Chapter 20: Money Demand
In its most basic sense, economics is about things. A person who wants food is motivated to undertake activities to obtain food, whether by directly producing food (such as farming) or producing something that can be exchanged for food, and money is merely the means by which this exchange takes place. In most instances, people will say that they want money, but what they really want are the things that money can buy. So the most basic demand for money is to have enough of it to be used in exchanges.
For most people, money passes through their hands rather quickly: the paycheck they earn on Friday buys groceries on Saturday or is mailed out to pay bills on Monday and they have a little left over to make purchases through the week. The vast majority of people live on a monthly cycle in which every cent they make is spent within one month. And so, their need of money is temporary and small - though in aggregate it seems significant.
People with a bit of experience or common sense also recognize money as a method of storing value for future use: they save up money to make major purchase, have a "rainy day" fund, save for their children's education, or save money to spend in their requirement. This desire to have spending power without an immediate purpose also drives the demand for money - and given the staggering sums that are saved up in pensions and individual retirement accounts, there is a significant demand to have money that is taken out of circulation.
It's also noted that the wealthier people are, the more money they tend to hold. A poor man may set aside a little cash to buy a new bed, a working-class family sets aside a little money to take a family vacation, a middle-class family sets aside money to send their children to college, and a wealthy family sets aside money to purchase a vacation home or a yacht.
Organizations (including businesses) have the same relationship with money that people do. They have money coming in and money going out, and manage a reserve of cash that enables them to persevere through periods when their expenses exceed their revenue. Organizations have a bit more sense and are a great deal more conservative in their estimates than the average person, and maintain very substantial reserves of money. And they likewise set aside money for major operations, such as opening a new store or factory.
It's mentioned that most wealth is not held in the form of money, but instead as investments because money loses its purchasing power to inflation - so the smart move is to hold money in vehicles that earn a return that is at least equal to the rate of inflation. The longer money is to be held, the greater the importance of placing it in a vehicle that will maintain its value.
Liquidity Preference Theory
The difficulty in predicting the demand for money is that it is largely a matter of preferences, which are not at all scientific. One can calculate the amount of money a person "needs" based on the costs of the goods that are necessary for his survival, but the amount of money a person wants is entirely subjective. How much is enough for a person to purchase comforts and luxuries is not objective, nor is how much a person wants to have set aside for emergencies and future purchases. It simply defies quantification.
And so, economists satisfy themselves by speaking of liquidity preferences rather than precise needs, and recognize that their calculations are entirely theoretical. There is some mention of John Maynard Keynes' liquidity preference theory, which has been largely dismissed as tautological and naive, in addition to being not very useful for predicting the demand of money. Keynes' later attempted to improve upon this by stating that the demand of money is "a function of" the need to make payments, the desire to have a contingency fund, and their speculation about the change in prices in the future - but this is also self-evident and the "function" could not be satisfactorily defined.
Other economists added their own refinements: that people have expectations about the performance of investment vehicles, that any investment must be worth the hassle of investing and the inconvenience of doing without their money for a while, that people are sensitive to inflation and tend to buy things sooner and hold the items (rather than the money to buy them) when they expect prices to rise, and so on. All of these observations are not at all brilliant, nor are any of them particularly well defined and quantified.
As such, we arrive at the beginning: people want some money to spend soon, and some more money to spend later. How much money they want for each purpose and how much time constitutes "soon" and "later" are entirely subjective and unquantifiable. We can look at spending and investing behavior of the past as a model for the future, and modify it arbitrarily when there is a predictable change, but there is ultimately no ability to understand nor precisely predict what quantity of money the participants in an economy (or even one person) will want to have.
Friedman's Theory of Money and Investments
Milton Friedman, another economist who was concerned with the money supply, considered money to be one form of value storage among several. While it is impossible to know what people want, it is possible to observe what people do with their money. Essentially, a person who has money has a limited number of options for what to do with it:
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Because each of these activities results in an outcome that can be more precisely measured, it is considered to be more useful. It also deals with a far more realistic and useful quantity - it is the amount of money people have, not the amount they want - as many people want an unlimited amount of money and will never actually have it.
The basic equation is rather uninformative: the sum of all wealth in an economy is divided into the amount that people hold, spend, and invest. An increase in one of these uses leads to a proportional decrease in the other two, because wealth must be moved from one of these uses to the other.
What made Friedman's calculations useful is that changes in the economic conditions can lead to predictable changes in the way in which people choose to manage their wealth. Expectations of increasing interest have little effect on the amount of money spent, but cause money that is held to be shifted into investments to take advantage of the higher returns; whereas expectations of inflation caused more money to be spent, decreasing both the amount held and invested.
By examining past events, Friedman was able to refine a model that could predict the demand for money (to spend or to hold) with reasonably good accuracy, though during certain periods of time (such as the 1970s), people would be more sensitive and react more dramatically than his model predicted. In any case, this model gave central banks a bit more precision in their ability to predict changes in the money supply.
Friedman's model, while quite remarkable, was by no means perfect and monetary economists have continued to theorize, model, critique, test, and improve upon methods for explaining the change in the demand of money, as will be shown in the next few chapters.