Macroeconomics guide, Unit 4, step 12 of 23Previous step Next step

Step 12: The Money Market

By the EconTutorials team. 11-minute read with 6 practice questions.

SyllabusAP Macro 4.5 · Cambridge 9.4 · IB 3.5

In 30 seconds

The money market shows the demand for money (MD) and the supply of money (MS); where they cross sets the equilibrium nominal interest rate.
MD slopes down because a higher interest rate raises the opportunity cost of holding money; it shifts with the price level and real GDP.
MS is vertical because the central bank sets it. Buying bonds shifts MS right and lowers the interest rate; selling bonds does the opposite.
Lower interest rates raise investment and shift AD right. With ample reserves, the central bank moves rates mainly by changing the interest it pays on reserves.

Video lesson coming soonA short animated lesson for this step will appear here.

Why people want to hold money

The money in your wallet could have gone into a bond that earns interest. You hold it as money because money is the one asset you can spend at once: at the café, on the bus, or in an emergency.

The demand for money (MD) is the total amount of money that households and firms want to hold. Economists split it into two parts.

Transactions demand: money held to pay for everyday purchases. It depends on how much spending there is, which is nominal GDP (the price level times real GDP). If prices rise or people buy more goods, they need more money in their pockets.
Asset demand: money held as a store of wealth, because it is safe and liquid. Its cost is the interest you give up by not holding bonds. When interest rates are high, holding money is expensive, so people hold less of it.

Cambridge and IB courses call this liquidity preference (Keynes’s term), with three motives: transactions, precautionary (money for emergencies, which also rises with income) and speculative (the asset demand, linked to interest rates and bond prices).

Key termDemand for money: the quantity of money people wish to hold at each nominal interest rate; it varies inversely with the interest rate because the interest rate is the opportunity cost of holding money.

The money demand curve: slope and shifts

On the money market graph, the vertical axis is the nominal interest rate ($ i $) and the horizontal axis is the quantity of money. The MD curve slopes downward. As the interest rate rises, the opportunity cost of holding money rises, so people move wealth out of money and into bonds, and the quantity of money demanded falls. A change in the interest rate is a movement along MD.

Other changes shift the whole curve:

Change	Effect on MD	Why
Price level rises	Shifts right	Each purchase costs more money, so more is needed for transactions
Real GDP rises	Shifts right	More goods and services are bought, so more money is needed
Price level or real GDP falls	Shifts left	Fewer dollars are needed for transactions

Common mistakeSaying “a rise in the interest rate shifts money demand left”. The interest rate is on the vertical axis, so a change in it is a movement along MD, not a shift. Only the price level, real GDP and similar factors shift MD.

Money supply and the equilibrium interest rate

The money supply (MS) is set by the central bank (the Federal Reserve in the US, the Bank of England in the UK). In this model the central bank decides the quantity of money, and that quantity does not depend on the interest rate. So the MS curve is a vertical line.

The equilibrium nominal interest rate is where MS crosses MD: the rate at which people are happy to hold exactly the amount of money the central bank has supplied.

\[ \text{Equilibrium: } MD = MS \text{ at the nominal interest rate } i^* \]

If the interest rate is above equilibrium, people hold more money than they want (an excess supply of money), so they buy bonds. Bond prices rise and, because bond prices and interest rates move inversely, the interest rate falls until it reaches $ i^* $. Below equilibrium, people sell bonds to get money, bond prices fall and the rate rises.

Worked example

For example, money demand in an economy is given by the table below (in billions of dollars). The central bank sets the money supply at $400bn. Find the equilibrium interest rate, then find the new rate if MS rises to $500bn.

Nominal interest rate	2%	4%	6%	8%
Quantity of money demanded (billions of dollars)	600	500	400	300

Step 1$ MS = 400: \; MD = 400 \text{ at } i = 6\%, \text{ so } i^* = 6\% $

Step 2$ \text{At } 6\% \text{ after the increase: } MS = 500 \gt MD = 400 \Rightarrow \text{excess supply of } \$100\text{bn} $

Step 3$ MS = 500: \; MD = 500 \text{ at } i = 4\%, \text{ so the new } i^* = 4\% $

More money pushes people to buy bonds, which drives the interest rate down from 6% to 4%.

Open market operations on the graph

The main tool for changing the money supply in this model is open market operations (OMOs): the central bank buying or selling government bonds (securities) with commercial banks.

Buying bonds (expansionary): the central bank pays for the bonds by adding to banks’ reserves. Banks have more to lend, the money supply rises, MS shifts right and the nominal interest rate falls.
Selling bonds (contractionary): banks pay for the bonds out of their reserves. Reserves fall, the money supply falls, MS shifts left and the nominal interest rate rises.

DiagramDraw the vertical axis as “Nominal interest rate (i)” and the horizontal axis as “Quantity of money”. Draw a downward-sloping MD curve and a vertical MS₁ line. Mark where they cross as i₁ and Q₁. Now the central bank buys bonds: draw MS₂ as a vertical line to the right of MS₁. It meets MD lower down, at i₂, which is below i₁, with a larger quantity of money Q₂. For a bond sale, shift MS left: the rate rises. If money demand rises instead, shift MD right along the fixed MS line: the rate rises.

Lowering the required reserve ratio or the discount rate (the rate the central bank charges banks for loans) also shifts MS right; raising them shifts it left.

Limited reserves versus ample reserves

The vertical MS story above describes a limited-reserves system: banks hold only just enough reserves, so small OMOs move the overnight interbank rate (in the US, the federal funds rate).

Since the 2008 financial crisis, the Federal Reserve has supplied so many reserves that banks hold far more than they need. This is an ample-reserves system. The demand for reserves is steep when reserves are scarce but almost flat when they are plentiful. With ample reserves, supply sits on the flat part, so buying or selling a few bonds barely changes the interest rate.

Instead the central bank uses administered rates: interest rates it simply sets by announcement.

Interest on reserve balances (IORB): the rate the Fed pays banks on the reserves they keep at the Fed. Since October 2008 the Fed has been able to pay interest on reserves. A bank will not lend reserves to another bank for less than it can earn risk-free from the Fed, so IORB acts as a floor that pulls the market rate towards it.
Overnight reverse repurchase (ON RRP) rate: a rate offered to a wider group of financial firms, helping keep the market rate from falling too far below the target range.

To tighten, the Fed raises its administered rates and market rates follow; to loosen, it cuts them. Only the tool differs; the effects on the economy are the same.

Key termAmple-reserves framework: a monetary system in which banks hold plentiful reserves, so the central bank controls short-term interest rates mainly by setting administered rates such as interest on reserves, rather than by changing the quantity of reserves.

From the interest rate to investment and AD

The money market matters because the interest rate is the cost of borrowing. The chain for an expansionary policy is:

\[ \text{Buy bonds (or cut IORB)} \rightarrow i \downarrow \rightarrow I \uparrow \text{ (and interest-sensitive } C \uparrow) \rightarrow AD \uparrow \rightarrow \text{real GDP} \uparrow, \; \text{price level} \uparrow \]

Cheaper borrowing raises investment in machines and buildings, and household borrowing for cars and houses. AD shifts right, by more than the first rise in spending because of the multiplier. Contractionary policy runs the chain in reverse, to cool an inflationary gap.

Worked example

For example, the central bank buys bonds and the nominal interest rate falls from 6% to 4%. Firms respond by raising investment by $20bn. The MPC is 0.8. Assuming the price level is constant, how far does real GDP rise?

Step 1$ \text{MPS} = 1 – 0.8 = 0.2 $

Step 2$ \text{Multiplier} = \frac{1}{0.2} = 5 $

Step 3$ \Delta \text{Real GDP} = 5 \times \$20\text{bn} = \$100\text{bn} $

A 2-percentage-point cut in the interest rate leads, through investment and the multiplier, to a $100bn rightward shift of AD.

Common mistakeMixing up the two interest-rate graphs. The money market uses the nominal interest rate and a vertical MS. The loanable funds market uses the real interest rate and an upward-sloping supply of loanable funds. Label the axis to match the graph you are drawing.

Exam tipAP Macro FRQs: label the vertical axis “Nominal interest rate” and the horizontal axis “Quantity of money”; draw MS vertical and MD downward-sloping; show the shift with arrows and label the old and new rates (i₁, i₂). Then explain the full chain in words: “the Fed buys bonds, so the money supply increases, the nominal interest rate falls, investment rises, AD increases and real GDP rises”. If the question says “ample reserves”, the correct tool is changing the interest rate on reserves, not an OMO. Cambridge 9708 and IB: explain liquidity preference with its three motives, and evaluate by noting that investment may not respond if business confidence is low.

Practise: 6 questions

Try each one on paper first, then check the worked answer.

EasyQ1. Real GDP rises. What happens to the demand for money and the equilibrium nominal interest rate, if the money supply does not change? Show worked answer

More transactions need more money, so MD shifts right. With MS vertical and unchanged, the new intersection is higher up: the equilibrium nominal interest rate rises.

EasyQ2. Using the money demand table in the guide (2% → 600, 4% → 500, 6% → 400, 8% → 300, in billions of dollars), what is the equilibrium interest rate if MS = $300bn? Show worked answer

MD = 300 when i = 8%. So the equilibrium nominal interest rate is 8%.

MediumQ3. Using the same table, MS = $600bn. (a) What is the equilibrium rate? (b) If the interest rate were 6%, describe the disequilibrium and how the market corrects it. Show worked answer

(a) MD = 600 at i = 2%, so i* = 2%.
(b) At 6%, quantity demanded = $400bn but supply = $600bn: an excess supply of money of $200bn. People use the spare money to buy bonds, bond prices rise, and so the interest rate falls until it reaches 2%.

MediumQ4. In a limited-reserves system, the central bank sells government bonds. Explain the effect on the money supply, the nominal interest rate, investment and aggregate demand. Show worked answer

Banks pay for the bonds with reserves, so reserves fall and banks can lend less: the money supply falls (MS shifts left). The nominal interest rate rises. Borrowing becomes more expensive, so investment falls. Lower investment shifts AD left, reducing real GDP and the price level.

MediumQ5. The Federal Reserve operates with ample reserves and wants to raise short-term interest rates. Which tool should it use, and why would an open market sale of bonds not work well? Show worked answer

It should raise its administered rates, mainly the interest on reserve balances (IORB). Banks will not lend reserves for less than the risk-free rate they can earn at the Fed, so market rates rise with IORB.
With ample reserves, the supply of reserves lies on the flat part of the reserve demand curve. A modest bond sale reduces reserves a little but leaves them still plentiful, so the interest rate hardly changes.

ExamQ6. An economy has a recessionary gap. The central bank operates in a limited-reserves system. (a) Identify the open market operation it should use. (b) Draw a correctly labelled money market graph showing the effect on the nominal interest rate. (c) Explain the effect on investment and real GDP. (d) State what happens to the price of existing bonds. [6 marks] Show worked answer

(a) Buy government bonds. [1 mark]
(b) Axes: “Nominal interest rate” (vertical) and “Quantity of money” (horizontal) [1 mark]. Downward-sloping MD, vertical MS₁ shifting right to MS₂, with the interest rate falling from i₁ to i₂ [1 mark].
(c) The lower interest rate reduces the cost of borrowing, so investment increases [1 mark]. AD shifts right and, through the multiplier, real GDP increases towards full employment [1 mark].
(d) The price of existing bonds rises, because bond prices move inversely with interest rates (the central bank’s buying also adds demand for bonds). [1 mark]

Check yourself

1. Why does the money demand curve slope downward?

Holding money means giving up interest on bonds; the higher the rate, the more you give up, so you hold less.

2. The central bank buys government bonds in a limited-reserves system. On the money market graph:

Buying bonds adds reserves, raising the money supply; the vertical MS moves right and meets MD at a lower rate.

3. In an ample-reserves system, the main tool for raising interest rates is to:

With plentiful reserves, small changes in their quantity barely move rates, so the central bank changes administered rates such as IORB.

Your score: 0 out of 3

The short version

Money demand comes from transactions (linked to nominal GDP) and asset demand (linked to the interest rate); it slopes down against the nominal interest rate.
A higher price level or higher real GDP shifts MD right and raises the interest rate.
Money supply is vertical, set by the central bank; equilibrium is where MS = MD.
Buying bonds shifts MS right and lowers the rate; selling bonds shifts it left and raises the rate. With ample reserves, the central bank uses administered rates such as interest on reserves instead.
Lower interest rates raise investment, shift AD right and, through the multiplier, raise real GDP.