Chapter 13 · Demand-side and supply-side policies
Money-market equilibrium
Find the equilibrium interest rate where money demand equals money supply. Explain excess demand or excess supply in the money market.
The economic idea
Money is an asset accepted as a medium of exchange, a unit of account and a store of value. Liquidity is the ease with which an asset can be used for payment without loss of value.
Money demand is the quantity of money balances households and firms wish to hold. Transactions and precautionary motives rise with income and spending, while the speculative or asset motive depends negatively on the interest rate because interest-bearing assets become more attractive as their return rises.
The interest rate is the opportunity cost of holding non-interest-bearing money in this model. A higher interest rate therefore reduces quantity of money demanded, giving the money-demand curve its downward slope.
The textbook money-supply curve is vertical because the central bank is assumed to choose the nominal quantity independently of the current interest rate. Modern central banks often implement policy by targeting a short-term interest rate and supplying reserves elastically, so the vertical curve is a teaching simplification rather than a literal description of every operating framework.
Money-market equilibrium occurs when desired money holdings equal the quantity supplied. Away from equilibrium, purchases and sales of bonds change bond prices; because bond prices and yields move inversely, the market interest rate adjusts until the market clears.
Reading the intersection of Dₘ and Sₘ
“Rate of interest” is on the vertical axis and “Quantity of money” is on the horizontal axis.
“Dₘ” is downward sloping because the opportunity cost of liquidity rises with the interest rate.
“Sₘ” is vertical because the model treats the quantity of money as fixed by the monetary authority at a point in time.
Equilibrium: E
“Dₘ” intersects the vertical “Sₘ” at “E”. The current money-market equilibrium is the interest rate “i” and quantity of money “Qₑ”.
Above i: excess supply of money
At an interest rate above “i”, desired money holdings on “Dₘ” are below “Qₑ”. People try to exchange excess money balances for bonds, raising bond prices and lowering the interest rate toward “E”.
Below i: excess demand for money
At an interest rate below “i”, desired money holdings exceed “Qₑ”. People sell bonds to obtain liquidity, lowering bond prices and raising the interest rate toward “E”.
Money demand is a decision to hold liquidity
Demand for money means the amount people wish to hold in a liquid form, not simply the amount they want to borrow. The interest rate is the opportunity cost of holding money instead of an interest-bearing asset.
Higher income or a higher price level can increase transaction demand and shift money demand. A change in the interest rate moves along the existing demand curve. Keep this distinction clear before using the model to explain a change in equilibrium.
How portfolio adjustment returns the money market to equilibrium
Compare desired balances on “Dₘ” with the fixed quantity “Qₑ” supplied by “Sₘ” at the prevailing interest rate.
An excess supply of money creates purchases of bonds; an excess demand for money creates sales of bonds.
Bond prices and interest rates move inversely, changing the opportunity cost of holding money.
Common mistakes to avoid
- “Sₘ” is not the supply of loanable funds and “Dₘ” is not aggregate demand.
- The vertical axis shows an interest rate, not the price level or the price of money.
- A movement along money demand is caused by a change in the interest rate; income, prices, payment technology or liquidity preference can shift the curve.
- The model does not imply that commercial banks passively multiply reserves into a fixed amount of broad money.
- Money-market equilibrium begins a transmission process; it does not by itself establish the final change in real GDP or inflation.
How to draw this diagram
- Title the diagram “Money-market equilibrium”. Label the horizontal axis “Quantity of money” and the vertical axis “Rate of interest”.
- Draw Dₘ first and label it clearly.
- Draw Sₘ next and label it clearly.
- Mark each relevant intersection and distinguish the initial, market and socially optimum or policy outcomes where applicable.
- Project important intersections to the axes with dashed guide lines and label the outcomes.
- Check that every symbol used in the explanation appears on the diagram and add arrows showing the direction of change.
Assumptions and limitations
- The model uses one interest rate even though economies contain many policy, deposit, lending, bond and risk-adjusted rates.
- It assumes a vertical, exogenous money supply and omits interest-rate-targeting operating frameworks.
- Bank lending, credit creation, regulation, collateral, risk premia and payment-system structure are not shown.
- The price level and real income are held constant even though both influence money demand.
- The diagram does not determine the strength or timing of monetary transmission to output and inflation.