Flight to Liquidity
The question
After several large corporate borrowers in the country of Verrin default, households and firms grow far more worried about how quickly they could sell the bonds they own. At every interest rate they now choose to keep a larger share of their wealth in checking deposits rather than in bonds. Assume the price level and real income are unchanged. Show the effect of this change on the money market, assuming the central bank takes no action. Show the effect on the Money Market graph.
Drag a curve, or use the arrow buttons. Want the free-play version with every control? Open this graph in the sandbox.
Flight to Liquidity: the worked answer
On the Money Market graph, Money demand (MD) shifts right.
Why Money demand (MD) shifts right
Wealth can be held as money, which is liquid but earns little interest, or as bonds, which pay interest but are less liquid. When bonds come to look riskier and harder to sell, people want to hold a larger portion of their wealth as money at every interest rate, which is an increase in money demand and shifts the MD curve to the right. The wealth moves between private holders rather than being newly created, and the central bank takes no action, so the total quantity of money is unchanged and the vertical MS line stays put.
What happens to the equilibrium
The equilibrium nominal interest rate rises while the quantity of money is unchanged.
The mistake students make on this one
The specific wrong answer here is shifting MS right because "people are holding more money now." Not one additional dollar was created; the deposits people acquire come from whoever sold them the bonds, so only the willingness to hold money at each rate changed, and the interest rate must rise until people are content holding the fixed quantity that exists.
On exam day
Money demand has an asset motive as well as a transactions motive, so when a stem describes people fleeing bonds for liquidity, shift MD right even though income and the price level never moved.
How this is graded
The checker reads every curve's position before and after your answer. You are marked correct only when Money demand (MD) shifts right and every other curve on the Money Market graph stays where it started — the same standard an AP reader applies to a drawn graph: the right shift, and nothing extra. There is no AI involved; the rubric is the geometry.
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