Lesson preview · Money Market
The Money Market
~12 min · Free to read
Keep 100 dollars in your wallet and the bank pays you nothing on it. Move that same 100 dollars into a savings account and it earns interest. So holding cash is not free. The interest you walk away from is the price of keeping money in your pocket. Cash is handy, but handiness has a cost.
That cost is the key to the whole money market — the market where the price of holding money is set. The price here is the nominal interest rate (the interest rate quoted on accounts and loans, before inflation is stripped out). Like any market, it has a demand side and a supply side. Get those two right and you can read off the interest rate where they meet.
Key Term
Money demand slopes down
Money demand is how much money people want to hold as cash and in current accounts, rather than locked away in interest-bearing assets like bonds. It slopes down against the interest rate, and the reason is opportunity cost.
The opportunity cost of holding money is the interest you give up by not putting it into an interest-bearing asset. When the interest rate is high, that sacrifice is large — so people hold less cash and shift more into bonds and savings. When the rate is low, the sacrifice is small — so they are happy to keep more cash on hand. Higher rate, less money held: that is the downward slope.
Key Term
Money supply is vertical
The money supply is the total quantity of money in the economy. The central bank — the public body that controls the money supply, such as the Federal Reserve in the United States — decides what that quantity is.
Because the central bank simply sets the amount, the money supply does not respond to the interest rate at all. A higher rate does not call forth more money; a lower rate does not shrink it. On the diagram that makes the money-supply curve a vertical line — the same quantity whatever the rate.
That is the takeaway: the interest rate is just the price where money demand meets money supply. Push the supply line right and the rate falls; push the demand line right and the rate rises.
Worked Example
An economy’s money market is in balance: the nominal interest rate is 5%. Consider two separate events. (a) The central bank raises the money supply, shifting the vertical supply line to the right, and the rate settles at 3%. (b) Instead, starting again from 5%, money demand rises and shifts the demand line to the right, and the rate settles at 7%. Explain the mechanism behind each new rate.
Trap · Common Misconception
"The central bank just sets the interest rate by decree"
It sounds like the central bank announces a rate and that is that. Not quite. What the central bank directly controls is the quantity of money — it moves the vertical supply line. The interest rate is then whatever the market produces where money demand meets that supply.
So the rate is a result, not a command. The central bank picks the money supply with a target rate in mind, but the rate itself comes from the crossing point. Move the supply line right and the rate falls out of the diagram lower; the bank does not stamp the number on directly.
Check yourself · no marks
A booming economy lifts real incomes, so households and firms want to hold more money for day-to-day spending. The central bank leaves the money supply unchanged. What happens to the nominal interest rate, and why?
Commit to one first. Guessing and being wrong beats reading the answer cold.
Practice · 1 / 4
Why does the money-demand curve slope down against the nominal interest rate?
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