Short on time? This page is the recap. For explanations, graphs and worked examples, use the full study guide.
Recap
- The money market compares the money people want to hold with the money that exists. Its “price” is the nominal interest rate, the opportunity cost of holding money instead of bonds.
- Money demand (MD) slopes down: a higher nominal rate makes holding money more costly, so people hold less.
- Money supply (MS) is vertical: given the monetary base set by the central bank, the quantity of money does not depend on the interest rate.
- Equilibrium: the nominal rate where quantity of money demanded = quantity supplied.
- Out of equilibrium, people buy or sell bonds, which moves bond prices and so interest rates back to equilibrium.
Key relationships
| Situation | What happens | Effect on nominal interest rate |
|---|---|---|
| Rate above equilibrium | Surplus of money; people buy bonds; bond prices rise | Falls |
| Rate below equilibrium | Shortage of money; people sell bonds; bond prices fall | Rises |
| Price level rises | MD shifts right | Rises |
| Real GDP rises | MD shifts right | Rises |
| Price level or real GDP falls | MD shifts left | Falls |
| Central bank buys bonds (expansionary) | MS shifts right | Falls |
| Central bank sells bonds (contractionary) | MS shifts left | Rises |
Assumptions behind the model
- Money earns little or no interest; bonds earn interest.
- The monetary base, and so the money supply, is set by the central bank and does not respond to the interest rate.
- Bond prices and interest rates move in opposite directions (Topic 4.1).
Mistakes to avoid
- Real interest rate on the axis. Use the nominal rate.
- MS drawn with an upward slope. It is vertical.
- Shifting MD when the interest rate changes. That is a movement along MD.
- Saying a surplus of money raises the rate. It lowers it.
- Saying a higher price level increases the money supply. It increases money demand.
- Unlabelled axes or curves. Write “Nominal interest rate”, “Quantity of money”, MS and MD.
Quick self-check
VD is the valda, the currency of the fictional country Valdoria used in the study guide.
- Money demand is Qd = 500 − 25i (VD bn, i in %). The money supply is VD 400 bn. What is the equilibrium nominal interest rate? (4%)
- In the same market, what is the situation at 6%? (Quantity demanded is VD 350 bn, so there is a surplus of money of VD 50 bn and the rate will fall.)
- Real GDP falls. What happens to MD and the nominal interest rate? (MD shifts left; the rate falls.)
Next: practice questions.