Equilibrium in the Market for Money

The money market is the interaction among institutions through which money is supplied to individuals, firms, and other institutions that demand money.

Money market equilibrium occurs at the interest rate at which the quantity of money demanded is equal to the quantity of money supplied. Figure Money Market Equilibrium combines demand and supply curves for money to illustrate equilibrium in the market for money. With a stock of money (M), the equilibrium interest rate is r.

Figure Money Market Equilibrium

The market for money is in equilibrium if the quantity of money demanded is equal to the quantity of money supplied. Here, equilibrium occurs at interest rate r.

Effects of Changes in the Money Market

A shift in money demand or supply will lead to a change in the equilibrium interest rate. Let’s look at the effects of such changes on the economy.

Changes in Money Demand

Suppose that the money market is initially in equilibrium at r ₁ with supply curve S and a demand curve D ₁ as shown in Panel (a) of Figure A Decrease in the Demand for Money. Now suppose that there is a decrease in money demand, all other things unchanged. A decrease in money demand could result from a decrease in the cost of transferring between money and non-money deposits, from a change in expectations, or from a change in preferences. Panel (a) shows that the money demand curve shifts to the left to D ₂. We can see that the interest rate will fall to r ₂. To see why the interest rate falls, we recall that if people want to hold less money, then they will want to hold more bonds. Thus, Panel (b) shows that the demand for bonds increases. The higher price of bonds means lower interest rates; lower interest rates restore equilibrium in the money market.

Figure A Decrease in the Demand for Money

A decrease in the demand for money due to a change in transactions costs, preferences, or expectations, as shown in Panel (a), will be accompanied by an increase in the demand for bonds as shown in Panel (b), and a fall in the interest rate. The fall in the interest rate will cause a rightward shift in the aggregate demand curve from AD ₁ to AD ₂, as shown in Panel (c). As a result, real GDP and the price level rise.

Lower interest rates in turn increase the quantity of investment. They also stimulate net exports, as lower interest rates lead to a lower exchange rate. The aggregate demand curve shifts to the right as shown in Panel (c) from AD ₁ to AD ₂. Given the short-run aggregate supply curve SRAS, the economy moves to a higher real GDP and a higher price level.

An increase in money demand due to a change in expectations, preferences, or transactions costs that make people want to hold more money at each interest rate will have the opposite effect. The money demand curve will shift to the right and the demand for bonds will shift to the left. The resulting higher interest rate will lead to a lower quantity of investment. Also, higher interest rates will lead to a higher exchange rate and depress net exports. Thus, the aggregate demand curve will shift to the left. All other things unchanged, real GDP and the price level will fall.

Changes in the Money Supply

Now suppose the market for money is in equilibrium and the central bank changes the money supply. All other things unchanged, how will this change in the money supply affect the equilibrium interest rate and aggregate demand, real GDP, and the price level?

Suppose the central bank conducts open-market operations in which it buys bonds. This is an example of expansionary monetary policy. The impact of central bank bond purchases is illustrated in Panel (a) of Figure An Increase in the Money Supply. The central bank’s purchase of bonds shifts the demand curve for bonds to the right, raising bond prices to P ^b₂. As we learned, when the central bank buys bonds, the supply of money increases. Panel (b) of Figure An Increase in the Money Supply shows an economy with a money supply of M, which is in equilibrium at an interest rate of r ₁. Now suppose the bond purchases by the central bank as shown in Panel (a) result in an increase in the money supply to M ′; that policy change shifts the supply curve for money to the right to S ₂. At the original interest rate r ₁, people do not wish to hold the newly supplied money; they would prefer to hold non-money assets. To reestablish equilibrium in the money market, the interest rate must fall to increase the quantity of money demanded. In the economy shown, the interest rate must fall to r ₂ to increase the quantity of money demanded to M ′.

Figure An Increase in the Money Supply

 

The reduction in interest rates required to restore equilibrium to the market for money after an increase in the money supply is achieved in the bond market. The increase in bond prices lowers interest rates, which will increase the quantity of money people demand. Lower interest rates will stimulate investment and net exports, via changes in the foreign exchange market, and cause the AD curve to shift to the right, as shown in Panel (c), from AD ₁ to AD ₂. Given the short-run AS curve SRAS, the economy moves to a higher real GDP and a higher price level.

Open-market operations in which the central bank sells bonds, that is, a contractionary monetary policy – will have the opposite effect. When the central bank sells bonds, the supply curve of bonds shifts to the right and the price of bonds falls. The bond sales lead to a reduction in the money supply, causing the money supply curve to shift to the left and raising the equilibrium interest rate. Higher interest rates lead to a shift in the AD curve to the left.

As we have seen in looking at both changes in demand for and in supply of money, the process of achieving equilibrium in the money market works in tandem with the achievement of equilibrium in the bond market. The interest rate determined by money market equilibrium is consistent with the interest rate achieved in the bond market.

Key concepts

· People hold money in order to buy goods and services (transactions demand), to have it available for contingencies (precautionary demand), and in order to avoid possible drops in the value of other assets such as bonds (speculative demand).

· The higher the interest rate, the lower the quantities of money demanded for transactions, for precautionary, and for speculative purposes. The lower the interest rate, the higher the quantities of money demanded for these purposes.

· The demand for money will change as a result of a change in real GDP, the price level, transfer costs, expectations, or preferences.

· We assume that the supply of money is determined by the central banks. The supply curve for money is thus a vertical line. Money market equilibrium occurs at the interest rate at which the quantity of money demanded equals the quantity of money supplied.

· All other things unchanged, a shift in money demand or supply will lead to a change in the equilibrium interest rate and therefore to changes in the level of real GDP and the price level

Numerical Tasks

1. Suppose the Central Bank sells $8 million worth of bonds. 1) How do bank reserves change? 2) Will the money supply increase or decrease?

2. Suppose the supply of bonds in the U.S. market decreases. 1) Show graphically and explain the effects on the bond and foreign exchange markets. 2) Use the AD-AS framework to show and explain the effects on investment, net exports, real GDP, and the price level.