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The Demand for Money
The Speculation Motive

One of the theories that has been offered to explain why households desire to hold a greater quantity of money when interest rates fall (and less when they rise) involves household expectations and the relationship of interest rates to bond values.

The market value of most interest-bearing bonds is inversely related to the interest rate. For example, suppose I bought a bond for $1000 that offers 8 percent interest and hold it for a year, then decide to sell it. In the meantime, interest rates have risen and a similar bond now offers 10 percent a year. Could I sell my bond for $1000? No, because why would anyone buy it when he or she could spend the same amount on a new bond and earn higher interest, I would have to lower the price of the bond in order to sell it. Thus, interest rates and the market value of bonds have an inverse relationship.

Now here’s where expectations come in. If market interest rates are higher than normal, people expect that they will come down. When interest rates fall, the value of bonds will rise. Therefore, people buy bonds (hold less money) when interest rates are high.

When interest rates are lower than normal, people expect that they will rise and that bonds will therefore lose value. They therefore wish to hold money instead. Because people are “speculating” about what interest rates (and therefore values of bonds) will do, this is called the speculation motive for holding money.

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