The Money Demand Function describes the relationship between the quantity of money that households and businesses wish to hold and various economic factors, primarily the level of income and the interest rate. It is often expressed as a function of income () and the interest rate (), reflecting the idea that as income increases, the demand for money also rises to facilitate transactions. Conversely, higher interest rates tend to reduce money demand since people prefer to invest in interest-bearing assets rather than hold cash.
Mathematically, the money demand function can be represented as:
where is the demand for money. In this context, the function typically exhibits a positive relationship with income and a negative relationship with the interest rate. Understanding this function is crucial for central banks when formulating monetary policy, as it impacts decisions regarding money supply and interest rates.
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