Demand for money

Also called: Liquidity preference · Topic: Banking, Credit Creation and Monetary Policy · NCERT: Class 12, Ch 3 "Money and Banking"

Meaning

Demand for money (liquidity preference) is the amount of their wealth that people choose to keep as money, rather than as bonds or other assets that earn interest. It is a trade-off. People weigh the benefit of liquidity (being able to spend at once, at full value) against the interest they give up by holding cash.

• It rises with income and the price level, because people have more transactions to pay for.
• It falls when the interest rate rises, because holding cash then costs more.
• Formula (NCERT, Keynes): Md = Mᵀd + Msd = kPY + (rₘₐₓ − r)/(r − rₘᵢₙ)

It matters because the interest rate settles where money demand equals money supply. This is the route by which the RBI's liquidity operations move market interest rates.

Explanation

Why holding money has a "price"

• Liquidity means how easily an asset can be turned into other goods.
• Money is the most liquid asset. You can spend it at once, at full value.

• A fixed deposit, bond or house is less liquid. Turning it into cash takes time, costs something, or both.

• Opportunity cost of holding money (what you give up by keeping cash) = the interest you could have earned.

• Example: you keep ₹10,000 as cash for a year instead of putting it in a 7% FD. You lose ₹700 in interest.

• So the interest rate is the "price" of holding money.

• The interest rate does two jobs at once:

• Higher r → holding cash costs more → people hold less money.

• Higher r → loans cost more → firms borrow less for machines and factories → investment falls.

• Keynes gave two motives for holding money: the transaction motive and the speculative motive. Together they make up total money demand.

Transaction motive: Mᵀd = kPY

• Why people need it: income arrives at fixed points (for example, a monthly salary), but spending goes on every day. So people keep some money in hand in between.
• One-person example (NCERT): you earn ₹100 on day 1 and spend it evenly over the month. Your balance falls from ₹100 to ₹0, so the average money you hold = (100 + 0) ÷ 2 = ₹50.
• Two-person example (NCERT): A buys from B, and B buys from A. The same ₹100 changes hands twice. So ₹200 of transactions need only ₹100 of money.
• Formula: Mᵀd = kT, or in terms of GDP, Mᵀd = kPY
• T = total value of transactions in the period.
• k = the share of T that people hold as money (0 < k < 1).

• P = price level. Y = real income (real GDP). PY = nominal GDP.

• Velocity of circulation (v) (how many times one rupee changes hands in a period): v = 1/k, and v · Md = T.

• Two-person case: k = 100/200 = ½, so v = 2. Check: 2 × ₹100 = ₹200.

• Worked example: P = 2, Y = 500 units, k = 0.25.

• Nominal GDP = 2 × 500 = ₹1,000.
• Mᵀd = 0.25 × 1,000 = ₹250. v = 1/0.25 = 4.

• If prices double (P = 4), Mᵀd doubles to ₹500. People need more cash to buy the same goods.

• Link to the Quantity Theory: v · M = PY is the familiar MV = PY. If v stays steady, more money mostly means more spending in rupee terms.

Speculative motive: Msd = (rₘₐₓ − r)/(r − rₘᵢₙ)

• Speculative motive means holding money instead of bonds to avoid a capital loss (a fall in the market price of an asset you own).
• Bond prices move opposite to interest rates.
• A bond pays a fixed coupon (yearly interest on its face value).

• If market rates rise, old bonds with fixed coupons look less attractive, so their price falls.

• NCERT example: a 2-year bond, face value ₹100, coupon 10%.

• Price = C/(1+r) + (C + F)/(1+r)².
• At r = 5%: ≈ ₹109.29. At r = 6%: ≈ ₹107.33.

• A 1 percentage point rise in r causes a loss of about ₹1.96 per bond.

• How expectations drive behaviour:

• When r is high: people expect r to fall, so bond prices should rise. They buy bonds and hold little money.
• When r is low: people expect r to rise, so bond prices should fall. They sell bonds and hold money.

• So speculative demand falls as r rises. The curve slopes downward.

• Worked example: rₘₐₓ = 10%, rₘᵢₙ = 2%.

r	Msd = (10 − r)/(r − 2)
10%	0
8%	≈ 0.33
6%	1
4%	3
2.5%	15
→ 2%	→ ∞ (liquidity trap)

Equilibrium and the liquidity trap

• Equilibrium interest rate: r settles where Md(Y, r) = Ms. Money supply (set by the RBI and the banking system) is a vertical line. Money demand slopes downward.
• If income rises:
• Transaction demand rises.

• Money supply stays the same, so r must rise to pull demand back down to supply.

• If the RBI raises the money supply (NCERT Box 3.1):

• People hold more money than they want.
• They use the extra money to buy bonds.
• Bond prices rise, so r falls.

• r keeps falling until people are happy to hold the larger money stock.

• Liquidity trap: at a very low rate (rₘᵢₙ), everyone expects r to rise.

• So people hold any extra money instead of buying bonds.
• The bond-buying step breaks down, so r cannot fall further.
• Money demand becomes infinitely elastic here: the Md curve turns flat (horizontal).
• Near the zero lower bound (rates close to 0%), central banks turn to other tools: quantitative easing, forward guidance and long-term lending. Examples: Japan from the 1990s, and the US, UK and eurozone after 2008 and in 2020.

In India

• Who manages the supply side: the RBI adjusts liquidity through the Liquidity Adjustment Facility (LAF). LAF means the RBI's operations to add money to, or take money out of, the banking system. It includes repo and reverse repo, the SDF and the MSF [4].
• The LAF corridor:
• Repo rate (the rate at which the RBI lends to banks for a short time against government securities) sits in the middle [4].
• MSF (Marginal Standing Facility, emergency overnight borrowing by banks) is the ceiling, at repo + 25 basis points [4].
• SDF (Standing Deposit Facility, where banks park surplus money with the RBI with no collateral) is the floor, at repo − 25 basis points [4].

• The SDF replaced the fixed reverse repo rate as the floor in April 2022 [4][5].

• Operating target: the Weighted Average Call Rate (WACR), the average rate on overnight loans between banks [4].

• Transmission chain (the money-demand logic at work):
• The RBI adds liquidity, for example through a repo auction.
• Banks have more cash to lend overnight, so the WACR falls towards the repo rate.
• Bond yields and bank loan rates follow.

• When the RBI takes liquidity out (through the SDF or reverse repo), the WACR rises within the corridor.

• Latest rates (August 2026 MPC): repo 5.25%, SDF 5.00%, MSF and Bank Rate 5.50%. The MPC kept the stance neutral (no leaning towards a cut or a hike) [2]. It voted unanimously to hold the repo rate at 5.25% in both June 2026 and August 2026 [2][3].

• Legal anchor:
• Under Section 45ZA of the RBI Act, 1934, the Centre sets the CPI inflation target in consultation with the RBI, once every five years [6][7].
• The first target, notified on 5 August 2016, was 4%, with a band of 2% to 6% [6].
• The Monetary Policy Framework Agreement of February 2015 adopted flexible inflation targeting [4].

Don't confuse with

• Money supply: this is the stock of money that the RBI and banks create. On the diagram it is a vertical line that does not depend on r. Money demand is the amount people want to hold, and it slopes downward against r.
• Transaction demand vs speculative demand: transaction demand (kPY) depends on income and prices. Speculative demand depends on the interest rate and on what people expect rates to do.
• Liquidity trap vs liquidity: liquidity is how easily an asset turns into cash. A liquidity trap is a situation where r is at rₘᵢₙ, money demand is infinitely elastic, and extra money cannot lower r.
• SDF vs reverse repo: both let banks park surplus money with the RBI. The SDF needs no collateral and has been the corridor floor since April 2022. The reverse repo needs government securities [4][5].

Prelims Hooks

• Money demand is directly related to income and the price level, and inversely related to the interest rate. The opportunity cost of holding money = the interest rate given up.
• Mᵀd = kPY; v = 1/k; v · Md = T. In NCERT's two-person example, ₹200 of transactions need ₹100 of money, so v = 2.
• Bond price and interest rate move in opposite directions. A 2-year, 10%-coupon ₹100 bond is worth ≈ ₹109.29 at 5% and ≈ ₹107.33 at 6%.
• Speculative demand is zero at rₘₐₓ and infinite at rₘᵢₙ. A liquidity trap = money demand is perfectly (infinitely) elastic.
• The RBI's operating target is the WACR, not the repo rate. Corridor: floor = SDF (repo − 25 bps), ceiling = MSF (repo + 25 bps) [4].
• Trap: the MSF is a borrowing window for banks, not a deposit window. As of August 2026, MSF = Bank Rate = 5.50% [2].

Mains Points

• Liquidity management is as important as the rate decision.
• The RBI announces the repo rate, but it moves the WACR through LAF operations [4].
• When there is too much or too little liquidity, the WACR drifts away from the repo rate.

• Then transmission (how fast bank loan rates follow the policy rate) weakens.

• Limits of monetary policy:

• The liquidity trap shows that at very low rates, extra money is simply held, not spent.

• With the repo rate at 5.25% (2026) [2], India is not near this trap. But it explains why advanced economies used QE after 2008 and in 2020, and why fiscal policy matters more in deep slumps.

• Digital payments are changing money demand.

• UPI, digital payments and wider financial inclusion lower k: people need less cash for each rupee of transactions. So velocity rises.
• This makes money demand harder to predict. It is one reason India moved from monetary targeting to an interest-rate operating target under flexible inflation targeting [4].
• Link this to the inflation target of 4% ± 2% [6].

Related concepts

• Interest rate
• Liquidity
• Opportunity cost of holding money
• Transaction motive
• Speculative motive
• Velocity of circulation
• Liquidity trap

Read more

• Demand for money and the interest rate