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What Are Two Sources Of Money Demand?

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The first source of money demand is transactions demand. People and firms use as a medium of exchange: households need money to buy groceries, and firms need money to pay for materials and labor. These needs constitute the transactions demand for money. But how does the demand for money vary with interest rates? Suppose our family is paying an opportunity cost for its checking account, the interest rate on money is less than that on other assets.

As interest rate rise, the family might say let's put only half of our money in the checking account at the beginning of the month, and put the other half in a savings account earning 8 percent per annum. Then on day 15 we shall take that $1500 out of the savings account and put it in our checking account to pay the next 2 week's bills.

The second source of money demand is asset demand. In general a well-constructed portfolio or combination of assets may want to contain low risk investments as well as riskier ventures. But it is not generally advisable to hold checking deposits as one of these nest eggs. The reason is that other assets such as government securities are just as safe as checking deposits and have higher interest rates. So it might be sensible to hold your assets in money market mutual funds because these are high yielding safe assets.

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