4.5 The Money Market

Money supply and money demand

The money market shows how the interest rate is determined by the supply and demand for money. The money supply (MS) curve is vertical because it's set by the central bank (Federal Reserve), not by the interest rate. The money demand (MD) curve slopes downward — as the interest rate falls, the opportunity cost of holding money decreases, so people hold more money.

Equilibrium interest rate

Equilibrium occurs where MS = MD, determining the nominal interest rate. If the interest rate is above equilibrium, there's a surplus of money — people buy bonds, driving rates down. If below equilibrium, there's a shortage — people sell bonds, driving rates up. Bond prices and interest rates move inversely.

Shifts in the money market

MS shifts when the Fed changes monetary policy (open market operations, reserve requirements, discount rate) — shifting MS right lowers interest rates; shifting left raises them. MD shifts with changes in real GDP (income) or the price level: higher income or prices increase money demand (shift right), raising interest rates, and vice versa.

Key terms

Money supply (MS) curve

Vertical curve representing the fixed quantity of money set by the central bank, independent of the interest rate.

Money demand (MD) curve

Downward-sloping curve showing that quantity of money demanded increases as the interest rate falls, due to lower opportunity cost of holding money.

Money market equilibrium

The point where money supply equals money demand, determining the nominal interest rate.

Effect of increasing MS on interest rate

Increasing the money supply shifts MS right, creating a surplus of money and lowering the equilibrium interest rate.

Bond prices and interest rates

They move inversely — when interest rates rise, bond prices fall, and vice versa.

Try an AP-style question

The money supply curve is vertical because…

1. banks set it
2. demand is fixed
3. interest rates are fixed
4. the Fed sets it independent of rates