Question

who are ultimate savers and borrowers? Why are savers more likely to save more when the interest rate is high. What are the three types of demand for money by households and why is that important for investment purposes?

Answer 1

The household sector contains the savers (primary investors) in society who are the mainproviders of funds used for investment in the business sector. Primary investors tend toprefer to exchange their cash for financial assets which are highly liquid and with low risk.Lending directly to companies involves low liquidity and high risk.

The ultimate borrowers are in the business sector. These companies need to invest in realbuildings, equipment and other assets with the view to maximise the wealth generated bytheir activities. These companies need to attract funds for use over many years and,therefore, take risks.

Interest rates determine the amount of interest payments that savers will receive on their deposits. An increase in interest rates will make saving more attractive and should encourage saving.A cut in interest rates will reduce the rewards of saving and will tend to discourage saving.

An increase in interest rates may lead consumers to increase savings since they can receive higher rates of return. This is related to the marginal propensity to save. Marginal propensity to save is the proportion of an increase in income that gets saved instead of spent on consumption.

The demand for money is related to income, interest rates and whether people prefer to hold cash(money) or illiquid assets like money.

Types of demand for money

• Transaction demand It is the money needed to buy goods. This is related to income.The demand for money is a function of prices and income.If income rises, demand for money will rise.
• Precautionary demand. It refers to the money needed for financial emergencies. It refers to money spent on unexpected purchases or emergencies.
• Asset motive/speculative demand. It refers to demand when people wish to hold money rather than buy assets/bonds/risky investment.The asset motive states that people demand money as a way to hold wealth. This may occur during periods of deflation or periods where investors expect bonds to fall in value.

Demand for money is very important for Investment putposes.The income or transaction motive is to bridge the gap between the receipt of the income and its eventual disbursement. And the business motive is to bridge the gap between the time when costs are incurred and the time when you receive the sale proceeds.The speculative motive for demand for money arises when investing the money in some asset or bond is considered riskier than simply holding the money. The speculative motive for demand for money is also affected by the expected rise or fall of the future interest rates and inflation of the economy.