Money Demand: Transaction Costs & Bonds

Traditional Motives for Holding Money

Keynes identified three main motives:

• Transaction Motive: This arises from the need to finance everyday transactions. The demand is positively related to income and the frequency of payments.
• Precautionary Motive: Individuals hold money as a buffer against unforeseen expenses. This demand is also positively related to income and uncertainty.
• Speculative Motive: This stems from the belief that bond prices (and hence interest rates) will change. If individuals expect interest rates to rise (bond prices to fall), they will hold more money, anticipating a better opportunity to buy bonds later.

Modifying the Motives in the Given Scenario

The scenario introduces a crucial element: a fixed cost for each conversion between money and bonds. This significantly alters the speculative demand for money.

Transaction and Precautionary Motives

These motives remain largely unaffected by the fixed conversion cost. The individual will still need money for transactions and as a precaution against unexpected needs. The demand will be primarily determined by income level and individual risk aversion. However, the fixed cost might encourage larger, less frequent transactions to minimize conversion fees.

Speculative Motive and the Fixed Cost

The fixed cost introduces a ‘band of indifference’ around the current interest rate.

• Small Interest Rate Changes: If the expected change in interest rates is small, the potential gain from converting to bonds will be less than the fixed conversion cost. In this case, the individual will prefer to hold money.
• Large Interest Rate Changes: Only if the expected change in interest rates is substantial enough to outweigh the fixed cost will the individual convert money to bonds.

This creates a wider range of interest rate expectations over which the individual will choose to hold money, effectively reducing the sensitivity of the speculative demand to interest rate fluctuations. The individual will only convert if the anticipated interest gain exceeds the fixed cost.

Determinants of the Individual’s Demand for Money

Based on the above analysis, the determinants of the individual’s demand for money are:

• Income Level: Drives the transaction and precautionary motives.
• Interest Rate: Influences the speculative motive, but its effect is dampened by the fixed conversion cost.
• Fixed Conversion Cost: A higher fixed cost reduces the sensitivity of the speculative demand to interest rate changes, increasing money holdings.
• Expectations about Future Interest Rates: Still play a role, but only significant changes in expectations will trigger conversion.
• Risk Aversion: Impacts the precautionary motive. A more risk-averse individual will hold more money.

The individual will optimize their money holdings by balancing the benefits of earning interest on bonds against the costs of conversion. This optimization will result in a less elastic demand for money compared to a scenario without conversion costs.