.

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