Well, so far, we've talked about the kinds of money. From commodity money, like gold coins, to bank money, and paper or fiat money. And we have also looked at the functions of money, as they serve as a medium of exchange, unit of account, and store of value. Our next question for this module is this. What determines the actual demand for money? We shall now see, we can think about the answer to this question in two main areas. Transactions demand for money, and the asset demand for money. The transactions demand for money arises, because people and businesses use it as a medium of exchange. For example, households need money to buy groceries. And firms need money to pay for materials and labor. This figure illustrates the mechanics of transactions demand. Here, we can see the average money holdings of a family that earns a $3,000 paycheck per month. Keeps it only in money, and spends the money during the month. Simple calculation will show that the family holds $1,500 on average in money balances. Now, the basic determinant of the amount of money demanded for transactions is, the level of nominal gross domestic product. As a rule, the larger the total money value of all goods and services that are exchanged in the economy, the larger amount of money that will be needed to negotiate these transactions. So, what do you think will happen to the transactions demand for money, if prices and nominal GDP doubled? Of course, if prices and nominal GDP double, the transactions demand for money will double. Now, the second major determinant of the demand for money, is the asset demand motive, or so-called, speculative motive. This arises because people use money as a store of value. As an example of the asset demand for money, suppose you are interested in investing in some stocks. But further suppose that after doing some research, you decide that at present, the prices of the stocks you want to buy are too high. In this case, you might decide to hold on to some cash rather than invest in the stocks now. But, you are holding the cash so you can be ready to buy the stocks when the prices become more attractive. In other words, you are intelligently speculative that a better financial opportunity will appear soon, in the form of lower stock prices. Note, however, that while money is an asset, money provides no rate of return or interest, and other assets, such as, stocks or savings accounts do. Now, here's the key point. When you hold money, its value can depreciate because inflation can erode its purchasing power. And that key point leads to this key concept. There is an opportunity cost to holding money that comes in two forms. First, here is the aforementioned loss of purchasing power when you hold money that arises because of inflation. Second, there is the interest rate or rate of return that you could have earned buying a bond or investing your money in a stock. So, here's the fun question. What do you think will happen to the asset demand for money if interest rates rise? And what do you think will happen to the asset demand for money if the expectation of inflation falls? Please jot down your answers now to both of these questions before moving on to the final words of this module. Well, if interest rates rise, the asset demand for money should fall, because the opportunity cost of holding cash is increased. In contrast, if your expectation of inflation falls, you will perceive a lower opportunity cost in the form of less risk of loss of value of your money due to inflation, so the asset demand for money will rise. Got it? If so, take a breather, and then move on to the next module, in one of my favorite stories of all the macroeconomics. If not, you may want to review the material before moving on to the next module.
