Demand for Money: Theory, Models, and M1 Analysis

Introduction to Money Demand

In economic terms, money can be defined as holdings of cash or non-interest-bearing bank accounts. Since these holdings are less advantageous than interest-bearing accounts or other forms of investment, there must be some motivation to keep cash or completely liquid assets. A range of motivations can be used to describe this behavior, and most of them involve liquidity in one form or another. For example, it is necessary to have liquid assets to make purchases or pay bills. When an individual receives a paycheck, they may deposit a portion of it into an investment account while keeping a portion liquid to cover monthly living expenses.

An individual may also move money into a liquid account when planning to make a purchase in the short term. On a macroeconomic level, the demand for holding money can also serve as an indicator of the state of the economy. For instance, if more people are holding money in aggregate, this could signal certain trends such as increased market volatility. This paper provides a brief literature review of this indicator and performs basic calculations using real data obtained from the Federal Reserve Bank of St. Louis.

Literature Review

The demand for money remains one of the most extensively studied topics, both theoretically and empirically, in macroeconomics. Since Goldfeld's (1976) study on the so-called "missing money," the correct specification of the money demand function has been an ongoing issue. More recently, the stability of U.S. money demand remains a hotly debated subject (Davis, Karemera, & Whitesides, 2013). Since the recessions of 1982 and 1993, and more recently 2008, many economists have posited a structural shift in the demand for money. These downturns have provided the foundation for economic debate, with some economists arguing that a complete structural shift in money demand has occurred, while others believe the changes are more temporary in nature.

There may also be factors beyond recessions and periods of uncertainty that affect the demand for money. Technology, for example, may play a role. Despite major improvements in payment technologies and their widespread diffusion over recent decades, cash transactions still account for a large share of overall payment transactions, both by number and by value. A recent cross-country comparison by Bagnall et al. (2014) found that more than half of the volume of point-of-sale (POS) transactions are paid for with cash, with the highest share at 82% in Austria and the lowest at 46% in the United States (Huynh, Schmidt-Dengler, & Stix, 2014).

Such trends in banking and payment technology can influence the relevance of M1 money holdings. Many banking technology improvements now allow consumers to pay for major purchases from interest-bearing accounts that would not traditionally be counted in the M1 money segment. Examples include money market accounts tied to checking accounts, or independent accounts that earn interest while remaining fully liquid. These technological improvements in banking have blurred the lines between interest-bearing and non-interest-bearing accounts, with implications for how the M1 money supply is measured.

Despite the varying measures and factors involved in accounting for money demand, the stability of long-run money demand is widely researched because it is relevant for policymakers. An unstable money demand — such as that caused by financial reforms in the 1970s — led several central banks to abandon money targeting in favor of using the interest rate as a monetary policy instrument (Dobnik, 2013). Newer models suggest that money demand might be a function of wealth and could be viewed from a portfolio perspective. For example, a wealthy investor might keep some money in cash or checking accounts simply to maintain liquidity when needed.

There is also debate about the most effective approach to monetary policy. The principal purpose of identifying aggregate money demand from households, businesses, and the government is to maintain the level of money needed to generate the desired levels of output, employment, and price stability (Kolluri, Singamsetti, & Wahab, 2012). Some believe that targeting the interest rate is a more effective way to control the money supply, while others view money demand and its stability as a critical monetary policy issue due to its direct link with money supply, interest rates, and economic growth. Several studies have examined aggregate demand for money, its stability, and its determinants — particularly income and interest rates — yet they have reported different results and reached differing conclusions, making it difficult to form a clear consensus (Kolluri, Singamsetti, & Wahab, 2012).

The Transaction Demand for Money

The demand for money is a function of how much wealth is to be held in M1 at any given time. There is an opportunity cost to holding money because it represents a foregone ability to earn interest through other investments. The simplest explanation for why people hold money is that they want to use it to purchase things. Money has no intrinsic value in itself; it only provides value when exchanged for goods or services. For example, money cannot be consumed directly, but it can be used to buy a meal. Thus the value of money is realized only through transactions.

If buying stocks and bonds were costless and instantaneous, M1 holdings would be virtually zero. However, it normally takes time and money to convert non-liquid assets into liquid ones. Therefore, most people hold a certain average level of money in their budget to pay for immediate needs — a concept referred to as the transaction demand for money. The transaction demand for money depends on three factors (Charusheela & Danby, 1998):

a) Interest rate: The interest rate is effectively the price of holding money balances — it represents the income foregone when holding money rather than investing it. If the interest rate rises, the returns on moving between money and other assets increase, so people will hold lower money balances. If the interest rate falls, the benefit of moving out of money into other assets diminishes, so people will hold higher money balances.

b) Aggregate income: If the volume of income and output in the goods markets increases, there will be a larger volume of transactions taking place. People will therefore need to hold a larger volume of money to meet those transactions and make payments.

c) Price level: If prices rise, people need to hold higher money balances to meet their payment obligations. If prices fall, a lower volume of money balances is needed to support the same level of transactions.

To model these factors, Federal Reserve data was imported into Excel using the FRED add-in tool, which automatically downloads the data into workbooks for analysis. An initial attempt plotted GDP, M1, and interest rates together to identify graphical patterns. Although informative, this approach did not yield the needed measure, and M1 data appeared to cut off around the year 2000. A more suitable workbook based on the Keynesian money market model was then identified and used for the analysis below.

Works Cited

Charusheela, S., & Danby, C. (1998). Macro notes 3: Money demand. Retrieved from Washington University:

Davis, B., Karemera, D., & Whitesides, L. (2013). The intertemporal stability of the U.S. money demand function: New evidence from switching regressions. Applied Economics Letters, 581–586.

Dobnik, F. (2013). Long-run money demand in OECD countries: What role do common factors play? Empirical Economics, 89–113.

Federal Reserve Bank of St. Louis. (2014). M1 money stock. Retrieved from Economic Research:

Huynh, K., Schmidt-Dengler, P., & Stix, H. (2014). The role of card acceptance in the transaction demand for money. Working Papers (Oesterreichische Nationalbank), 1–38.

Kolluri, B., Singamsetti, R., & Wahab, M. (2012). Short-run and long-run money demand: Recent evidence. Journal of Accounting and Finance, 91–103.