WHY DO PEOPLE HOLD MONEY?

We understand reasonably well what controls the supply of money (M). But the classical economists were never very satisfactory in explaining changes in V. Households arid businesses don’t generally decide to spend their money faster or slower. We need something that corresponds better to our knowledge of the way people make their spending decisions, if we are to have an acceptable theory of money in relation to spending.

Thinking along this line led another group of classical economists to the “cash-balances” approach, which emphasized the demand for money (then called “cash”) balances. Nobody wants to hold money for its own sake—you can’t eat it, drink it, or use it directly for anything. Money yields no return unless it is invested. People will spend the money they get unless there is some special reason for holding on to it. The crucial question therefore is: How big are the money balances that people feel they need to hold? Why do people hold this no-yield asset, money, instead of exchanging it for something of more direct use?

The big answer is, people hold money because of the buying power it gives them over goods and services, now and in the future. If John Doe decides he doesn’t need to hold as much money as he has on hand, he will spend it. But if he feels that he needs a larger money balance, he will hold down his expenditures relative to his income to build up his money balance. Conversely, if people want to reduce their cash balances, they increase their expenditures. Thus, changes in the desired level of money balances will have a direct impact on current spending. They don’t change the amonut of money there is to hold, but they do change V and hence the level of aggregate demand. Obviously, this approach is closely related to the money-velocity approach.

Recent analyses of why people decide to hold more or less money have generally stressed three motives for holding money: the “transactions” motive (having enough money for dayto-day individual and business purposes); the “precautionary” motive (having money on hand to be prepared for unforeseen contingencies); and the “speculative” motive (holding money because you think the prices of things you want to buy are coming down). When these motives grow stronger, total expenditures by individuals and businesses drop, given any fixed amount of money for the public to hold, because people will hold on to more of their money rather than spend it. Conversely, when the motives for holding money are weakening, you can look for increased spending. These motives provide a framework for analyzing the money balances that people will try to hold. If you combine them with an analysis of what determines the amount of M there is to hold, you have the core of the “cash-balances” approach.

Increasingly, modern economists have tried to simplify and clarify the public’s demand for money balances. Recent empirical studies suggest that the demand for money is basically a function of (that is, is dependent on) two variables: the level of income and the interest rate on close money substitutes like bonds. Thus, they write the demand for money balances as follows:

Md=f(Y,i),

where Md is the demand for money to hold, Y is income, and i is the interest rate. Higher income (Y) means a higher demand for money to hold, for transactions and possibly for precautionary purposes.7 Conversely, a higher interest rate on money substitutes induces people to hold less money, i.e., to shift from money to interest-yielding assets. This equation appears to fit past experience well, and hence, presumably, can provide a reasonable forecast of how much of any additional M people will choose to hold and how much to spend at any time. But the research results are not conclusive, and more econometric work is needed before we can be sure of the resuits.

Equilibrium and the Demand for “Real Balances.” Suppose that we all decide to build up our money balances by decreasing our expenditures relative to our incomes; as a group we want to hold more purchasing power in the form of money balances. We want to increase our “real money balances,” sometimes just called “real balances.”

Will the result be higher money balances all around? If your inclination is to say yes, stop and think again. With any given supply of money, there can be no change in the total amount of money balances held, because there isn’t any more money for the public to hold. Thus, the result of a general attempt to build up money balances is a decrease in total expenditures as V decreases, not an increase in total balances, as long as the total amount of money is unchanged. (Remember the fallacy of composition.)

Will this concerted attempt to accumulate purchasing power be completely thwarted? The answer is no. By pulling down total expenditures, the public’s desire to build up its money balances will ultimately decrease prices (and probably production and employment as well). As prices fall, the existing amount of money will command more real goods and services. Thus, even though the total stock of money remains unchanged, the public will succeed in increasing its “real balances.” People don’t plan it that way, but they increase the real value of their money balances by bringing on deflation, and possibly depression with it. When prices have fallen enough to give existing money balances the desired amount of real purchasing power in relation to incomes and other assets, the public’s demand for money balances will again be in equilibrium. People (households, businesses, and others) will again be satisfled to hold just the amount of money that exists.