The reason for wanting to hold money originally stressed in the quantity theory is the so called transactions motive. It is still thought to be important, although it is no longer believed to be the only major motive for holding money.
Virtually all transactions in an economy require money. Money is passed from households to firms to pay for the goods and services produced by firms; and money is passed from firms to households to pay for the factor services supplied by households to firms. These transactions force both firms and households to hold money balances called transactions balances.
Consider the balances held because of wage payments. Assume, for purposes of illustration, that firms pay wages every Friday and that households spend all their wages on the purchase of goods and services, with the expenditure being spread out evenly over the week. Thus on Friday morning firms must hold balances equal to the weekly wage bill; on Friday afternoon households will hold these balances. Over the week, households’ balances will be drawn down as a result of purchasing goods and services. Over the same period, the balances held by firms will build up as a result of selling goods and services until, on the following Friday morning, firms will again have amassed balances equal to half the wage bill and so will households; thus total money balances held will be equal to the weekly wage bill.
The size of these transactions balances depends, therefore, on the size of the wage bill. If the wage bill doubles, either because twice as many people are employed at the same rate or because the same number is employed at twice the wage rate, the balances held must double. The argument has been conducted in terms of the wage bill, but a similar analysis holds for payments for all factor services.
Because the size of the wage bill and other payments tend to vary directly with the level of national income, the transactions demand tends to vary directly with the level of national income.
Transactions balances must be held because payments and receipts are not perfectly synchronized. The more often that wages are paid, the more nearly synchronized payments and receipts will be and the smaller will the balance held need to be. Changes in social institutions such as the pattern or paying bills will thus affect the transaction balances required. Assume – an extreme example – that wages are paid daily instead of weekly. On the average, the total balances required will be equal to the total daily wage bill, which is of course only a fraction of the weekly wage bill, and thus a change to a shorter pay period should lead to a lower transactions demand for money.
A change in the pay period is only one example of an institutional change that can alter the transactions demand for money. A current example is the growth of short-term money substitutes such as credit cards. With short-term consumer credit you can come much closer to synchronizing your payments with your receipts. If, for example, you can charge all of your purchases and then pay the charge accounts on payday, you do not need transactions balances except during the small interval between receipt of your pay and paying your bills.
In most societies perfect synchronization of payments and receipts is not possible and transactions balances must be held. For given social institutions these balances will tend to vary directly with national income.
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