Real Incomes Rise, Rates Follow

Real Incomes Rise, Rates Follow, step by step

1. 1

   Start at Equilibrium

   The money market begins in equilibrium where money demand (MD) crosses the vertical money supply (MS). The vertical axis is the nominal interest rate and the horizontal axis is the quantity of money. MD slopes down because a higher nominal interest rate raises the opportunity cost of holding cash instead of interest-bearing assets.

2. 2

   Incomes and Transactions Rise

   Real output and real incomes grow, so households and firms make more purchases every month. Every one of those purchases has to be settled with money, so people keep larger balances on hand. This is transactions demand: at every nominal interest rate people now want to hold a larger quantity of money than before, so money demand shifts right. The trigger is real income and not the interest rate, which is why MD shifts instead of sliding along itself.

3. 3

   A Shortage of Money Appears

   At the old nominal interest rate people now want to hold more money than actually exists, a shortage of money. They sell bonds to raise cash, which pushes bond prices down. Falling bond prices are the same event as rising interest rates, so the nominal interest rate is bid up.

4. 4

   The Nominal Interest Rate Settles Higher

   The rate keeps rising until the quantity of money people want to hold falls back to the fixed quantity the central bank supplies, so the new MD crosses the unchanged MS. That fall in quantity demanded is a movement along the new MD, not another shift of it. The equilibrium quantity of money does not change, because the central bank alone sets it, and the vertical MS makes that easy to see. The nominal interest rate is the only thing that adjusts, and it ends higher than it started.

Where it ends up

Higher real income raises the transactions demand for money, shifting MD right; with a vertical money supply fixed by the central bank, the nominal interest rate rises.

Now draw it yourself

Same graph, graded on whether you move the right curve and leave the rest alone.

• Merchants Stop Taking Cards →
• Flight to Liquidity →
• Recession and Cash Balances →

More Money Market walkthroughs

• Expansionary Policy: The Fed Buys Bonds →
• Contractionary Policy: The Fed Sells Bonds →
• Reserve Requirement Cut, Rates Fall →
• Payment Technology Cuts the Cash People Hold →