Risk aversion in financial markets
And demand for money
There are many reasons why people hold money and these include: daily transactions for their day to day purchases; precautionary motive, for unforeseen emergency expenses; and, speculative purposes based on the belief that better opportunities for investment will come along and that, in particular, interest rates will rise. (Slavin, Macroeconomics 1996 p. 289).
Slavin (1996) also discusses the factors affecting the quantity demand for money, namely; price levels, income, credit availability, and interest rate. All of these factors affect the demand for money either negatively or positively. Let us take a closer look at interest rate. Economists agree that when interest rates are high, people will want to hold less money and put these instead in income/interest generating instruments. After all, the potential loss in income is the foregone opportunity (or opportunity cost.)
However, for a person who is risk-averse, meaning his tolerance for risk is low and would be more secure holding on to his money and safe instruments such as savings and time deposits, bonds, money market funds, and other interest bearing securities, he will definitely prefer to hold on to his money rather than lose sleep over the possibility of losing money in interest-generating instruments. Therefore, the rule that says the higher the interest rate is, the lower the demand for money does not hold water to a person who is risk-averse especially if the investment is dubious and “risky”. Risk-averse people prefer to put their money in safe placements that will guarantee safe and fixed returns, albeit low at times. For them, security is premium.
Many people though, are risk-takers, and are unmindful of the dangers or risks involved in their investments for as long as the rates of return are high. No wonder pyramid scams and other dubious money-making ventures that promise high returns still flourish and, sadly, many people still fall prey to this.
Slavin, S. Macroeconomics, 4th Ed. Richard Irwin: NJ. 1996.