The demand for money may seem like a complicated or confusing financial term. But money demand all boils down to how much of your wealth you want to have in the form of actual money or cash, compared to the amount you want to keep in various investment accounts.
When we refer to “actual money,” we’re talking about spendable money that you have on hand. This could be cash that you have in your pocket or your home, or it could be the money that you currently have in your checking account at the bank. Essentially, any money that is available to you for spending at a moment’s notice would be considered actual money, or cash, for our purposes. Money demand is the process of deciding how much of that you actually need.
Any money you’ve accumulated in your savings account, mutual funds, retirement accounts, etc. would be considered investments. These funds are basically earning you more money over time by accumulating interest. Whereas having cash on hand won’t earn you any additional funds.
While many people might not consider the relationship between the money in their pocket or checking account and their investments, it’s important to understand it nonetheless. As you continue to grow in your personal finance journey, this term may become more relevant.
If you’re curious about demand for money, and how it may impact your life and your finances, read on to learn more about it. You’ll discover everything you need to know about the demand for money, how interest rates come into play, and what the money demand curve is all about.
What Is Money Demand?
Demand for money is something that each individual will need to consider for themselves based on their specific financial needs and goals.
How much of your money should you be keeping in investment accounts versus on hand for everyday spending? How will the ratio you determine affect your overall return on investment? Is there a benefit to keeping more cash on hand versus in investment accounts, or is it the other way around? These are all great questions to consider as you learn more about demand for money and how it impacts you.
Let’s start by discussing the benefits of having cash on hand as well as investing your money. Having money in your checking account is necessary and important for a number of reasons. You use that money for everyday expenses like gas, groceries, and bills. When unexpected expenses pop up you need to have cash to resolve them. If you had to pull money out of your retirement or mutual fund every time an expense arose you would soon find yourself out of savings.
The benefits of investing are fairly obvious as well. By investing some of the money you make you’re setting yourself up for success in the future.
Maybe you want to retire by a certain age so you contribute a certain amount to your 401K every month to meet that goal. You may also contribute a percentage of your income to other investments like mutual funds or other stocks. Investments are simply a way to earn more money with the money you already have.
If you’re currently in a position where you have a lot of money in investments, and you still have plenty left over for spending, then it’s time to start thinking about your demand for money. If you aren’t in a position like this, then it may be time to find ways to increase your income so you can invest more of your money.
Types of Demand for Money
When considering your own money demand, there are a few different ways to assess your financial situation. Demand for money can be broken down into three categories. Make sure to familiarize yourself with these before finalizing your specific plan for money demand.
You’ll want to consider:
- Transactions demand
- Precautionary demand
- Asset motive/speculative demand
Each of these is an important part of overall money demand. In addition to considering things like interest rates, financial goals, and your credit history, you’ll also want to be familiar with the following:
Transaction demand is one of the main aspects to consider within money demand. Transactions demand is the amount of money that you need to pay for everyday goods and services. It’s when you’re holding money aside from your paycheck to use for bills, groceries, rent, and other expenses. The amount of cash you need for these transactions is your transactions demand.
So how do you determine your demand for money when it comes to transactions? The easiest way to start would be to add up all of your everyday transactions. This will include rent, utility bills, groceries, loan payments, gas for your car, and any other regular expenses.
Even holding money aside for discretionary spending like going out for dinner or going to a movie would be factored into your transactions demand for money. Basically, the money in your checking account, no matter what you plan to use it on, would be a part of your transactions demand.
Having a budget is a great way to determine how much of your money supply you will need to hold for transactions versus other financial assets. A budget is essentially just a breakdown of all of the money you spend and all of the money you earn.
Creating a budget is fairly simple. Start by adding up all of your expenses. Once you have your total expenses, subtract that number from your total income. Now you know how much you have left over for your financial goals.
You can choose to make a budget on a daily basis, weekly basis, monthly basis, or even annual basis. Any money left over after your expenses can be put toward savings, investments, or discretionary spending.
It’s always a good idea to keep a budget so you know how much money you have to spend on any given day. A budget will also give you good insight into how much money to hold for transactions.
If you’ve ever heard of an emergency fund, then you’ve heard of precautionary demand for money. Money demand for the purposes of unexpected expenses or emergencies would be considered your precautionary demand for money.
We’ve all had the need for some extra cash at some point in our lives. Bills pop up that we forgot about, injuries and medical bills occur, and vehicles break down. When these things happen, it’s always helpful to have some money set aside to deal with emergencies.
Deciding how much money to have in your emergency fund is deciding what your precautionary demand is.
Experts advise a three-month emergency fund. This means enough money to be able to afford your regular expenses and bills for three months.
Now, this can be a daunting amount of money to save. Especially if your income isn’t very high and you have a difficult time setting money aside. But your focus shouldn’t be on saving three months’ worth of money, it should be on saving as much as you can afford to with each paycheck.
Start by aiming for a two-week emergency fund. Then once you save that much, set your sites higher with a one-month fund. Eventually, if you’re diligent and disciplined, you’ll have a solid emergency fund to cover your precautionary demand.
Asset Motive/Speculative Demand
Speculative demand for money is the process of deciding whether or not your money should be in stocks and bonds or not, based on the current market conditions.
The easiest way to understand speculative money demand is through the example of someone who is holding money in the form of bonds. When you have your money in bonds, the value of that money can rise and fall depending on the financial market.
If a bond holder thought that the value of bonds was going to drop, they may decide to remove their money from the bond and hold money in cash instead. Thus, avoiding a loss in the value of their money. So they are “speculating” that their money will be worth more outside of bonds.
Determining your own personal speculative money demand will take a fairly thorough understanding of financial markets. So if you’re interested in investing in stocks and bonds consider starting by taking some online courses on those subjects.
What Is an Interest Rate?
An interest rate is essentially the cost of borrowing money in one form or another. Interest rates are fees that are charged, expressed through a percentage of the Principal, for the service of borrowing money or using credit.
The interest rate charged for various loans or credit products will vary. Mortgages, credit cards, lines of credit, auto loans, and bank loans will all carry different interest rates. Knowing the interest rate for the loan or credit product you’re considering is one of the most important parts of the shopping process.
While there are usually other fees involved, the interest rate is likely the biggest indicator of how much the loan will cost you overall. Just remember, the lower the interest rates, the lower your interest payments, and the lower the total cost of the loan. Other fees to find out about will be application or an Origination fee, prepayment penalties, processing fees, and late fees.
As you can see, the interest rate is just one fee to consider. So how do you keep track of all of these charges? Fortunately, there’s an easy way to determine the overall cost of the loan with the interest rate and all of these other fees included. And it’s called the APR, or annual percentage rate.
Interest Rate vs. APR
The APR of a loan or financial product is the overall cost of borrowing if you have the loan for an entire calendar year. It includes not only the interest rate, but all other fees as well.
Like the interest rate, the APR will also be expressed as a percentage of the principal amount. The APR is a much better indicator of the overall cost of the loan than just the interest rate. Lenders are also required to disclose the APR no matter what financial product you’re considering. When you’re looking for a new credit card or loan, the best way to compare various options will be through the APR.
It’s also important to note that your APR, as well as your interest rates, will depend on a few different factors: the type of loan, the lender, the regulations where you live, and your personal credit history.
Simple and Compound Interest Rate
Knowing the difference between a simple interest rate and compound interest rate will be important in determining the type of loan and interest you choose.
Simple interest rates are charged only on the principal amount. While compound interest rates are charged on the total amount of both principal and previous interest charges. Basically, compound interest rates would be interest charged on interest.
Obviously when considering the interest rate for a loan or credit product, simple interest will save you more money in the long run than compound interest. But usually you won’t get to decide which type of interest rate you get. It will typically depend on the type of loan you choose.
Fixed Interest Rate vs. Variable Interest Rate
Another factor to consider when it comes to routine Personal finance, as well as demand for money, would be whether your interest rate is fixed or variable. When you pay interest, no matter the type of loan, it will either be a fixed rate or variable.
A fixed interest rate is one that stays the same throughout the life of the loan. Every interest payment you make, from when you take the loan out to when it’s fully paid off, will have the same interest rate. Many personal loans, auto loans, and even some mortgages offer fixed interest rates.
A variable interest rate is one that fluctuates over time based on the current financial markets. You’ll know if you have a variable interest rate if your interest payments change during the life of the loan. When the benchmark interest rate that all others are based on increases, your interest rate rises as well. And when it goes down, your interest rates fall with it.
It’s crucial to be aware of the type of interest rate you have with your loan. And if you’re choosing between fixed or variable interest rates, remember that there are pros and cons to both.
While a variable interest can be a good thing when the financial markets are doing well, they can also cost you more money when that shifts. When your interest rate rises, so do your loan payments. But with a fixed interest rate you’ll have consistency. A fixed rate allows you to plan for all of your payments regardless of where the benchmark rate is.
Choosing between these two interest rates—if you have a choice—will depend on your own specific financial situation and preferences.
The Relationship Between Interest Rates and Money Demand
So how does your interest rate play into your demand for money? Well, it could affect your demand for money in a couple of different ways.
The first would be through speculative demand. If you’re holding bonds and you suspect that the interest rate might drop, then you may choose to hold your money in cash rather than bonds. But if the interest rate may rise, you would likely continue to keep your money in bonds.
Money demanded may also be affected by interest rates when it comes to keeping your money in high-yield savings accounts, 401Ks, and other investment accounts. When the interest rate you’re getting is good, you may choose to keep more of your money in those accounts.
Demand for money may seem like a complicated financial concept. But when you break it down, it’s all about where you keep your money and why. How much should you have in savings? How much should you have in investment accounts? And how much do you need for regular everyday spending? When you can answer all of these questions, then you pretty much have money demand figured out for your specific financial situation.