ECON 1002
TUTORIAL SHEET 4
QUESTION 3 (SOLUTIONS)
Part (a)
Why do people demand money? What lowers the demand for money?
The amount of wealth that everyone in the economy wishes to hold in the form of money
balances is called the demand for money.
Three motives for holding money: the transactions motive, the precautionary motive and the
speculative motive.
The transactions motive
Most transactions require money. For example, money passes from consumers to firms to pay
for the goods and services produced by firms, and money passes from firms to employees to
pay for the labour services supplied by workers to firms. Money balances that are held to
finance such flows are called transactions balances.
The transactions motive arises because payments and receipts are not synchronized.
There exists a positive relationship between transactions balances and GDP. Therefore, the
larger the value of GDP, the larger the value of transactions balances that will be held.
The precautionary motive
Precautionary balances provide a cushion against uncertainty about the timing of cash flows.
People often demand money as a precaution against an uncertain future. Unexpected expenses
such as medical bills often require immediate payment. The need to have money available in
such situations is referred to as the precautionary motive for demanding money.
The precautionary motive arises because individuals and firms are uncertain about the degree
to which payments and receipts will be synchronized.
The precautionary motive, like the transactions motive, causes the demand for money to vary
positively with the money value of GDP.
