Money Demand

The second piece of the theory of liquidity preference is the demand for money. As a starting point for understanding money demand, recall that any asset’s liquidity refers to the ease with which that asset is converted into the economy’s medium of exchange. Money is the economy’s medium of exchange, so it is by definition the most liquid asset available. The liquidity of money explains the demand for it: People choose to hold money instead of other assets that offer higher rates of return because money can be used to buy goods and services. Although many factors determine the quantity of money demanded, the one emphasized by the theory of liquidity preference is the interest rate. The reason is that the interest rate is the opportunity cost of holding money. Thai is, when you hold wealth as cash in your wallet, instead of as an interest-bearing bond, you lose the interest you could have earned. An increase in the interest rate raises the cost of holding money and, as a result, reduces the quantity of money demanded. A decrease in the interest rate reduces the cost of holding money and raises the quantity demanded. Thus, as shown in Figure 1, the money demand curve slopes downward.