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Keynes identified three motives for holding money: transactions (regular purchases), precautionary (unexpected expenses), and speculative (avoiding capital losses when rates are expected to rise). Money demand increases with income and decreases with interest rates.
Illustrate each motive with concrete examples. Show how total money demand combines all three components.
From your work on money's functions, you know that money serves as a medium of exchange, a store of value, and a unit of account. These functions naturally give rise to distinct reasons why individuals and businesses want to hold money balances rather than converting them into interest-bearing assets. Keynes was the first to systematically decompose money demand into its component motivations, and that decomposition remains the foundation of monetary economics.
The transactions motive is the most intuitive: people need money on hand to make routine purchases. Even if income arrives weekly or monthly, spending is continuous — you need cash to pay for groceries on Tuesday even if your paycheck doesn't arrive until Friday. The quantity of money demanded for this purpose rises roughly proportionally with income: more income means more purchases, which means larger cash buffers. The precautionary motive is an extension of the transactions motive: people also hold extra money as a buffer against unexpected expenses — a medical bill, a car repair, an emergency. This demand also rises with income, partly because higher-income individuals have more at stake and partly because their expenditure patterns are more variable.
The speculative motive is Keynes's most original contribution and his most lasting insight about why interest rates affect money demand. The alternative to holding money is holding bonds, which pay interest but also fluctuate in price. Bond prices move inversely with interest rates: when rates rise, existing bond prices fall. If you expect interest rates to rise in the future, holding bonds is risky — you'll suffer a capital loss that could exceed the interest earned. In that case, it makes sense to hold money instead, preserving your nominal value while you wait for rates to stabilize. Conversely, when interest rates are high (expected to fall), bonds offer both high current yield and prospective capital gains, so money becomes costly to hold relative to bonds. The speculative demand for money therefore falls as the interest rate rises — a downward-sloping relationship in the money demand function.
Combining all three motives gives total money demand as Mᵈ = L(Y, i), increasing in income Y and decreasing in the nominal interest rate i. This function — the liquidity preference curve — is the demand side of the money market. Its interaction with the money supply determines the equilibrium interest rate, which is the core mechanism through which monetary policy affects the real economy in the Keynesian framework and the building block of the LM curve in the IS-LM model you'll study next. The critical insight is that money is not demanded just for transactions; it is held because it offers liquidity — the ability to act quickly in an uncertain world — and the price of that liquidity is the foregone interest on bonds.