Many factors affect the quantity of money demanded by people, in the same way that many factors affect the demand for goods and services. (Mankiw, Principles of Economics, pp. 630). Firstly, we define money as the “economy’s medium of exchange, so it is be definition the most liquid asset available” and liquidity refers to “the ease with which that asset is converted into the economy’s medium of exchange”.
(Mankiw pp. 736).The book “The Principles of Economics” (Mankiw pp. 736-740) underlines the factors that affect the quantity demand for money.The first factor that determines the quantity of demand for money is interest rate. The interest rate represents the opportunity cost of holding money.
It means that when you hold money in your wallet, instead of placing it in an income generating fund like a savings deposit or interest-bearing bond, you lose the interest that you could have earned. Therefore, any increase in the interest rate raises the cost of holding money and reduces the quantity of money demanded. In other words, interest rate and quantity of money demanded are negatively correlated. Price level is another factor that affects quantity demand for money.When prices rise, people need more money to buy goods and services.
Thus, quantity demanded for money increases (or positively correlated) with increase in prices.Income. The higher a person’s level of income, the higher his level of spending is. This is embodied in the theory of marginal propensity to spend. Therefore, the higher the level of spending, the higher the quantity of money demanded.
Credit Availability. The availability of credit affects the quantity of money demanded since a person who can get credit need not pay in cash. Thus, increasing credit availability exerts a downward pressure on the quantity of money demanded.In summary, we can make four generalizations: (Slavin, Macroeconomics, pp.
290)1. As interest rates increase, people tend to hold less money.2. As rate of inflation increases (price levels), people tend to hold more money3.
As the level of income rises, people tend to hold more money4. People tend to hold less money as credit availability increases.