III

Micro-Economic Foundations
of the Demand for Money
Summary

At the individual, or micro, level demand for money balances will be a function (i) of
the differential between the perceived yield on money and on other assets; (ii) of the
costs of transferring between money and other assets; (iii) of the price uncertainty of
assets; and (iv) of the expected pattern of expenditures and receipts. In practice,
analysis of the demand for money as a function of all these variables simultaneously
has proved difficult to handle, and so the analysis has been artificially segmented into
two main parts. First, consideration of asset-price uncertainty is suppressed and the
'transactions' demand for money is studied, involving minimisation of the costs of
undertaking expenditures. Then the 'speculative' demand for money is analysed
specifically incorporating asset-price uncertainty, but usually involving drastic sim-
plifying assumptions about transfer costs and/or the time pattern of expenditures.
This dichotomy is not valid; nevertheless the tradition of examining these two aspects
of the demand for money separately is followed here, since this approach has been so
common that the development, and literature, of the subject cannot be appreciated
otherwise.
We concentrate on the inventory-theoretic analysis of the transactions demand for
money, starting with Baumol's simplified initial model- which largely abstracts from
uncertainty - but moving on to the more complex but more realistic models,
developed for example by Orr, in which there is uncertainty about the future flow of
cash payments. Once such uncertainty is introduced it is difficult to distinguish the
'transactions' from the 'precautionary' motives for holding money. Section I then
ends with a short summary of the attack made on this approach by Sprenkle. He
claims, on empirical grounds, that the money holdings of companies, for example, are
far larger than can be explained by the inventory theory, and on practical grounds
that these models have overlooked many of the important institutional features of the
monetary system.
In Section 2, we begin with the restatement ofTobin's classic analysis of'Liquidity
Preference as Behaviour towards Risk' within a system with one safe and one risky
asset in a single period context, an analysis which is compared and contrasted with
Keynes's analysis of the speculative demand for money. The approach is then
extended to deal with the more general situation where the investor is confronted with
an assortment of risky assets, touching here on modern portfolio analysis. Finally,
some of the problems of moving from a single-period to a multi-period analysis are
presented, though hardly solved.
In Section 3, we return to the inventory-theoretic approach, describing how this
strand of analysis has been extended during the last decade into a new, more macro-
economic, form, namely the 'buffer-stock' or 'disequilibrium' theory of money
holding. There are several versions of this latter approach, and we assess these

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C. A. E. Goodhart, Money, Information and Uncertainty
© C. A. E. Goodhart 1989
52 MONEY, INFORMATION AND UNCERTAINTY

separately. It is noted how closely this inventory-theoretic, buffer-stock approach

coheres with the paradigm of micro-markets outlined in Chapter I, with market
makers holding inventories of both cash and goods.

1. The Transactions Demand for Money

Because of uncertainty, especially owing to a lack of personal information as a result

of which A cannot be sure of B's creditworthiness, and vice versa, there will be a
demand for some instrument which will obviate the need either for such personal
information or for barter in the course of exchange transactions and will thereby
serve as a specialised means of payment. In Chapter 2, Section 3, we saw how a
government can issue monetary instruments of this kind in the form of liabilities
upon itself- even at a zero interest rate. Although the government can command, or
delegate - say to the Central Bank - monopoly control over the issue of legal tender
within its own demesne, financial intermediaries (banks) can provide liabilities which
will act as close substitutes for legal tender- i.e., as monetary liabilities fulfilling the
function of a means of payment. But banks could make their liabilities into close
substitutes for currency only by ensuring the maintenance of convertibility between
their deposit liabilities and legal tender and also by providing certain payment
transmission facilities that enhance the attractiveness of cheque payment. 1
The maintenance of sufficient reserves of legal tender to ensure instantaneous
convertibility and the provision of payment transmission services are expensive. It,
therefore, follows that private-sector financial intermediaries will have to offer a
lower rate of interest on demand deposits than on liabilities which are not im-
mediately exchangeable at a fixed rate into a legal tender (e.g., marketable assets), or
which are only exchangeable into legal tender at a fixed rate after a period of notice or
on an appointed date. In the latter case, there would be certain penalties, or
transactions costs, incurred should the asset holder attempt to switch back into legal
tender, or into demand deposits, before the due date. There can thus be a whole
spectrum of interest rates on private-sector liabilities; the intermediary is able to offer
a higher rate on those assets which it is not committed to redeem at short notice into
monetary liabilities at a fixed rate and which have a lower frequency of withdrawal,
since it can then deploy its earning assets in a higher yielding portfolio and provide
fewer transmission services; the investor, in turn, will demand a higher mean expected
yield to make up for the additional risk of variations in the nominal price of
marketable assets and/or the extra transaction costs of switching between non-
monetary financial assets and money.
Likewise, the public sector can also issue a range of marketable debt, not
exchangeable at a fixed rate into legal tender, and non-marketable fixed-price debt,
the convertibility of which into means of payment is limited by institutional
constraints or by transactions costs. Despite its ability to gain command over real
resources by issuing zero-interest fiat money, the authorities may prefer to issue
higher interest debt for that purpose, because the effect on the economy (and thus on

' In Section 5 of Chapter 2, we did consider briefly whether other financial intermediaries
could provide payments' services on the basis of liabilities (assets to their holders) not
convertible at a fixed par into legal tender, but with a varying nominal value. I believe that this
development may become more widespread, and in so doing confuse further the definition of
'money', but it is as yet a relatively small-scale phenomenon.