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…
