by Jurgen Brauer, May 2003
Copyright: J. Brauer. No reproduction without permission.

When you go to your boss and ask for a raise, do you demand more money? Most people would say "sure, asking for a raise is really like demanding more money for the work I do." This is an example of a phrase, money demand, being used very differently by ordinary people and economists.

Here is what economists mean. By definition, all the material wealth that is yours must exist in some physical form (or else it would not be material). The wealth your home represents is in the physical form of a house. Your monetary wealth may be held in the form of savings, or bonds and stock holdings which, when converted to cash, also are material. In Africa, your wealth may be your cattle herd. For car mechanics and other crafts people, at least in the US, a good portion of your wealth may be locked up in your tools. More eclectically, people can hold wealth in the form of art collections, rare cars, hoards of precious metals, or cellars stocked with fine wines.

The point is that whatever material wealth you possess, you will hold it in one or more physical forms. Economists are interested in why people hold wealth in one form rather than another, and we theorize that, on average, the higher the return on holding wealth in one particular form, the more people will shift wealth to that category. For instance, if the bond market does well relative to the stock market, people would be expected, on average, to shift wealth from stocks to bonds.

Fair enough. But what does this have to do with money demand? Economists define "money" as that form of your wealth that you choose to hold either in cash or in checking and savings accounts at your bank. Money demand is "cash" demand. It follows that if the return on wealth held in non-cash forms is low, people will shift wealth back into cash. Our cash demand increases when non-cash markets aren't doing so well (and vice versa of course).

Demand for money ("cash") depends not only, as I assumed thus far, on rates of return in the non-cash markets. It also depends on habits and motives. One, for example, is the precautionary motive. Most people know that as a precaution they should hold at least three months worth of salary in cash (in your checking or savings accounts) in case unforeseen circumstances require some large outlay. Rather than being forced to sell your wine collection or part of your stock portfolio, it is preferable if you can simply tap into savings socked away for this purpose.

Interesting, you say, but what does it matter? Suppose that you have three months' salary in checking as a precaution. Now let's say the economy is doing badly, unemployment rises, and you feel that three months' salary isn't enough. You cash out part of your non-cash portfolio to lay up six months' salary. Your non-cash demand dropped, and your cash demand increased. What will be the effect on rates of return (interest rates) in the non-cash and cash markets? Since you are selling in the non-cash market, rates there will be dropping. And since you are demanding in the cash market, rates there will be rising.

This can pose a challenging problem for the economy at large and for the people at the Federal Reserve Bank whose obligation it is to manage the economy's interest rate. After all, a rising interest rate means not only that holding cash becomes more attractive. It also means that borrowing money to buy homes, or cars, or to finance an education, or to build a new office building, or to buy the car mechanics' tools, has become more expensive.

The higher the interest rate at which to borrow money, the less people will borrow. If I buy a new set of tools on borrowed money at seven percent, my new tools will need to generate more than seven percent return so that I can repay the loan. But if the interest rates go up to ten percent, I may not be able to generate enough income to pay that high rate. Economic activity stalls.

Thus, fluctuating money demand (the fluctuating desire to hold one's wealth in the form of "cash") influences interest rates which, in turn, influence the rate of borrowing funds which, in turn, influences overall economic activity of the country at large.

What can the policymakers do? About the only option is to adjust the money supply so that money demand fluctuations are matched by money supply fluctuations to nudge interest rates just where the Fed wants them to be.

Next time you go to see your boss about that raise, you won't be thinking about money demand the same way as before.