1. depends negatively on the level of real income.
2. depends positively on the real interest rate and the expected rate of inflation.
3. depends positively on the domestic price level.
4. does not depend on any of the above as indicated.
Choose the option above that is correct.
Option 3 is the correct one. What matters to people is not the amount of nominal money balances they hold but their amount of real money balances---the usefulness of a given stock of money depends on how much goods it can buy. Thus, when the price level goes up by, say, 10 percent people's real money holdings will go down by 10 percent. They will thus have to acquire 10 percent more nominal money balances to keep their real money holdings at the desired level. The amount of nominal money balances people wish to hold will thus depend positively on the price level. Options 1 and 2 are wrong choices because they have it backwards---desired money holdings depend negatively on the nominal interest rate and positively on real income.
The nominal interest rate has two components---the real interest rate and the expected rate of inflation. The cost of holding money increases when either of these increase. An increase in the real interest rate means that people can get a bigger return on their investments in real capital than previously. An increase in the expected rate of inflation means that the amount of real goods money can buy will erode at a faster rate. For both these reasons, holding nominal money balances becomes more costly. To the extent that money holdings bear interest at market rates this cost will be mitigated, but cash never bears interest and demand deposits, the other major component of money, rarely do.
An increase in the level of income leads to an increase in desired money holdings because the volume of transactions made in the economy varies directly with the level of income. The greater the volume of transactions, the greater the demand for money.