As we all know that money is one of the most important things in our life. So what do we demand money for? According to the Keynesian theory of money demand, there are three motives for holding money. “The first motive is the transaction motive; most transactions require money. Money passes from consumers to firms to pay for the goods and services; firms pay wages to their employees. The second motive is the precautionary motive. It arises because households and firms are uncertain about the degree to which payments and receipts will be synchronized. The speculative motive is the final one. Money can be held as an asset. Firms and individuals may hold some money in order to against the uncertainty in fluctuating price of other financial assets.”

We must distinguish between money and bonds. Money can be used for transactions, but holding money has zero interest in return, whereas holding bonds pay a positive interest rate, but can not be used for transactions. The price of bonds is negatively related to the interest rate, an increase in the price of bonds leads to a decrease in the interest rate. The price of money is fixed in money terms. Holding all your wealth in the form of money is very convenient, but you will not receive interest income. Holding all your wealth in the form of bonds, you will receive interest income, but it is inconvenient to make transactions. Therefore, it is clear that people should hold both money and bonds for the benefit of interest income as well as the convenience of transactions. The question is in what proportion should people hold these two financial assets. This depends on the level of transactions and the interest rate. In macroeconomics, it is hard to measure the total volume of transactions, but it is reasonable to assume that it is roughly proportional to nominal income. The relation between the demand for money, nominal income and the interest rate can be written as: Md=YL(i). Where Y denotes nominal income, L(i) denotes a function of interest rate, and has negative effect on money demand. Graph A and B show the relationship between the three variables:

In the graph A, when the interest rate rises from to , the quantity of money demanded falls from M to M , at graph B, the quantity of money demanded is positively related to nominal income, when the nominal income increase from Y to Y , the quantity demanded rises from M to M . The price level here is held constant. Now we should assume other things being equal, the nominal demand for money varies in proportions to the price level, when the price level doubles, the nominal demand for money also double. The nominal quantity demand divided by the price level equal the real demand for money.

We have known that nominal income and interest rate are the determinants of demand for money. Now, I would like to do further analysis about these two determinants. First of all, what is the determination of interest rate? Suppose that the central bank of England decides to supply a certain amount of money; for a given nominal income level the demand for money curve is downward sloping because people desire to hold less money as interest rate rise. M is the supply of money curve drawn as the vertical line due to it is fixed. The money market is equilibrium when money supply=money demand at E and the interest rate is determinated. If the interest rate is lower than the equilibrium point, there will be an excess demand for money, then bonds will be offered to sell, this will force the price of bonds falls and lead to the interest rate increases to the equilibrium point. In the other hand, if the interest rate is higher than the equilibrium point, there will be an excess supply of money, bonds will be wanted, more bonds are demanded cause the price of bonds to rise, so the interest rate will be