Therefore, at higher interest rates people tend to hold less money for transaction purposes. In this way Baumol and Tobin emphasised that transaction demand for money is not independent of the rate of interest. If the holding company itself didn't co-sign on the debt, it isn't liable for the loss. Like other capital assets, money also yields return and provides services. Thus, the amount of money held under speculative motive depends upon the rate of interest.
One of the most important functions of money is that it is the universally accepted medium of exchange -- this is the main reason you hold money. That means people now hold less money, relative to bonds, than they used to and want to. Briefly, therefore, the speculative demand for money is a function of the rate of interest. The discount rate is a special rate that banks need to pay if they borrow reserves. Thus, the need to hold money balances is in part a result of the institutional payments mechanisms in the economy. The higher the price level, the more money balances a person has to hold in order to purchase a given quantity of goods.
In this way Tobin derives the aggregate liquidity preference curve by determining the effects of changes in interest rate on the asset demand for money in the portfolio of individuals. It is somehow one kind of biological motives. The cash held under this motive is used to make speculative gains by dealing in bonds whose prices fluctuate. That is to say, the transactions demand for money rises with the increase in income and vice versa. Three Reasons Why People Hold Money Why People Hold Money Economists have identified three broad motives: a. This can be explained in terms of opportunity cost of money holdings. In that case, shocks to money demand under money supply targeting will translate into changes in real and nominal interest rates and result in economic fluctuations.
An inverse relationship between the speculative demand for money and the rate of interest is depicted. According to Keynes, it is because of the existence of liquidity trap that monetary policy becomes ineffective to tide over economic depression. Tobin argues that a risk averter will not opt for such a portfolio with all risky bonds or a greater proportion of them. This is a stock equilibrium: there is a certain amount of money circulating in the economy, and a certain amount that people wish to hold. So consider a person who owns some land, holds some bonds, and has some stock market investments.
There is no intrinsic value in the money balances you hold except in their use as a medium of exchange. In this case, it is not worth it to move out of money into other assets and then back when you need to make payments on transactions, so you will hold a higher level of money balances. As soon the thing becomes old the effect of money as motivator vanishes. Supply of money is also a stock concept. Various researchers showed that money demand became much more unstable after 1975.
The longer the time-interval involved, the larger will be the money balances required to be held for transactions purposes and vice versa. Economists identify two reasons why people will demand money balances, or desire to hold a certain stock of money even if there is no intrinsic value for the money balances they hold. While most businesses and individuals may feel as though they would rather have their money working for them instead of simply being held, there could be valid reasons for not investing. It will be seen from Fig. When or if interest rates do fall, their bonds will rise in value.
Therefore, the demand for money is a function of liquidity preference. Interest represents the opportunity cost of holding money instead of bonds, saving and fixed deposits. What Are Three Types Of Motives? But the demand for money to satisfy the speculative motive does not depend so much upon what the current rate of interest is, as on expectations about changes in the rate of interest. If the money is awarded in continuous basis like monthly increment in allowances, the motivation effect remains alive for few months. If the interest rate is not that high, then it is not worth it to move in and out of money and bonds in order to receive this interest payment.
If a wealth holder chooses to hold a greater proportion of risky assets such as bonds in his portfolio, he will be earning a high average return but will bear a higher degree of risk. This is enough to generate a curve which plots the demand for money -- the amount you wish to hold as opposed to holding wealth as bonds -- as a function of r. On the other hand, a higher interest rate will induce them to reduce their money holdings for transaction purposes as they will be induced to keep more funds in saving deposits to earn higher interest income. Thus, the precautionary demand will be relatively stable. It can also be lower, though in that case the Fed would probably raise it so that banks would not be tempted to use Fed borrowing as a cheap source of funds. Therefore, the demand for money cannot be divided into two or more different departments independent of each other. Of course if I think that interest rates are unusually high, then I will buy as many bonds as possible to lock in the higher interest rate.