Broadly speaking, the demand for money is thought to depend on three major factors: (a) total wealth to be held in various forms of assets; (b) relative price of and return on one form of wealth as compared to the other forms; and (c) tastes and preferences of the wealth-holders.
Cost of holding cash balances is influenced by (a) the rate of interest and (b) the expected rate of change in the price level. An increase in the rate of interest or the price level causes a decline in the cash balances and vice versa the yield on various forms of wealth as used by Friedman in his demand function are discussed below:
1. Total Wealth:
For the ultimate wealth owner, total wealth is the analogue of the budget constraint in the consumer demand theory. It is the total that must be divided among various forms of assets.
Due to difficulty of getting estimates of total wealth, Friedman substituted permanent income (Y) for wealth in his demand- for-money function. Permanent income is the expected income flow from total wealth.
2. Human and Non-Human Wealth:
Total wealth includes both human and non-human wealth, but there exist legal and institutional constraints in converting human into non-human wealth. Therefore, Friedman introduces the ratio of non-human to human wealth (w) as a variable in the demand function.
The nominal rate of return on money may be zero as on currency, or positive as on saving deposits or even negative if current account deposits are subject to net service charges. But money is demanded for the services it yields and these services arise because of money's command over goods and services.
Thus, the real yield on money will depend upon the price index (P) because the level of pr ices governs the ability of money to command goods and services.
Bond is considered to be a perpetual security, or consol, which yields an income stream whose value, is fixed in nominal terms. Thus, the yield on bond (r) consists of the sum of its coupon plus any anticipated capital gain due to an expected fall in the market mterest rate or less any anticipated capital loss due to an expected rise in the market rate.
The equity is identical to the bond except that it contains a cost- of-living escalator so that its income stream always maintains constant purchasing power. The yield on equity (r) is composed of three elements: (a) its coupon yield, (b) any expected capital gains or losses due to changes in interest rates, and (c) any expected changes in the general price level.
Physical goods held by wealth-owners yield income in kind (i.e., utility) which cannot be measured by an explicit interest rate. However, their real return is affected by the changes in the price level. Friedman uses the nominal yield on commodities (r) to consist of their expected rate of price change per unit of time.
7. Human Capital:
In the absence of slavery, no market price for human capital exists and thus a rate of return on this form of wealth cannot be computed directly.
8. Other Variables:
Friedman introduces a variable designated by to stand for any influence other than income that can be expected to affect tastes and preferences for money.