Lesson summary: the money market (article)

In this lesson summary review and remind yourself of the key terms and graphs related to the money market.

Lesson Summary

If we want to buy things, we need money to do so. But, by keeping our wealth in the form of money, we give up the opportunity to earn interest by keeping our wealth in the form of some other asset. This tradeoff is the source of the demand for money: as interest rates decrease, it makes more sense for us to keep money in the form of money and not other assets.

At the same time, there is only so much money that exists at any given time. The money supply ( $M 1$ ‍) is a fixed amount that doesn’t change just because interest rates have changed. The money supply changes when either the monetary base changes or banks make loans.

If you are thinking to yourself, “Wait, supply and demand for something sounds a lot like a market,” you are absolutely correct! Just like every other market we have seen, there are four important elements:

equilibrium price
equilibrium quantity
supply
demand.

The price of money is the nominal interest rate, the quantity is how much money people hold, supply is the money supply, and demand is the demand for money.

Key Terms

Key term	Definition
money market	a graphical model showing the interaction of the demand for money and the money supply
money supply	a curve that shows the relationship between the amount of money supplied and the interest rate; because the central bank controls the stock of money, it does not vary based on the interest rate, and the money supply curve is vertical.
money demand	a curve showing the relationship between the quantity of money demanded and the interest rate; the money demand curve is downward sloping
liquidity preference	the amount of wealth that people want to keep in the form of cash in order to use it as a medium of exchange
transactions motive	The desire to hold money in order to buy things

Key Takeaways

The demand for money is downward sloping

Suppose you live in a world where you can only store your wealth in bonds or cash, and you have $$ 1000$ ‍ in cash. You can earn a $10 %$ ‍ return if you buy a bond, but the return to holding your wealth in the form of money is zero. That bond sounds pretty attractive, so you spend all of your money buying bonds.

Now you have a slight problem: all of your wealth is in the form of bonds and you are hungry. You take the bonds to the donut shop but they only accept cash. The donut shop holder wants to be paid now, not a year from now when those bonds mature!

So you have a choice: sell your bonds and eat, or keep your bonds and earn interest. The tradeoff between keeping your assets liquid (in the form of cash) or in some other asset (bonds) is called liquidity preference. The amount you are willing to hold in the form of cash is going to depend on a lot of things, such as the price of donuts, how hungry you are, and how easy it is to move wealth between cash and bonds.

Your liquidity preference will also depend on the interest rate. If the interest rate suddenly went down to less than $1 %$ ‍, then holding onto these bonds doesn’t make as much sense as it did at $10 %$ ‍. This inverse relationship between liquidity preference and the interest rate means that the demand for money is downward sloping.

The money supply is vertical

The money supply is ultimately determined by the monetary base and the money multiplier. In most countries, that country’s central bank determines the size of the monetary base. Remember that the monetary base includes reserves in vaults and currency in circulation outside of banks. For example, central banks might change the reserve requirements to change the monetary base.

The money supply doesn’t depend on the interest rate, it only depends on the central bank. Because of this, the money supply curve is vertical at the quantity of the money supply, not upward sloping or downward sloping.

The nominal interest rate adjusts until the money market is in equilibrium

In any market, an equilibrium occurs when the quantity supplied is equal to the quantity demanded. Prices adjust until the market is in equilibrium. The money market is no exception. The only difference between the markets we saw in Unit 1 and the money market is:

The price is the nominal interest rateThe supply curve is vertical

In the money market, the nominal interest rate adjusts until the quantity of money that people want to hold is the same as the quantity of money that exists. If the nominal interest rate is above equilibrium high, people reduce their holdings of cash. If the nominal interest rate is below equilibrium, they increase their holdings of cash.

What makes people want to hold exactly the amount of cash that exists? Let’s go back to our example where we have $$ 1000$ ‍ in the form of bonds. When the interest rate is very low, such as $2 %$ ‍, the return to those bonds is low. The opportunity cost of keeping wealth in cash (which we can also use to buy stuff) is very low.

Also, recall that interest rates and bond prices are inversely related, so a low-interest rate means we can get a high price for these bonds. This sounds like a no-brainer . . . let’s sell off those and get some cash!

Unfortunately, everyone else has the same idea. Suppose at an interest rate of $2 %$ ‍, people want to hold $$ 500$ ‍ million in cash. But, the money supply is only $$ 300$ ‍ million. There is a shortage of the thing we want (cash), so we have to try even harder to get that cash by selling even more bonds.

As the supply of bonds increases, the price of bonds decreases. Since bond prices and interest rates are inversely related, the interest rate starts creeping up. The interest rate will keep increasing until people decide that the return to holding bonds is high enough to stop selling them off. Now, the money market is in equilibrium and the quantity of money supplied equals the quantity of money demanded.

Something similar happens when the interest rate is very high. Suppose at an interest rate or $20 %$ ‍, bonds are very attractive but cash isn’t. People start trying to trade in their cash for bonds. The demand for bonds increases, which increases the price of bonds. As bond prices increase, the interest rate decreases. Interest rates decrease until bonds don’t really seem that attractive anymore, and people stop trying to trade in cash for bonds.

Changes in the supply and demand for money

The central bank controls the money supply, so it can take actions to increase the money supply and decrease the money supply. Changes in the money supply lead to changes in the interest rate.

But what about the demand for money, can it change? Absolutely! There are a few reasons why the demand for money might change:

Changes in national income
- when real GDP increases, there are more goods and services to be bought. More money will be needed to purchase them. On the other hand, a decrease in real GDP will cause the money demand curve to decrease.
Changes in the price level (inflation or deflation)
- if the price of everything increases by $20 %$ ‍, you need $20 %$ ‍ more money in order to buy things. When there is an increase in the price level, the demand for money increases. Conversely, when there is a decrease in the price level, the demand for money decreases.
Changes in money technology
- the demand for money is driven by the transactions motive (we want money so we can buy things). When new technologies make it easier to convert wealth into money, we keep less of it on hand.

Sure! Suppose that we have a very simple economy that only sells, you guessed it, donuts.

Changes in real GDPCurrently, the price of donuts is $$ 2$ ‍ per donut and $300$ ‍ donuts are produced each year. Real GDP is $$ 2 \times 300 = $ 600$ ‍

Suppose our currency only comes in one denomination, $$ 1$ ‍ bills, and each $$ 1$ ‍ bill can only be used once. We would need $600$ ‍ $$ 1$ ‍ bills in order to buy all of these donuts.

Now, what happens if real GDP changes. Suppose that now there are 400 donuts being made. Real GDP is:

$$ 2 \times 400 = $ 800$ ‍

Now we need $800$ ‍ of those $$ 1$ ‍ bills in order to purchase all of the donuts. Our demand for money had increased, even though the interest rate has not changed.

-Changes in price level

Now, suppose instead that the amount of donuts hasn’t changed, but the price level has. Each delectable frosted disk now costs $$ 3$ ‍. If only $300$ ‍ donuts are being made, real GDP hasn’t changed. But, nominal GDP has changed:

$$ 3 \times 300 = $ 900$ ‍.

Now, we need $900$ ‍ of those $$ 1$ ‍ bills in order to purchase all of the donuts.

-Changes in technology

Recall when real GDP increased to $$ 800$ ‍, we needed $800$ ‍ $$ 1$ ‍ bills to buy the increased output because we could only use each $$ 1$ ‍ once. What if someone develops a more durable $$ 1$ ‍ bill that can be used twice instead? Now, a money supply of only $$ 400$ ‍ is needed in total, because each dollar bill can be used twice.

In general, it turns out that we can relate all of these examples to a formula that we will see again in an upcoming lesson. This equation is called the quantity theory of money, which says:

$M V = P Y$ ‍

Key Graphical Models

Money market

The money market illustrates how the demand for money and the supply of money interact to determine nominal interest rates. Note that the demand for money ( $D_{M}$ ‍) is downward sloping and the supply of money is vertical ( $S_{M}$ ‍ and $S_{M 2}$ ‍).

In this graph, the money supply has increased. As a result of the increase in the money supply, the quantity of money demanded at the old rate of interest ( $i_{1}$ ‍) is less than the money supply.

Common misperceptions

Some students get confused about what interest rate is represented in the money market:real or nominal? It’s the nominal rate. Think of the nominal interest rate as the interest rate on the sign outside of a bank. A sign that says, “Now paying higher interest rates!” is advertising a higher nominal interest rate. The real interest rate is that nominal interest minus the rate of inflation.
It might seem odd that the money supply curve is always perfectly vertical. Keep in mind what the vertical money supply curve is saying: the central bank determines the monetary base, and therefore the money supply. This money creation might change interest rates, but it is not being done in response to interest rates, so the supply of money is perfectly vertical.

Discussion questions

In a correctly labeled graph of the money market, show the impact of selling bonds on the interest rate.
If the money supply increases, will bond prices increase, decrease, or stay the same? Explain.
If there is an increase in the money supply, bond prices will increase. When the money supply increases, nominal interest rates decrease. Bond prices and interest rates are inversely related, so when interest rates go down, bond prices go up.
Show the impact of inflation on interest rates using the money market. Explain why the change that you showed occurs.

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rayamato610
3 years agoPosted 3 years ago. Direct link to rayamato610's post “Does an improvement in pa...”
Does an improvement in payment technology increase money demand?
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(4 votes)
- thuhuongle0802
  3 years agoPosted 3 years ago. Direct link to thuhuongle0802's post “To me, the relationship i...”
  To me, the relationship is not entirely clear. I think it should decrease the money demand instead. Payment technology makes it easier for people to hold money securely. It's easier for people to take their saving money out, so they do not need to hold much money on hand knowing that they can take it out when they need to.
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  (3 votes)
Ant Cacchione
2 years agoPosted 2 years ago. Direct link to Ant Cacchione's post “Can someone help explain ...”
Can someone help explain to me the third discussion question? I do not understand
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(1 vote)
- wuzehua2015
  a year agoPosted a year ago. Direct link to wuzehua2015's post “Inflation means an increa...”
  Inflation means an increase in the price level within a country. When the price level increases, households demand more money for their consumption. This translates into a higher money demand curve (a rightward shift), resulting in a higher equilibrium interest rate.
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  (2 votes)
arpneh.23
2 years agoPosted 2 years ago. Direct link to arpneh.23's post “does a decrease in money ...”
does a decrease in money demand increase aggregate supply?
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(1 vote)
- wuzehua2015
  a year agoPosted a year ago. Direct link to wuzehua2015's post “No it does not. Factors t...”
  No it does not. Factors that increase the aggregate supply are either increases in the quantity or quality of the factors of production (increase both the long run AS and the short run AS), or decreasing production costs and lower corporate taxes (increase the short run AS only). A decrease in money demand results in a lower equilibrium interest rate, and the interest rate is a shifter of the aggregate demand. In this case, a lower interest rate leads to an increase in interest-sensitive expenditures, including consumption (C) and investment (I). Therefore, the aggregate demand will increase as a result.
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  (1 vote)
gosoccerboy5
4 years agoPosted 4 years ago. Direct link to gosoccerboy5's post “So.. why can't you use th...”
So.. why can't you use the market for loanable funds to model this? Wouldn't it be a lot more efficient, not to mention the opportunity costs incurred while learning this model? (Wow, I am already thinking like an economist!)
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(1 vote)
cabeard21
3 years agoPosted 3 years ago. Direct link to cabeard21's post “if the price level increa...”
if the price level increases does the curve for money demand shift or does it just move downward on the same curve?
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(1 vote)
Jinx
10 months agoPosted 10 months ago. Direct link to Jinx's post “i can't understand why bo...”
i can't understand why bond prices can initiatively affect interest prices, and why 20% interest rates are not attractive. isn't some explanation above wrong? - just the content of "can you tell me how this happens?" above.
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(1 vote)
chingsumsin
9 months agoPosted 9 months ago. Direct link to chingsumsin's post “I am still confused why s...”
I am still confused why some questions in "changes in the money market" illustrated money demand decrease will cause the interest rate decrease/ money demand increase will cause the interest rate increase
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(1 vote)
M.J.G.
4 years agoPosted 4 years ago. Direct link to M.J.G.'s post “An increase in the money ...”
An increase in the money supply leads to an increase in consumer spending, and thus an increase in aggregate demand. An increase in aggregate demand leads to an increase in output and thus an increase in money demand. Does this mean raising the supply of money raises demand for money at the same time, and vice versa?
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(0 votes)
- gosoccerboy5
  4 years agoPosted 4 years ago. Direct link to gosoccerboy5's post “Well, the money market te...”
  Well, the money market tends to mainly focus on the short run. Of course, as inflation rises, the nominal interest rate will eventually increase to compensate. But before prices can catch up (and also the other effects you mentioned), increasing the money supply will lower rates.
  In other words, yes, money demand catches up, but it takes time.
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  (2 votes)
lqiming2
4 years agoPosted 4 years ago. Direct link to lqiming2's post “If we make the money supp...”
If we make the money supply smaller, the n.i.r will decrease. However, which direction will the curve of the money supply shift?
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(0 votes)
- Davoid Coinners
  4 years agoPosted 4 years ago. Direct link to Davoid Coinners's post “You're wrong. Making the ...”
  You're wrong. Making the money supply smaller would increase interest rates, shifting the money supply curve to the left.
  A smaller money supply would stifle competition between banks and an overall amount of money being held within banks. This increases the interest rate, and discourages lending as a result.
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  (2 votes)

Lesson summary: the money market (article) | Khan Academy (2024)