What Is the Demand For Money?

[Q:] I read the article "Why Don't Prices Decline During A Recession?" on inflation and the article "Why Does Money Have Value?" on the value of money. I can't seem to understand one thing. What is the 'demand for money'? Does that change? The other three elements all make perfect sense to me but 'demand for money' is confusing me to no end. Thanks.

[A:] Excellent question!

In those articles, we discussed that inflation was caused by a combination of four factors. Those factors are:

1. The supply of money goes up.
2. The supply of goods goes down.
3. Demand for money goes down.
4. Demand for goods goes up.

You would think that the demand for money would be infinite. Who doesn't want more money? The key thing to remember is that wealth is not money. The collective demand for wealth is infinite as there is never enough to satisfy everyones desires. Money, as illustrated in "How much is the per capita money supply in the U.S.?" is a narrowly defined term which includes things like paper currency, travellers checks, and savings accounts. It doesn't include things like stocks and bonds, or forms of wealth like homes, paintings, and cars. Since money is only one of many forms of wealth, it has plenty of substitutes. The interaction between money and its substitutes explain why the demand for money changes.

We'll look at a few factors which can cause the demand for money to change. For a more formal treatment of theories of the demand for money see Paul Turner's Notes on "The Demand For Money".

1. Interest Rates

Two of the more important stores of wealth are bonds and money. These two items are substitutes, as money is used to purchase bonds and bonds are redeemed for money. The two differ in a few key ways. Money generally pays very little interest (and in the case of paper currency, none at all) but it can be used to purchase goods and services. Bonds do pay interest, but cannot be used to make purchases, as the bonds must first be converted into money. If bonds paid the same interest rate as money, nobody would purchase bonds as they are less convenient than money. Since bonds pay interest, people will use some of their money to purchase bonds. The higher the interest rate, the more attractive bonds become. So a rise in the interest rate causes the demand for bonds to rise and the demand for money to fall since money is being exchanged for bonds. So a fall in interest rates cause the demand for money to rise.

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