Money Market

Money supply meets money demand, how the nominal interest rate is set.

Equilibrium: M* = 50.0, i* = 4.5

Current equations

Md: i = 9 − 0.09·MMs: M = 50

The market for liquidity itself. The central bank fixes the money supply (the vertical line); households and firms demand money for transactions, more when incomes or prices are high, less when interest rates make parking cash costly. The nominal interest rate balances the two.

Source: Mishkin, Money, Banking and Financial Markets, ch. 5

Shift the curves

Money supply (central bank policy)0

The central bank sets Ms: expansion shifts the vertical line right and lowers i.

Money demand (income, price level)0

Higher income or prices mean more transactions. Md shifts right, pushing i up.

The Money Market model, in writing

Definition

The demand for holding money (for transactions, falling as interest rates rise) meets the money supply set by the central bank, determining the nominal interest rate.

Md(i, Y) = Ms ; Md rises with income Y, falls with interest rate i

The intuition

Holding cash means giving up interest, so when rates are high people hold less money. If the central bank expands the money supply, people find themselves holding more cash than they want and buy bonds, pushing bond prices up and interest rates down: that is the liquidity effect behind every rate cut.

Exam tip

The money supply curve is vertical (the central bank fixes the quantity, not the price). Higher income shifts money DEMAND right and raises rates, a favourite twist question.

Related models in Money & Finance

Loanable Funds Market →Baumol-Tobin Money Demand →Capital Asset Pricing Model (CAPM) →Term Structure of Interest Rates →