Money Market
What is Money Market?
The money market is the model in which the supply of and demand for money determine the nominal interest rate.
The money supply is vertical because the central bank sets it, and money demand slopes downward. Their intersection sets the equilibrium nominal interest rate. Expansionary monetary policy shifts money supply right, lowering interest rates.
Money Market: a worked example
Let the central bank fix the money supply at $600 billion, so supply is vertical at that quantity, and let money demand be Md = 900 - 50i with i in percent. Equilibrium requires 600 = 900 - 50i, so 50i = 300 and i = 6%. Now the central bank buys bonds and the money supply rises to $700 billion. Solving 700 = 900 - 50i gives 50i = 200 and i = 4%. At the old 6% rate people want to hold $600 billion while $700 billion exists, so the $100 billion surplus goes into buying bonds. Bond prices rise, yields fall, and the rate settles at 4%. That 2 point drop then raises interest sensitive investment and consumption in the aggregate demand model.
The mistake students make with money market
On free response questions students answer an open market purchase by shifting money demand. The purchase changes the quantity the central bank supplies, so the vertical supply curve moves right while the demand curve stays exactly where it was drawn. A related error is drawing money supply with an upward slope, as though banks would offer more money at higher rates. Quantity supplied does not respond to the interest rate in this model because the central bank picks the quantity outright, which is precisely why the curve is vertical.
Money Market questions
Why is the money supply curve vertical in the money market?
The central bank sets the quantity of money through open market operations and its other tools, and that quantity does not change when the interest rate changes. A curve that reports the same quantity at every rate is drawn vertical. Money demand supplies all of the downward slope in this model, so a vertical supply crossing a downward sloping demand pins down the nominal interest rate.
What happens to interest rates when the money supply increases?
Nominal interest rates fall. With demand unchanged, adding $100 billion to a $600 billion money supply leaves people holding more money than they want at the old rate, so they buy bonds. Bond prices rise, and a fixed coupon divided by a higher price is a lower yield, which is the same thing as a lower interest rate. In the worked case the rate slides from 6% to 4%.
How is the money market different from the loanable funds market?
The money market determines the nominal interest rate from the stock of money and the demand to hold it. The loanable funds market determines the real interest rate from the flow of saving and the demand to borrow. Monetary policy is normally shown in the money market, while government borrowing and crowding out are shown in loanable funds. Watch the axis label, because graders check whether the rate is nominal or real.
Formula / Example
This is the live Money Market sandbox. Drag the curves, or open the full version.
Related terms
Common comparisons
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