The amount of wealth that everyone in the economy wishes to hold in the form of money balances is called the demand for money. There is a cost to holding any money balance. The money could be used to purchase bonds which earn a return in the form of interest. By holding money balances, a person foregoes the return he could have earned by purchasing bonds. This may be called the opportunity cost of holding any money balance.

It is obvious that money will be held only when it provides services that are valued at least as highly as the opportunity cost of holding it.

We may distinguish between demand for real balance and demand for nominal money balances.

Real money demand is the number of units of purchasing power that the public wishes to hold in the form of money balances.

For example, in an imaginary one-product economy (say rice), the number of kilos of rice that could be purchases with the money balances held would be the measure of their real value. In a more complex economy it should be measured in terms of the number of ‘basket of goods’ represented by a price such as the Wholesale Price Index (WPI), that could be purchased with money balances held. When we speak of the demand for money in real terms, we speak of the amount demanded in constant rupees (that is, with a constant price level).

As discussed in the earlier chapter, the two important functions of money are: (a) it serves as a medium of exchange, and (b) it works as a store of value. While its function as a medium of exchange gives rise to what is called the ‘transactions demand’ for money, the store of value function gives rise to the ‘asset demand’ for money. The aggregate demand for money is the sum of these two separate demands.

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