What are the main determinants of money demand in the standard medium-of-exchange model, and how does a rise in income impact money demand?

• A. Money demand depends on income/transactions, interest rate, and prices; higher income increases money demand.
• B. Money demand depends only on the level of prices.
• C. Money demand is fixed by monetary policy.
• D. Money demand depends on government spending.

Answer: (A)

The key idea is that how much money people want to hold reflects how much they transact, the opportunity cost of holding money, and the overall price level. In the standard money-demand relation, real money balances (Md/P) are a function of income and the interest rate: Md/P = L(Y, i). Multiply by the price level to get nominal money demand: Md = L(Y, i) × P. Because higher income means more transactions, the transaction demand for money rises with Y, so a rise in income increases money demand. The interest rate matters because a higher rate raises the opportunity cost of holding money, dampening money demand, and the price level matters because higher prices mean more money is needed to buy the same amount of goods, pushing money demand up.