How is Nominal Demand for Money Represented in Economics?
Nominal demand for money can be represented as a function of income and liquidity preference. As follows:
Mᵈ is the money demand and $Y is income, in dollars. L(i) is a liquidity preference function based on the interest rate. Remember that money demand is demand for cash (“money”), not for assets like bonds or equities.
So, we’re saying that people’s demand for cash reflects their income and liquidity preferences. You can think of liquidity preferences as risk tolerance; how much cash versus investments you have on hand.
Interest rates can be thought of as opportunity costs for holding money versus interest-bearing assets; the higher the interest rate, the more incentivized one is to own, say, bonds versus cash.
In the above equation, there are always proportional increases in money demand — if income doubles, for example, then so does money demand (this holds under most conditions, though real-world scenarios may exhibit non-linear relationships).
We can alternatively think of money demand entirely as a function of the interest rate and income, as follows:
In this equation, we don’t know if increases in income are proportional, but we do know that higher income still leads to higher money demand. There are a few reasons for this core assumption and relationship:
- More income usually means more cash is needed on hand to cover everyday transactions.
- Higher income leads to more responsibility and potential liabilities, which may require more cash on hand.
- The Keynesian Liquidity Preference Theory details people’s base interest in holding money. Read my article on it here.
We can also note that money demand is a downward-sloping function of the nominal interest rate because of consumer liquidity preferences:
Interest rate is on the vertical axis and money on the horizontal axis. Note that increases in income shifts demand to the right, increasing money demand.
So, as the interest rate increases, money demand decreases. As stated, this is because as interest rates rise, the opportunity cost for money increases, since one can earn more by investing money in savings accounts, bonds, or other interest-bearing assets.
So, ceteris paribus, consumers and businesses will invest more as interest rates increase, and therefore money demand decreases as interest rates increase.
Equilibrium in the Money Market
As a final note on the nominal demand for money, keep in mind that financial market equilibrium requires money supply to be equal to money demand:
Since we know the equation for money demand, we can swap it in:
This equilibrium relation is called the LM relation.
All in all, that covers the need-to-know basics—how money demand is represented in economics & relevant relationships.
Hope that helps, and drop any questions in the comments! Check out my other articles on economics here (useful for studying, or just learning).
