The Money Market: Study Guide (Macroeconomics 4.5)

What is the money market?

In Topic 4.4 you saw how banks expand the money supply. Now the question is: what decides the interest rate? The money market model answers it.

The money market brings together the people who want to hold money and the amount of money that exists. It is not a place. It is a model of how much money households and firms want to keep in spendable form (currency and checkable deposits) compared with the amount the central bank and banking system have created.

Every market has a price. In the money market the “price” is the nominal interest rate.

Why? Holding money has a cost. Cash in your wallet and money in a checking (current) account earn little or no interest. If you held a bond instead, you would earn interest. So the nominal interest rate is the opportunity cost of holding money: it is what you give up for the convenience of having money ready to spend.

Key definitions:

• Money demand (MD): the relationship between the nominal interest rate and the quantity of money people want to hold.
• Money supply (MS): the quantity of money in the economy, which depends on the monetary base set by the central bank and on the banking system.
• Equilibrium nominal interest rate: the rate at which the quantity of money demanded equals the quantity of money supplied.

Money demand: why the curve slopes down

People want to hold money for two broad reasons:

• To make transactions. You need money to pay for groceries, rent and wages. More spending in the economy means more money is needed.
• As an asset. Money is safe and easy to use, so people keep some of their wealth in it rather than in bonds.

When the nominal interest rate rises, holding money becomes more expensive, because each valda kept in money gives up more interest. People move some of their wealth into bonds and other interest-earning assets. The quantity of money demanded falls.

When the nominal interest rate falls, the opportunity cost of holding money falls, so people are happy to hold more money. The quantity of money demanded rises.

This is an inverse relationship, so the money demand curve slopes downwards.

A change in the nominal interest rate causes a movement along the MD curve. It does not shift it.

Money supply: why the curve is vertical

The central bank determines the monetary base. With a given monetary base, the banking system creates a given quantity of money. In this model, that quantity does not depend on the nominal interest rate.

So the money supply curve is a vertical line at the quantity of money in the economy. It shifts only when something changes the amount of money, mainly monetary policy by the central bank (Topic 4.6).

Our fictional economy: Valdoria

Valdoria is the fictional country used across the Marlbridge macroeconomics pages. Its currency is the valda (VD). Its central bank is the Central Bank of Valdoria (CBV). All data below are fictional.

The table shows Valdoria’s money demand. The CBV’s actions leave a money supply of VD 700 bn.

Nominal interest rate	Quantity of money demanded	Quantity of money supplied
10%	VD 500 bn	VD 700 bn
8%	VD 600 bn	VD 700 bn
6%	VD 700 bn	VD 700 bn
4%	VD 800 bn	VD 700 bn
2%	VD 900 bn	VD 700 bn

Worked example 1: equilibrium and disequilibrium

Question. (a) Find the equilibrium nominal interest rate. (b) Describe the situation in the money market at 8% and at 4%. (c) Explain how the interest rate moves back to equilibrium from 8%.

(a) The quantity demanded equals the quantity supplied (VD 700 bn) at 6%. That is the equilibrium nominal interest rate.

(b) At 8%: quantity demanded = VD 600 bn, quantity supplied = VD 700 bn. There is a surplus of money of 700 − 600 = VD 100 bn. People hold more money than they want to.

At 4%: quantity demanded = VD 800 bn, quantity supplied = VD 700 bn. There is a shortage of money of 800 − 700 = VD 100 bn. People want to hold more money than exists.

(c) At 8%, households and firms are holding VD 100 bn more money than they want. They use the extra money to buy bonds and other interest-earning assets. The demand for bonds rises, so bond prices rise. Because bond prices and interest rates move in opposite directions (Topic 4.1), interest rates fall.

A quick illustration: a bond that pays a fixed VD 60 a year gives a return of 60 ÷ 1,000 = 6% if its price is VD 1,000. If buyers push its price up to VD 1,200, the return falls to 60 ÷ 1,200 = 5%.

The rate keeps falling until it reaches 6%, where people are happy to hold exactly VD 700 bn.

From 4% the process runs the other way. People want more money than they have, so they sell bonds to get money. Bond prices fall, interest rates rise, and the rate climbs to 6%.

Check. A surplus of money means the interest rate is too high; a shortage means it is too low. This is the same logic as a surplus or shortage of T-shirts in Topic 1.6, with the interest rate playing the part of the price.

What shifts the curves

Money demand shifts when people want to hold a different amount of money at every interest rate:

Change	Effect on MD	Why
Price level rises	Shifts right	Each purchase costs more valdas, so more money is needed for the same transactions.
Price level falls	Shifts left	Fewer valdas are needed for the same purchases.
Real GDP (real income) rises	Shifts right	More goods and services are bought, so more transactions need money.
Real GDP falls	Shifts left	Fewer transactions.
Payment technology makes it easier to keep wealth in interest-earning assets until it is spent	Shifts left	People need to hold less money at any interest rate.

Money supply shifts when the quantity of money changes. In this course the main cause is monetary policy: for example, a central bank purchase of government bonds adds reserves to banks, raises the monetary base and shifts MS right; a sale shifts it left. Topic 4.6 covers the tools in detail.

The general rule for the money market:

• MD right (or MS left) → higher equilibrium nominal interest rate.
• MD left (or MS right) → lower equilibrium nominal interest rate.

Worked example 2: a rise in the price level, then a policy response

Question. The price level in Valdoria rises. At every interest rate, people now want to hold VD 100 bn more money than before. The money supply stays at VD 700 bn. (a) What is the new equilibrium nominal interest rate? (b) Explain the adjustment. (c) What money supply would the CBV need to bring the rate back to 6%?

(a) The new quantities demanded are: 10% → VD 600 bn, 8% → VD 700 bn, 6% → VD 800 bn, 4% → VD 900 bn. The quantity demanded equals VD 700 bn at 8%. The equilibrium rate rises from 6% to 8%.

(b) At the old rate of 6%, people now want VD 800 bn but only VD 700 bn exists: a shortage of VD 100 bn. People sell bonds to get money. Bond prices fall and interest rates rise. The quantity of money demanded falls along the new MD curve until it equals VD 700 bn at 8%.

(c) At 6% the new MD curve shows a quantity demanded of VD 800 bn. So the CBV would need to raise the money supply to VD 800 bn, an increase of VD 100 bn, to bring the rate back to 6%.

Check. The quantity of money in equilibrium did not change: it is still VD 700 bn, because MS is vertical. Only the interest rate changed.

How the money market fits the rest of the unit

The equilibrium nominal interest rate affects the value of other financial assets. When the money market rate falls, bond prices rise; when it rises, bond prices fall. Interest rates on loans tend to move in the same direction, which is how the money market connects to investment and aggregate demand in Topic 4.6.

In Topic 4.6 you will also see that some central banks steer interest rates mainly by setting rates they control directly, rather than by changing the money supply. The money market graph is still one of the models you can use to show the short-run direction of a monetary policy action.

Common misconceptions

• “The money market graph uses the real interest rate.” It uses the nominal rate. The real rate belongs on the loanable funds graph (Topic 4.7).
• Drawing MS sloping upwards. Given the monetary base, MS is vertical.
• “A higher interest rate shifts money demand left.” A change in the interest rate is a movement along MD, not a shift.
• “A surplus of money makes interest rates rise.” A surplus means the rate is above equilibrium. People buy bonds, bond prices rise and the rate falls.
• “Money demand is how much money people would like to have in total.” Everyone would like more wealth. Money demand is about how much of their wealth people choose to hold as money rather than as bonds.
• “A higher price level increases the money supply.” It increases money demand. The supply changes only when the quantity of money changes.
• Labelling the horizontal axis “Quantity” or “Q”. Write quantity of money, and label the curves MS and MD.

Where this leads

Next, in Topic 4.6, you will see how a central bank uses its tools to shift the money supply or set its own interest rates, and how this changes investment, aggregate demand, real output and the price level: go to the Monetary Policy study guide. First, try the practice questions, then use the revision notes and the checklist to consolidate.