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 (
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
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
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.
[Can you tell me how this happens?]
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
, you need 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.
- if the price of everything increases by
- 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.
[Can you tell me a story to help explain these more?]
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 (
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 (
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.
[Ok, I think I have it. Can I check my graph?]
If the money supply increases, will bond prices increase, decrease, or stay the same? Explain.
[I tried my best, can I check my work?]
Show the impact of inflation on interest rates using the money market. Explain why the change that you showed occurs.
I'm deeply immersed in the intricacies of the financial world, particularly in the domain of the money market. My expertise extends to the fundamental concepts discussed in the provided article. Let me delve into the key terms and graphs related to the money market to enhance your understanding.
Money Market Concepts:
-
Demand for Money:
- Definition: The desire to hold money for various purposes, influenced by factors like interest rates, prices, and technology.
- Graphical Model: Illustrated by the downward-sloping "money demand" curve, showcasing the inverse relationship between liquidity preference and interest rates.
-
Money Supply:
- Definition: The total amount of money in circulation within an economy.
- Graphical Model: Represented by a vertical curve, indicating that the money supply is determined by the central bank and remains constant regardless of interest rate changes.
-
Liquidity Preference:
- Definition: The amount of wealth individuals prefer to keep in the form of cash for transactional purposes.
- In Practice: Explained through scenarios like choosing between holding bonds and cash for immediate expenses, known as liquidity preference.
-
Transactions Motive:
- Definition: The desire to hold money for regular transactions.
- Example: Choosing to hold cash to facilitate daily purchases.
Key Takeaways:
-
Downward-Sloping Demand: The demand for money decreases as interest rates increase, highlighting the tradeoff between holding cash and other interest-bearing assets.
-
Vertical Money Supply: The money supply is determined by the central bank and remains constant, resulting in a vertical supply curve.
-
Equilibrium in Money Market: The nominal interest rate adjusts until the quantity of money demanded equals the quantity supplied, achieving market equilibrium.
Changes in Supply and Demand:
-
Central Bank Control: The central bank influences the money supply, leading to changes in interest rates.
-
Demand for Money Shifts: Changes in national income, price levels, and advancements in money technology can alter the demand for money.
Key Graphical Models:
- Money Market Graph: Displays the interaction between the downward-sloping demand for money and the vertical money supply, depicting how changes impact nominal interest rates.
Discussion Questions:
-
Impact of Selling Bonds: In a graph of the money market, selling bonds would affect the interest rate, and you can check your understanding by visualizing this scenario.
-
Money Supply Increase and Bond Prices: Explore the relationship between an increase in the money supply and its impact on bond prices, explaining the dynamics.
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Inflation's Impact on Interest Rates: Illustrate the effect of inflation on interest rates using the money market graph and provide an explanation for the observed change.
Feel free to seek further clarification or ask additional questions related to the captivating world of the money market.