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1. Learning Outcomes
After studying this module, you shall be able to

Understand what is meant by transactions demand for money.

Understand what is meant by precautionary demand for money.
Understand what is meant by speculative demand for money.
Understand the concept of active balances and liquidity trap.
Understand the portfolio approach.

2. Introduction

J. M. Keynes gave his theory on demand for money in his book

imply the actual cash balances that they hold but the amount of cash balance that they
want to hold. They want to hold money as it is the most liquid asset as it can be converted
into other assets. This desire to hold money (cash) rather than other forms of wealth
(stocks and bonds) is called the liquidity preference.
According to him, there are three motives of holding money in cash-Transactions motive,
precautionary motive and speculative motive and corresponding to each motive there is
the demand for money.

3. Transactions demand for money

The amount of money that people hold in cash to conduct their day to day personal and
business transactions is referred to as the transactions demand for money. Both
individuals and business enterprises hold money for transaction purposes. The need to
hold money for transaction arises because there is a time gap in the receipt of income
while the expenditure happens on a continuous basis.
The transactions demand for money is an increasing function of the level of money
income when other factors like spending habits of people, price level of goods, etc are
held constant. This can be depicted as
Mt = f(Y)

ECONOMICS Paper 6: Advanced Macroeconomics

Module 26: Precautionary and speculative demand for money, Portfolio
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Where Mt is the transactions demand for money and Y is the level of income in the
economy. The above function can be written as M = kY because in the short run, the
proportion of money income held for transaction purpose is constant.
This kind of demand for money is interest inelastic i.e. the demand for money held for
transaction purpose is not affected by the changes in the market interest rate as shown in
figure 1.

Figure 1: Transaction demand for Money

4. Precautionary demand for money

Apart from keeping money to meet transactions demand, people also hold money to meet
some unforeseen circumstances or contingencies like- medical expenses, repairs, etc.
This holding of money in excess to what is required for transaction purpose to meet
unanticipated needs is called the precautionary demand for money.
This demand for money too is determined by the income level and is interest inelastic. Its
relationship with the level of income can be depicted as
Mp = f(Y)
This shows that higher the level of income, higher would be the demand for
precautionary purposes both by households and business enterprises.
Since it is also interest inelastic, a curve depicting its relationship with interest rate would
be similar to the one shown in figure 1.
Active balances-The combined sum of money held for transactions and precautionary
purpose both by households and business enterprises is called active balance. This can be
shown as-
Mt +Mp = f(Y)

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5. Speculative demand for money

This demand for money is interest elastic. When the interest rate rises people prefer to
hold less of money in the form of cash since holding money as such has an opportunity
cost. While when the interest rates are on a decline (if they fall from i1 to i2 in figure 2),
the speculative demand for money rises (from M1 to M2). This inverse relationship
between rate of interest and speculative demand for money is represented in the
following figure 2.

Figure 2: Speculative Demand for money

Thus, the total demand for money is given by M tD =Mt + Mp +Ms (Sum of all the
three).And the total money demand curve would be a horizontal summation of all the
three curves and would be as depicted in figure 3

Figure 3: Liquidity Trap

Liquidity trap- It is a situation in which the prevailing interest rates are too low and
savings rates are high. This makes the monetary policy ineffective. In a liquidity trap,

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consumers tend to avoid bonds because they expect that the interest rates will soon rise.
Because bonds have an inverse relationship to interest rates, they do not want to invest in
an asset whose price is expected to decline.

6. Portfolio approach
Wealth can be held in the form of cash, shares, bonds, government securities, gold, etc. A
combination of these assets which the wealth holder holds is referred to his/her portfolio.
While holding of cash does not offer any return but other assets offer returns in the form
of interest, etc. The sum of investment in all these assets should be equal to the total
wealth of the wealth holder.
According to Mankiw, the demand for money function can be written as
{M/P}d = L ( rs, r b, e
, W)
-ve, -ve, -ve, +ve
Where M is the nominal money demand, P is the price level, r s is the expected real return
on stock, rb is the expected real return on bonds e is the expected inflation rate and W
is the real wealth.
When the expected real return on stock or bonds increases, money becomes less attractive
and its demand falls. When the expected inflation increases, holding money is not
preferred therefore the negative relation. And the demand for money increases with real
wealth, implying a positive relation.
Utility of portfolio theory in studying money demand
The utility of portfolio theory in studying money demand depends upon the measure of
money supply we are considering.
The portfolio theories to studying money demand may not be plausible when applied to
M1 measure of money supply. This is because M1 includes only- currency notes and
coins with public, demand deposits of all commercial banks and other deposits with RBI.
These forms of money (M1 components) earn little or interest. They (components of M1)
are a dominated asset because they exists alongside other assets (such as treasury bills,
money market mutual funds and deposit certificates) which have the same risk as the
components of M1 but earn higher interest rate. Therefore these other assets dominate
M1. Portfolio theories therefore are not able to explain the demand for dominated form of
money (adapted from Mankiw).
Portfolio theories are more applicable when applied to broad measure of money supply
like M3.It is in case of M3 that risk, return becomes of utmost importance when deciding
on the portfolio.

James Tobin is a recipient of Nobel Prize in Economics. According to him, wealth

holders hold a diversified portfolio consisting of a variety of assets like- money, stock,
bonds, etc. There is an element of risk in the holding up of securities and the more the
risk assumed, the more is the expected return by the investor. Therefore, the investor tries
to obtain a balance between riskless assets such as money, which do not yield interest and
ECONOMICS Paper 6: Advanced Macroeconomics
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risky but high return giving assets such as stocks and bonds. This implies that the investor
faces a tradeoff between risk and return.
The relationship between risk, return and the process of selection of an optimal portfolio
by the investor can be explained through figure 26.4 in which
The X axis represents risk. On the OY axis, , portfolio in
bonds (in %) is shown. The investor is a diversifier who considers risk and return as
imperfect substitutes. He is willing to take greater risk if compensated by additional
return. This is why the shape of the indifference curve is as shown in the figure.
The straight line OD represents the terms at which market trades returns for risk and is
called the opportunity locus. Point O shows that the entire wealth is held in cash and
therefore the return is zero. Point F corresponds to the maximum return that the investor
can earn, by holding his entire wealth OW in bonds. The line OF measures the risk of the
assets portfolio, as a function of the percentage of total portfolio held in the form of
bonds.

Figure 4

Initially, the investor attains equilibrium at point E1, where OD1 is tangential to IC 1 and
the investor preference converges with the market. Any higher IC is not attainable in the
present market scenario and a lower IC would not be maximizing his returns for any
given level of risk. At this equilibrium position, he is investing OW1 amount of money in
bonds and holding the rest, i.e. WW1 amount of money in cash. His return is U1 while
the risk undertaken is R1.
The investor is holding a portfolio of bonds and money. The portfolio holding depends
upon- the bond holding line i.e. OF, the budget line i.e. OD and the shape of the IC i.e.
the nature of the investor.
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Thus the investor, who acts as a diversifier does not put all his liquid wealth either in cash
or in bonds but puts a part of it in each.

Effect of a rise in interest rate and the optimal portfolio curve

Suppose, the interest rate increases from i1 to i2.This would cause the opportunity locus
to pivot from OD1to OD2.This is because, for the same level of risk, the expected rate of
return is more (due to increase in interest rates). As return is the sum of interest rate and
capital gain, therefore when interest rate goes up, return also goes up.
So this new opportunity locus becomes tangential with an even higher IC curve i.e. IC2,
where the investor invests OW2 amount of money in bonds, holds WW2 amount as cash
and earns U2 return with a risk level of R2.
Therefore, when interest rate increases, the investor increases the investment in bonds
and reduces his cash balances.
Joining the two equilibrium points we get an optimal portfolio curve i.e. ab, which traces
the behavior of the investor due to changes in interest rates.

relationship between demand for money and rate of interest. As the rate of interest
increases, the portfolio favors the holding of bonds against money. However, it must be
noted that the optimal portfolio line is not a straight line but it is a curve which is concave
to the Y axis. As a result, the proportional increase in the rate of interest is possible only
when more and more bond holding takes place such that there is less and less of money to
be converted into bonds.

Money demand and portfolio approach

As the rate of interest increases, the bond holding increases as per portfolio approach.
This would imply that the aggregate money demand curve would show a negative
relation between rate of interest and demand for holding money. And since, money
holding declines at a faster rate, the M2 function or speculative money demand function
would be downward sloping and would be convex to the origin

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basis for understanding how in the presence of risk and while holding a portfolio of
assets, there exists a negative relationship between rate of interest and demand for real
cash balances.

Other types of investors

Broadly investors can be grouped as Risk averse and Risk lovers. Risk averse investors
desire more return for undertaking more of risk. In other words there is a positive
relationship between risk and expectation of return. Within this category there are two
types of investors-Diversifiers and Plungers. Diversifiers are those who undertake
incremental risk only when compensated by more than proportional return. This is a
normal behavior and therefore they are also called rational investors. In case of Plungers,
their behavior is somewhat abnormal because their expectation is that, with incremental
risk, although return should be positively related, but, it could decline in relative terms. In
this category there are two extreme types of investors, those who hold all money and
those who hold all bonds.
Finally there is a category of investors who are called Risk lovers. They are in the
speculative business for the thrill of it and therefore display perverse behavior. Their
expectation is that when risk increases then return would decline in absolute terms.

The above discussion o or to be

a diversifier. The following section would describe the behavior of other categories of
investors.

In case of plungers, the ICs would be upward sloping but concave to the X axis such that
for an increase in risk, the expectation of return would be less than proportionate. A
higher IC would be preferred to a lower IC because all along the curve, the return would
be higher for a given risk.

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There are three different ICs, U0,U1 and U2. U2 lies completely above the budget line,
OD, therefore it cannot be reached. Both U1 and U0 intersect the budget line at some
point implying that at least one combination on them is attainable. So the choice is
between U1 and U0. And since U1 is a higher indifference curve, the equilibrium would
be on U1 at point O, where the entire wealth is held in the form of money.

The second type of plungers have ICs that are positively sloped but increase less than
proportionately but are flatter than the all money category. Suppose there are three ICs
U0,U1 and U2.All the three of them intersect the budget line, OD, at different points. But
since U2 is the highest of them all so U2 would be preferred over U0 and U1.Any IC
above U2 is not available because at E, where U2 intersects the budget line, we are
investing our entire wealth i.e. OW in bonds and nothing more is left for investment.
Such an investor invests his/her entire wealth in bonds.
Risk lovers
There are three ICs, U0,U1 and U2.The investor would prefer a higher IC because for the
same risk the return is higher on a higher IC. At E0 and E1, the entire budget is not
expended, therefore, the investor would go all the way up to E2. At E2, the entire wealth
is held in the form of bonds. No amount of money is held as cash.

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Module 26: Precautionary and speculative demand for money, Portfolio
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7. Summary

The desire to hold money (cash) rather than other forms of wealth (stocks and
bonds) is called the liquidity preference.
The amount of money that people hold in cash to conduct their day to day
personal and business transactions is referred to as the transactions demand for
money. It depends on the level of income and is not affected by interest rates. It is
represented by the function Mt = f(Y).
Holding of money in excess to what is required for transaction purpose to meet
unanticipated needs is called the precautionary demand for money. This demand
for money is determined by the income level and is interest inelastic. It is
represented by the function Mp = f(Y) .
The combined sum of money held for transactions and precautionary purpose
both by households and business enterprises is called active balance.
Speculative demand for money is interest elastic. There is inverse relationship
between rate of interest and speculative demand for money.
The total demand for money is given by M tD =Mt + Mp +Ms.
Liquidity trap is a situation in which the prevailing interest rates are too low and
savings rates are high. Monetary policy is ineffective in this situation.

ECONOMICS Paper 6: Advanced Macroeconomics

Module 26: Precautionary and speculative demand for money, Portfolio
approach
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According to Mankiw, the demand for money function is given by {M/P}d = L (

e
rs , rb , W ).
Portfolio theories are more applicable when applied to broad measure of money
supply like M3.
According to James Tobin, wealth holders hold a diversified portfolio consisting
of a variety of assets like- money, stock, bonds, etc and there is an inverse
relationship between demand for money and rate of interest.
Investors can be classified as Risk averse and risk lovers. Risk averse in turn can
be classified as diversifiers and plungers.

ECONOMICS Paper 6: Advanced Macroeconomics

Module 26: Precautionary and speculative demand for money, Portfolio
approach