Demand for Money

People demand money for two functions:

1. Transactions demand (D_t)

• People want money as a medium of exchange to purchase goods and service.

• The transactions demand for money varies directly with nominal GDP and is independent of interest rates.  We specify nominal GDP because households and firms will want more money for transaction purposes if either prices or real output increases.

2. Asset Demand (D_a)

• People want money so they can hold money as assets

• The asset demand for money varies inversely with the rate of interest.

Rationale: Interest rates can be seen as the opportunity cost of holding money.  When the opportunity cost of holding money is low, the public will choose to hold a large amount of money as assets.  When the opportunity cost is high, the public will choose to hold a small amount of money as assets.

Total Demand for Money (D_m)

The total demand for money can be found by adding together the demand for money for transactions and for assets.

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