AP Macroeconomics 4.5: The Money Market

The money market is where the quantity of money people want to hold meets the quantity of money there is. Its price is the nominal interest rate.

Money demand (MD) shows how much money households and firms want to hold at each nominal interest rate. You saw in 4.1 that holding money is not free. Cash and checking balances earn little or nothing, so every dollar you hold gives up the interest it could have earned in a bond. The nominal interest rate is the opportunity cost of holding money.

When the rate is high, holding money is expensive, so people keep less of it and move the rest into bonds. When the rate is low, holding money costs little and they keep more. That inverse relationship makes money demand slope down, on a graph with the nominal interest rate on the vertical axis and the quantity of money on the horizontal axis.

Why nominal and not real? Inflation shrinks the buying power of money and of bonds alike, so what you give up by holding money instead of a bond is the bond's whole nominal interest.

Money supply (MS) is the quantity of money in the economy. The central bank determines the monetary base, the currency and bank reserves you met in 4.3. In an economy with limited reserves, banks lend out their excess reserves, and the money multiplier from 4.4 turns that base into a money supply.

Given that base, the quantity of money does not depend on the nominal interest rate. A higher rate prints no currency and creates no reserves, and in this model banks already lend all the excess reserves they have. So at 2 percent or at 8 percent the quantity of money is the same, and MS is drawn as a vertical line at that quantity.

The line moves only when something changes the quantity of money itself, and that is the central bank's job. Changing it is monetary policy, the subject of 4.6.

One warning before you draw: this graph's vertical axis is the nominal interest rate. The real interest rate belongs on a different graph, loanable funds, in 4.7.

Put the two curves on one graph. Equilibrium in the money market is at the nominal interest rate where the quantity of money demanded equals the quantity supplied, where MD crosses MS. Mark that rate i1 and the quantity Q1.

At any other rate the market is in disequilibrium, and bonds do the adjusting.

Above i1, people want to hold less money than there is: a surplus of money. They spend the money they do not want on bonds. More buyers push bond prices up, and as you saw in 4.1, a higher price for a bond means a lower interest rate on it. Rates keep falling until people are content to hold all the money there is.

Below i1, people want more money than there is: a shortage of money. They sell bonds to get it, bond prices fall, and interest rates rise back to i1.

Money demand shifts when people want to hold more or less money at every interest rate.

• A higher price level: the same purchases take more dollars, so MD shifts right. A lower price level shifts it left.
• Higher real GDP: more output means more purchases to pay for, so MD shifts right. Lower real GDP shifts it left.

That is the Think first answer. MD shifted right along a money supply that did not move, so the rate rose, and the quantity of money stayed at Q1 because MS stayed put. A change in the nominal interest rate on its own never shifts MD; it is a movement along the curve.

Money supply shifts when the central bank changes the quantity of money. In an economy with limited reserves, a central bank purchase of bonds adds reserves, banks lend them, and MS shifts right: the rate falls and the quantity of money rises. A sale shifts MS left. Lowering the required reserve ratio from 4.4 lets banks lend more of each deposit, so MS shifts right; raising it shifts MS left. 4.6 covers how these tools work when reserves are ample.