Transactions demand for money
Transactions demand, in economic theory, specifically Keynesian economics,
is one of the determinants of the demand for money (and credit), the others
being speculative demand and precautionary demand. The transactions
demand for money refers specifically to money narrowly defined to include
only its most liquid forms, especially cash and checking account balances. This
form of money demand arises from the absence of perfect synchronization of
payments and receipts. The holding of money is to bridge the gap between
payments and receipts. The transactions demand for money is due to the
household's motive to hold money for daily transactions and the business's
motive to facilitate daily operations.
The transactions demand for money is positively affected by the amount of
real income and expenditure, and is negatively affected by the rate of interest,
which is the opportunity cost of holding money for this or any other reason. It
also depends on the timing of expenditures and the length of the payment
period.
The Baumol-Tobin model focuses on the optimal number of transactions per
unit of time for a household, which dictates the transactions balances held on
average over time.
Precautionary Demand for Money
Keynes believed that apart from the money held for the planned
transactions additional money balance were held in case of unexpected
expenditures such as medical or repair bills.
Just like the transaction demand balances, these vary positively with
income and negatively with interest rate.
Because the motives for holding precautionary balances are similar to
those for transaction demand, we can simply sub assume precautionary
demand to be the “Unexpected Transaction Demand”.
SPECULATIVE DEMAND
Let’s ask the same question that Keynes asked.
Why an individual would hold any money above that needed for the
transactions and precautionary motives when bonds pay interest and money
does not?
This is because of the uncertainty about the future interest rates. If interest
rates were to move in such a way that the expected capital loss of bonds
outweighs the interest earnings on the bonds, investors would want to hold
money instead.
Such money would be held by those “speculating” on future changes in
interest rate.
This is mainly the speculative demand for money. Now, we have to see the
relation between interest rates and the speculative demand for money.
Interest rate is the opportunity cost of holding money. If interest rate is low
then there is less opportunity cost of holding money. That means that you will
have to forego very little amount of interest returns if you want to keep
money in your hand in comparison to if the interest rate was high.
Hence, if interest rates are low, more money is demanded and if interest rates
are high, less money is demanded.
Now let’s understand it with the help of example. Suppose you bought a bond
at the then prevailing market price of bond, let’s say at $1000 that entitles you
to payment of $50 per year. This is called coupon payment.
• Market interest rate is $50/ $1000 = 0.05
(5%)
• If interest rate remains same i.e. 5%, you will still sell the bond for
$1000
• If interest rate rises to 10%, going price today for a bond with a coupon
payment of $50 would be $50/0.10= $500.
You paid $1000 for a bond but now you will be selling it at a capital loss of
$500.
A rise in market interest rates results in a capital loss on previously existing
bonds.
• If interest rate falls to 2%, going price today for a bond with a coupon
payment of $50 would be $50/0.02 = $2500.
A decline in interest rate results in a capital gain on previously existing bonds.
Return on money is zero.
Expected return on bond= interest returns+/-expected capital gain or loss
If we expect the bond interest rate to rise, it is possible that expected capital
loss on bonds will outweigh the interest earning.
Money would be a preferred asset. Money held in anticipation of a fall in bond
prices is Keynes’s speculative demand for money.
Keynes converts this to a relationship between money demand and the level
of the interest rate by an assumption about how people form expectations
about future interest rate changes.
ASSUMPTION: Investors have a relatively fixed conception of normal interest
rate.
When actual interest rate is above the normal rate, they expect it to fall and if
it is below the normal rate, they expect it to rise.
Knowing this how expectations of interest rates are formed, we can develop a
relationship between level of speculative demand for money and interest rate.
M2: speculative demand for money by ith individual.
M1: transaction and precautionary demand
M1 + M2 = M
M + B = Wh
When actual interest rate is greater than normal rate, individual expect the
interest rate to fall. Bonds will be preferred.
M2=0
(Wh-M1= Bonds)
When the actual interest rate below the normal interest rate but above the
critical interest rate, still bonds will be preferred because interest earnings on
bonds will be greater than the expected capital loss.
This is because only a small rise in r is expected as r returns to normal interest
rate.
At critical interest rate, expected capital loss on bonds will be equal to interest
earnings.
The lower the interest rate, the more investors would find that given their
view of normal rate, money was preferred asset.
At very low interest rate, all investors would expect that interest rate would
rise in future and hence money will be a universally preferred asset.
EXTENSIONS OF KEYNES’S THEORY OF
MONEY AS A STORE OF WEALTH
Keynes’s theory can be criticized on two grounds:
1.) Keynes’s theory implies that investors would hold all of their wealth in
bonds as long as interest rates was above the critical rate. {a rate below which
the expected capital loss on bonds outweighs the interest earnings on bonds}
If interest rates fell below this critical rate, investors will transfer all their
wealth to money.
Keynes’s theory can not explain why an individual investor holds both money
balances and bonds as store of wealth, but such portfolios does occur.
2.) According to Keynes’s theory, investors hold money as an asset when
interest rate is low because they expect interest rate to rise and return to
normal level.
A crucial element of Keynes’s theory is the existence of a fixed or at least only
slowly changing normal level for the interest rates around which actual
interest rates fluctuates.
Keynesian economists have made some modifications that take into
consideration the portfolio diversification which doesn’t depend on Keynes’s
particular assumption about investor expectations of a return of the interest
rate to a normal level.
Demand for Money as a Behaviour
toward Risk
According to Tobin’s theory, the individual investor has no normal level to
which the interest rates are always expected to return. He assumes that
individuals believe capital losses and gains to be equally likely i.e. the
expected capital gain are zero. The best expectation of the return on bonds is
simply their interest rate (r). But this is only the “Expected Return”. The actual
return includes some capital gain or loss.
Thus bonds pay an expected return of ‘r’ but they are a risky asset as the
actual return is uncertain.
Money in contrast is a riskless asset. The nominal return on money is zero
which is lower than the expected return ‘r’ in the case of bonds. However
money involves no capital gain or loss.
The overall expected return of the portfolio would be higher if the portfolio
were all bonds, but an investor who is risk averse will be willing to sacrifice
higher return to some degree for a reduction in risk.
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The expected return on the
portfolio depends on the
interest rate (r) and the
proportion of the portfolio
that the individual places in
bonds.
The total risk associated with
the portfolio depends on the
uncertainty concerning bond
prices and the proportion of
the portfolio places in bonds.
The lower quadrant shows
allocation of portfolio
between bonds and money
which results in each riskexpected return
combination.
If the individual holds all his wealth (Wh) as money and none in bonds,
portfolio will have zero expected return and zero risk associated with it. This
is shown by the origin in the graph.
As the proportion of bonds in the portfolio increases, the expected portfolio
return and risk both rise.
The terms on which the individual investor can increase the expected return
on the portfolio at the cost of increasing risk are represented by the line T. As
the investor moves along T, more bonds and less money is held.
We assume that the investor is risk averse i.e. the investor will accept higher
risk only when compensated for it by increase in expected returns. The
investor’s utility function is given by
U=U(R,
Three different indifference curves, showing the terms at which the investor is
willing to accept more risk if compensated by higher expected return. As we
move from U1 to U2 to U3 we are moving to higher levels of utility. Greater
level of R is associated with given level of risk.
Indifference curves are upward sloping to show the risk averse nature. Curves
become steeper as we move to the right reflecting ‘increasing risk aversion’.
The more risk the individual has already taken on, greater will be the increase
in expected return required for the investor to accept addition in risk.
To determine the optimal portfolio allocation, the investor will move along the
T schedule till the point where it is just tangent to one of the indifference
curves. At this point the terms at which the investor is able to increase
expected return by accepting more risk, given by the slope of the T schedule,
will be equated to the terms on which the investor is willing to make this
trade-off, given by the slope of the indifference curve.
This is point of Utility Maximisation given by E. From the lower quadrant, we
can see that the portfolio corresponds to bonds = B* and money balances =
M*.
Thus Tobin wants to show that the demand for money is behaviour toward
risk.
It is the result of attempting to reduce risk below what it would be if all the
wealth were held in bonds. This gives the investor higher utility.
Money demand and rate of interest
Tobin's theory implies that the amount of money held as an asset depends on
the level of interest rate
An increase in interest rate will improve terms on which the expected return
on the portfolio can be increased by accepting greater risk.
At higher interest rate a given increase in risk which corresponds to a given
increase in the amount of bonds in the portfolio will result in a greater
increase in expected return on portfolio.
According to the figure
An increase in interest rate from r0 to r1 to r2 will rotate the T-schedule in a
counterclockwise direction - T(r0) to T(r1) to T(r2).
The point of portfolio optimization shifts from point E to F and then to G.
In response to increase in interest rate, individual will increase proportion of
wealth held in interest bearing assets, bonds and decrease holding of money.
Conclusion
Tobin’s theory implies, as did keynes, that demand for money as a store of
wealth depends negatively on the interest rate
Within tobin’s framework, an increase in i can be considered an increase in
payment received for undertaking risk.
When this payment is increased, the individual investor is willing to put a
greater proportion of the portfolio into the risky asset (bond) and thus
smaller proportion in safe asset (money).