Money Market
Money supply, money demand, and interest rate determination.
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What this graph shows
This is the money market, where the central bank sets the money supply and the market sets the nominal interest rate. Money supply (MS) is a vertical line because the Federal Reserve fixes the quantity of money regardless of the interest rate. Money demand (MD) slopes down because a higher interest rate raises the opportunity cost of holding cash, so people hold less money.
The rate that clears the market is where money demand crosses the vertical supply line. Open market operations move the MS line: buying bonds shifts MS right and lowers the rate, while selling bonds shifts it left and raises the rate. Shifting money demand shows how a change in the price level or real income moves the rate at a fixed supply.
How to read it
The horizontal axis is the quantity of money and the vertical axis is the nominal interest rate. The key feature is that money supply is a vertical line, so it does not respond to the interest rate, while money demand slopes downward. Equilibrium is the point where MD meets the vertical MS line, and reading across to the axis gives the market nominal interest rate. Because MS is vertical, any move of that line changes the interest rate on its own.
Three things to try
- Shift MS right to mimic the Fed buying bonds. The vertical supply line slides out and the equilibrium interest rate drops, the mechanism behind expansionary monetary policy.
- Shift MS left to mimic the Fed selling bonds. The interest rate rises, showing contractionary policy pulling money out of the economy to cool inflation.
- Shift MD right while leaving MS fixed. The interest rate rises even though the money supply never changed, showing how higher income or a higher price level raises rates on its own.
Common questions
Why is the money supply curve vertical in the money market?
The money supply is set by the central bank and does not depend on the interest rate, so it is drawn as a vertical line at whatever quantity the Fed chooses. Changing that quantity moves the whole line left or right rather than moving along it.
What is the difference between the money market and the loanable funds market?
The money market determines the nominal interest rate with a vertical money supply set by the Fed, while the loanable funds market determines the real interest rate with an upward-sloping saving supply. One shows short-run monetary policy, the other shows saving and investment.
How does the Fed lower the interest rate?
The Fed buys government bonds through open market operations, which increases the money supply and shifts the vertical MS line to the right. With more money available, the equilibrium nominal interest rate falls.
Money Market: key terms
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