Higher prices, more money demanded

The chain in words

1. Step 1

   Before prices rise

   The horizontal axis is the quantity of money. The vertical axis is the nominal interest rate. Money demand slopes down, money supply is fixed and vertical. The market is at E₀.

2. Step 2

   Money demand shifts right

   When everything costs ten percent more, the same shopping trip needs ten percent more money. People want to hold more money at every interest rate, so money demand shifts right. At the old rate, people want more money than exists.

3. Step 3

   The interest rate rises

   People sell bonds to top up their balances. Bond prices fall and the interest rate rises to E₁. The money stock is unchanged, so the whole adjustment happens through the interest rate.

Takeaway. A higher price level raises money demand and, with a fixed money supply, raises the interest rate.

Draw it yourself

More on the money market graph