What Determines Whether Consumers Hold Money or Investments in Economics?
Money in economics is defined as the leading medium of exchange and the most liquid asset. For example, holding literal cash or money in a checking account may be thought of as “money.”
Alternatively, investments are interest-bearing or appreciable assets that aren’t as liquid as money. Bonds are most used as examples when studying economics, though equities, real estate, commodities, and precious metals are also comparatively illiquid assets.
So, when consumers earn income, they can make the decision to hold money, or to purchase investments. Generally, their decision comes down to income and interest rates, which cumulatively represent their liquidity preference, or their preference for money. See here:
So, we can say that money demand, or the demand for money compared to investments, is a function (the function “L”, which you can substitute for f or any other letter) of interest rates (i) and income (Y).
The two core relationships present in this relationship are as follows:
- As interest rates go up, money demand goes down.
- As income goes up, money demand goes up.
This is because interest rates, especially on bonds, are essentially the risk-free opportunity cost to money. As the opportunity cost rises, one is more incentivized to invest their money to capture those greater returns.
Meanwhile, as income rises, transactions costs and potential liabilities increase, so people and businesses usually need to keep more cash on hand. Thus, more income increases demand for money.
So, that’s all which determines whether consumers hold money or investments—hope it helps.
Check out my other articles on economics here (useful for studying, or just learning).
