In this chapter the research will focus on the background of the research to give findings of past researchers, justification of the research, problems statement which is the gap which has been left out by other researchers, list of the objectives of the research and lastly state how the research will be organized.

Defining money demand function is a central concern for monetary policy makers, because the combination of money supply and money demand determines interest rates, and therefore affects the final goals of monetary policy. A stable money demand allows for better predictions of the effect of monetary policy on interest rates, output, and inflation, and therefore reduces the possibility of an inflation bias (Cziráky and Gillman, 2006). Stable money demand is a also precondition for an effective monetary policy, especially for countries pursuing a monetary targeting framework (Qayyum, 2005).

Demand for money has a close link with interest rates, real GDP, exchange rate and inflation. An increase in the federal funds rate and other short-term interest rates will reduce the attractiveness of holding money balances relative to higher-yielding money market instruments and thereby reduce the amount of money demanded and slow growth of the money stock, (M1, M2 and M3); this shows that money demand and interest rate have a negative relationship. A positive relationship is indicated by GDP and Demand for money, for example, the amount of money demanded, at any given interest rate, is Proportional to nominal income, as measured by nominal GDP. For example, if GDP increases by 10% then the demand for money increases by 10% as well, at any given interest rate.

Definition of terms

Money demand

The demand for money is the desired holding of financial assets in the form of money: that is, cash or bank deposits. It can refer to the demand for money narrowly defined as M1 (non-interest-bearing holdings), or for money in the broader sense of M2 or M3.