Money Demand Essay

4889 words - 20 pages

Macro Notes 3: Money Demand 3.1 Demand for Money The notion of a demand for money may strike you at first glance as bizarre. Don't you just want as much as you can get? Or isn't money what you use when you demand other goods? Here is where we have to remember that money is a stock not a flow, and that income and wealth are not money. Demand for money is a question of how much of your wealth you wish to hold in the form of money at any point in time. (Supply of money is also a stock concept.)Your demand for money is how much of your wealth you wish to hold as money at any moment in time. It is thus a stock demand. Your wealth is a stock, and you must decide how to allocate that stock of ...view middle of the document...

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. Thus, one reason to hold money is to use it as a means of payment in transactions in the future. Now, if there was a perfect match between the moments you receive money in transactions and the moments you use money, you would not need to hold any money at all. If I were paid every Friday, and I could pay all my bills on the same day, then I would need to hold very little money.Unfortunately, in the real world, there is not going to be an exact match between when I receive money and when I need to make payments. Let us say that as a work study student, you receive $500 every month as payment for your work. This payment comes once a month. But you need to pay for rent, food, movies, books, copying, pens etc. This is spread out over the month. So, on the first of the month, you deposit $500 in you bank account at Fulton bank, and then you withdraw this money and run your account down to zero over the course of the month. In the course of the month, you hove an average money holding of $250. Same thing happens the next month, and the next, over the year.Your average holding of money then, is $250: this is how much you have on average in your bank account over the course of a year.If instead, you were paid $250 every two weeks, then you would hold $250 at the beginning of the two weeks, and run it down to zero over the course of two weeks, repeat this the next two weeks, and so on.Can you see that on average, you would be holding $125 in your account?In other words, the need you have for holding money balances will depend on the smoothness with which the time you get paid and the time you use the money to make payments mesh. Thus, the need to hold money balances is in part a result of the institutional payments mechanisms in the economy. An agrarian day laborer in India does not hold very much cash balances because she will get paid on a daily basis in small amounts and then use up the money she receives to pay for her transactions of purchasing food almost immediately. She will have a near zero holding of money balances. But in a system where people are paid with longer term contracts, regularized wages and salaries, and where they get paid in intervals of a week, a fortnight or a month, and where incomes are relatively stable, the need to hold money balances will be higher.Even if there was not a perfect match between my receipts of cash and the moments in which I use it as a means of payments for transactions, if I could costlessly and immediately convert any bonds I hold into money, then there is no reason to hold money. I would hold all wealth as bonds, and sell a bond for money the moment I need to make a purchase, holding money for only an instant.So for example, you are paid $500 per month. You hold an average balance of $250 as you start out the month with a $500 bank balance, and then run to down...

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