Demand for money means the proportion of its wealth that a community would like to hold with it in the form of ready cash. we know that wealth of any individual or a community comprises assets like house, buildings, lands, gold and silver, bonds, debentures, shares, securities, etc. and also of a certain amount of cash balance. While all these assets earn income and can also bring capital gains, money or cash balance gets nothing in return. The question that naturally arises is that when cash holding means a loss of income which it could have earned if it were converted into other assets, why the community or individuals still hold some cash balance?
To simplify the analysis, we can divide all wealth into two parts viz., money represent the cash balance that an individual wants to hold, bonds represent all other forms of assets in which wealth is kept. Since, the choice is now to hold the given amount of wealth either in the form on money or in bonds, it automatically follows that an increase in demand for money means a decrease in demand for bonds and vice versa. However, while money balance yields no income, bonds earn income in the form of annual rate of interest. The wealth holder has thus to weight the 'convenience' of holding money against the 'income foregone' by holding money and not holding bonds.
The opportunity cost of holdings any money balance is the extra interest that could have been earned if the money had been used instead to purchase bonds.
Since, holding wealth in form of money or cash balance imposes an opportunity cost on the wealth holder in the form of loss of interest income foregone, then why do people keep some part of wealth in cash rather than bonds?
The reason is obvious. If we have locked up all our finances in bonds and are now in need of buying some goods from the market, we have first to sell those bonds, and with the money so obtained buy those goods that we require. The selling of bonds may be time consuming and may also involve some expenses in going to the stock exchange, contacting the brokers, payment of brokerage, etc. Securities or bonds cannot generally be sold at their face value immediately. We could have avoided all this waste of time and expenditure involved in converting bonds into money if we had on us some ready cash with which we could have immediately bought the goods that we wanted. This is because while money is the most readily acceptable medium of exchange, securities are not. Every seller of goods would accept money in exchange for the sale of his goods but he may refuse to accept securities in return for goods sold.
This characteristic of money, viz., its ready acceptability at face value as a means of payments is called liquidity. Money is most liquid of all the assets because payments in money are acceptable by everyone within the geographical area of the country. Therefore, people will always like to keep some part of their income or financial assets in the form of money. This desire of the people to hold money in preference to other assets is called liquidity preference.
The demand for money of liquidity preference, therefore means the demand to hold money or to have a cash balance with them rather than holding assets like bonds, debentures, securities, etc.SUBMIT ASSIGNMENT NOW!