4.5 The Money Market
The money market sets the nominal interest rate where money demand equals the money supply the central bank fixes.
Money demand slopes downward: at higher nominal interest rates, holding money means giving up more interest, so people hold less of it. Money demand shifts right when price levels or real GDP rise, because more transactions need financing.
The money supply is a vertical line — the central bank sets it, so it does not respond to the interest rate. Equilibrium is where the two curves cross, and that intersection determines the nominal interest rate.
If the central bank increases the money supply, the vertical line shifts right and the nominal interest rate falls; decreasing the money supply raises it. On the exam, always label the y-axis 'nominal interest rate' — this is the #1 labeling error on money market FRQs.
Key terms for 4.5
Drag the curves yourself — the fastest way to make 4.5 stick.
Labeling the money market's y-axis as the real interest rate — that belongs to the loanable funds market. The money market determines the NOMINAL rate.
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