Demand for money: the transaction motive

Why do people hold money, instead of keeping all their wealth in things that earn interest? Holding money has an opportunity cost: the interest you give up. People still prefer some money because it is liquid (instantly usable): this is liquidity preference.

In general, people demand more money when their income rises, and less when interest rates rise.

The transaction motive. People are paid on one day but spend all through the month: receipts and payments do not match in time. So they hold money to bridge the gap. If someone is paid ₹3,000 on the first day and spends it evenly over the month, their money falls steadily from ₹3,000 to zero, so on average they hold ₹1,500.

Transaction demand for money is a fraction k of the value of transactions T: Md = k × T. Since the value of transactions depends on real output and prices, Md = k × P × Y: it rises with real GDP and with the price level.

The velocity of money, v, is the number of times a rupee changes hands in a period: v = 1 ÷ k. For example, if a money stock of ₹500 finances ₹2,000 of transactions in a month, each rupee is used 4 times: v = 4, and k = 0.25.

Note: the demand for money is a stock (an amount held at a time); transactions are a flow (over a period).