Money Demand and Interest Rates

What are Money Demand and Interest Rates?

What is Money Demand?

Money demand represents the desire to hold financial assets in the form of cash by an individual or organization. When discussing money demand, it’s important to note that it doesn’t signify the desire for cash itself (because everyone would certainly want more cash), but rather answers the question of how much financial assets one wants to hold at a particular time in the form of cash (instead of bonds, stocks, savings deposits, etc.).

Let’s consider a simple example. If you have 20 million dong in cash, and you intend to deposit 5 million dong into a savings account while keeping the remaining 15 million dong for transactional purposes, then your money demand is 15 million dong.

In another scenario, a company holds $200,000 in cash but needs to invest in a project worth $500,000. In this case, the company’s money demand is $500,000. To obtain this amount, they need to borrow or issue bonds and then sell the bonds to raise capital.

So, what motivates people to hold cash? According to the legendary economist Keynes, people have three main motives for holding cash:

  1. Transaction Demand: Essential expenses for individuals or organizations always exist, and the timing of these expenses varies. Therefore, some cash for transactional purposes is necessary. For example, a household always needs cash to pay for electricity, water, groceries, etc. Generally, transaction demand tends to increase as the economy grows.
  2. Precautionary Demand: People often hold cash as a precaution for unforeseen future situations that may require cash. Just as commercial banks must set aside reserves for bad debts, organizations borrowing money face the risk of default.
  3. Speculative Demand: In the FX market, speculative demand for a currency increases when many people believe that the currency will appreciate in the future. Additionally, speculative demand for cash can be demonstrated by a preference for holding cash instead of other financial assets (such as stocks or bonds) because you perceive them as riskier. In this case, money demand increases when the expected returns of risky assets decrease, or when their risks increase.

What is Interest Rate?

Interest rate is typically used in borrowing activities and represents the cost that borrowers must pay to lenders. However, from a macroeconomic perspective, interest rates have a broader meaning. It’s the cost of money, or in other words, it’s the cost of holding cash. The more cash you hold, the higher the cost you incur. Why is that?

If at a certain point in time you don’t have cash but you have a demand for it, then you will borrow and will have to repay principal and interest in the future. This means that interest rate is the cost of holding cash at the present time, which you wouldn’t have to pay if you didn’t borrow money.

Taking another example when you have cash available, if you invest it in risk-free assets like government bonds or deposit it in highly-rated credit banks, you will earn interest. However, if you hold all that money in cash, you won’t benefit from that interest rate. Thus, the opportunity cost of holding cash is the interest rate (which you could earn if you invested in bonds).

From these two examples, you can somewhat understand why interest rate is the cost of money.

Relationship Between Money Supply, Money Demand, and Interest Rates

For commodities, when prices rise, demand decreases. Similarly, for money, when interest rates rise (the cost of money increases), money demand decreases. Because then, you tend to invest more, at least in risk-free assets like government bonds with higher yields, and reduce the desire to hold cash. Conversely, when interest rates fall, money demand increases. Therefore, you can construct a money demand curve against interest rates as below, which is a downward-sloping curve.

Money Demand and Interest Rates

Money Demand and Interest Rate Relationship

For money supply, Central Banks have complete control over money supply regardless of whether interest rates in the market rise or fall. When they haven’t changed monetary policy, money supply is always a fixed quantity. Therefore, the money supply curve will be a straight line parallel to the horizontal axis, meaning it’s independent of interest rates.

Money Demand and Interest Rates

Money Supply and Interest Rate Relationship

If we construct both money supply and money demand curves on the same graph, they intersect at a unique point, where the interest rate is called the equilibrium interest rate. Typically, market interest rates tend to move towards equilibrium, where the amount of money people want to hold equals the money supply in the economy.

Money Demand and Interest Rates

Money Supply, Money Demand, and Equilibrium Interest Rate

When the interest rate is lower than the equilibrium interest rate (at interest rate r1 in the image), money demand exceeds money supply. In this case, people want to hold more cash, they sell bonds, leading to bond prices falling and pushing bond yields back to equilibrium. Conversely, when the interest rate is higher than the equilibrium interest rate (at interest rate r0 in the image), money demand is less than money supply, people have less desire to hold cash and buy bonds, pushing bond yields down, and interest rates move back to equilibrium.