The money demand curve plots the relationship between interest rates and the quantity of money we use or hold as cash. In this case, money means currency, checking accounts and travelers' checks. This is money that people generally use for transaction purposes.
People have a choice between holding bonds or holding money. Bonds earn an interest rate, money does not. People choose how they want to divide their wealth between these different types of assets.
Although people may prefer to hold all their wealth in interest-bearing assets such as bonds, people cannot use bonds to buy goods and services. People need money to buy goods and services. There is a trade-off between holding bonds, because bonds earn a greater returns, and holding money, which pays no return, but can be used for transaction purposes.
Money demand is the relationship between the price of money or the opportunity cost of holding money -- the interest rate on a bond -- and the amount of money in your pocket. The higher the interest rate is, the higher the opportunity cost of holding money. Higher interest rates cause people to hold less money in their pockets or in their checking accounts. On the other hand, when interest rates are lower, people hold more money than they would otherwise and less of their wealth in interest-earning assets like bonds.
Why don't people just hold bonds and sell their bonds when they need money? One reason is that there is a cost of converting one asset into the other asset. Economists often call these costs "shoe leather costs". It costs money to convert your wealth from one type of asset into the other.
What causes the money demand curve to shift? Income causes the money demand curve to shift. People with higher income need more money so that they can buy more things. If one's income increases, that person will hold more money so that they can buy more things. If their income falls, people hold less money.
People's future expectations also affect how much money they hold. If a person is worried that they will lose their job, that person might actually reduce current money holdings and, instead, save that money. This is what we call precautionary savings. People spend less and save more to offset income decreases in the future. If a person feels confident in their future income, they may increase their current money holdings. They are confident in the future. Money demand is the inverse relationship between an interest-bearing asset, like a bond or savings account, and money which is used for transaction purposes. Income and future expectations also affect money demand.
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