Page 149 - DECO201_MACRO_ECONOMICS_ENGLISH

Macro Economics

Notes For example, at a high rate of interest, one may be tempted to assume the greater risk of
a smaller precautionary balance in exchange for the high interest rate that can be earned
by converting part of this balance into interest bearing assets.
Although precautionary demand may be formally distinguished from transactions demand,
the total amount of money held to meet both demands is viewed primarily as a function
of the level of income.

The Speculative Motive

Speculative demand for money is for taking advantage of fluctuating prices of bonds. The
market price of a bond depends on (i) the bond ROI and (ii) current market ROI. Higher the
current ROI, lower the market price of bond. There is inverse relation between market ROI and
market price of bond.

Example: Suppose a person buys a new bond at an issue price of 1000, and carrying 8%
ROI. Suppose after sometime the market ROI rises to 10%. Now, if that person wants to sell the
bond, he will not get 1000, but he will get less. Why should one buy the old bond at 1000 and
earn only 8%? He will buy a new bond for 1000 and earn 10%. However, if the old bond is
available for 800, he will buy it, because investing 800 gives him an income of 8 which
equals 10% ROI.
Given inverse relation between ROI and market price of bond, how is speculative Md related to it?
The “speculation” is about whether ROI is going to fall, or going to rise in future. The expectation
is that if the ROI is higher than normal, the chances are that ROI will fall in future. ROI higher
than normal means lower price of bond. So, buy bonds when ROI is high. Buying bonds means
less holding (demand) of money. Therefore, higher the R/I lower the speculative Md.
By the same reasoning, sell bonds when the ROI is low. Selling bonds means more holding
(demand) of money. So, lower the ROI, higher the speculative Md.

Task Give examples to show that money has a transaction demand and speculative
demand.

Self Assessment

Multiple Choice Questions:
11. ....................................... is the opportunity cost of holding money.
(a) Income (b) Savings
(c) Expenditure (d) Interest
12. There is ...................................... relation between ROI and demand for money.

(a) Direct (b) Inverse
(c) No (d) Indirect
13. Average rupee amount of each transaction depends upon .............................

(a) Income (b) Interest
(c) Price level (d) GDP

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