THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 588

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PA R T V I I Monetary Theory
Let us now examine the theories of money demand that arose from this search
for a better explanation of the behaviour of velocity.

KEYN E S S LI Q U IDI TY PRE FE RE NC E TH EO RY
In his famous 1936 book The General Theory of Employment, Interest, and Money,
John Maynard Keynes abandoned the classical view that velocity was a constant
and developed a theory of money demand that emphasized the importance of
interest rates. Keynes, at Cambridge at the time, naturally enough followed the
approach developed by his Cambridge predecessors. His theory of the demand for
money, which he called the liquidity preference theory, also asked the question, why do individuals hold money? But Keynes was far more precise than his
predecessors regarding what influences individuals decisions. He postulated that
there are three motives behind the demand for money: the transactions motive,
the precautionary motive, and the speculative motive.

Transactions
Motive

In the classical approach, individuals are assumed to hold money because it is a
medium of exchange that can be used to carry out everyday transactions.
Following the classical tradition, Keynes emphasized that this component of the
demand for money is determined primarily by the level of people s transactions.
Because he believed that these transactions were proportional to income, like the
classical economists he took the transactions component of the demand for money
to be proportional to income.

Precautionary
Motive

Keynes went beyond the classical analysis by recognizing that in addition to holding
money to carry out current transactions, people hold money as a cushion against an
unexpected need. Suppose that you ve been thinking about buying a fancy stereo; you
walk by a store that is having a 50%-off sale on the one you want. If you are holding
money as a precaution for just such an occurrence, you can purchase the stereo right
away; if you are not holding precautionary money balances, you cannot take advantage of the sale. Precautionary money balances also come in handy if you are hit with
an unexpected bill, say for car repair or health needs not covered by insurance.
Keynes believed that the precautionary money balances people want to hold
are determined primarily by the level of transactions that they expect to make in
the future and that these transactions are proportional to income. Therefore, he
postulated, the demand for precautionary money balances is proportional to
income.

Speculative
Motive

If Keynes had ended his theory with the transactions and precautionary motives,
income would be the only important determinant of the demand for money, and he
would not have added much to the classical approach. However, Keynes took the
view that people also hold money as a store of wealth. He called this reason for
holding money the speculative motive. Since he believed that wealth is tied closely to
income, the speculative component of money demand would be related to income.
However, Keynes looked more carefully at the factors that influence the decisions
regarding how much money to hold as a store of wealth, especially interest rates.
Keynes divided the assets that can be used to store wealth into two categories:
money and bonds. He then asked the following question: why would individuals
decide to hold their wealth in the form of money rather than bonds?