Lesson summary: the money market (article) | Khan Academy (2024)

If we want to buy things, we need money to do so. But, by keeping our wealth in the form of money, we give up the opportunity to earn interest by keeping our wealth in the form of some other asset. This tradeoff is the source of the demand for money: as interest rates decrease, it makes more sense for us to keep money in the form of money and not other assets.

At the same time, there is only so much money that exists at any given time. The money supply ($M1$‍) is a fixed amount that doesn’t change just because interest rates have changed. The money supply changes when either the monetary base changes or banks make loans.

If you are thinking to yourself, “Wait, supply and demand for something sounds a lot like a market,” you are absolutely correct! Just like every other market we have seen, there are four important elements:

1. equilibrium price
2. equilibrium quantity
3. supply
4. demand.

The price of money is the nominal interest rate, the quantity is how much money people hold, supply is the money supply, and demand is the demand for money.

Suppose you live in a world where you can only store your wealth in bonds or cash, and you have $\mathrm{\$}1000$‍ in cash. You can earn a $10\mathrm{\%}$‍ return if you buy a bond, but the return to holding your wealth in the form of money is zero. That bond sounds pretty attractive, so you spend all of your money buying bonds.

Now you have a slight problem: all of your wealth is in the form of bonds and you are hungry. You take the bonds to the donut shop but they only accept cash. The donut shop holder wants to be paid now, not a year from now when those bonds mature!

So you have a choice: sell your bonds and eat, or keep your bonds and earn interest. The tradeoff between keeping your assets liquid (in the form of cash) or in some other asset (bonds) is called liquidity preference. The amount you are willing to hold in the form of cash is going to depend on a lot of things, such as the price of donuts, how hungry you are, and how easy it is to move wealth between cash and bonds.

Your liquidity preference will also depend on the interest rate. If the interest rate suddenly went down to less than $1\mathrm{\%}$‍, then holding onto these bonds doesn’t make as much sense as it did at $10\mathrm{\%}$‍. This inverse relationship between liquidity preference and the interest rate means that the demand for money is downward sloping.

The money supply is ultimately determined by the monetary base and the money multiplier. In most countries, that country’s central bank determines the size of the monetary base. Remember that the monetary base includes reserves in vaults and currency in circulation outside of banks. For example, central banks might change the reserve requirements to change the monetary base.

The money supply doesn’t depend on the interest rate, it only depends on the central bank. Because of this, the money supply curve is vertical at the quantity of the money supply, not upward sloping or downward sloping.

In any market, an equilibrium occurs when the quantity supplied is equal to the quantity demanded. Prices adjust until the market is in equilibrium. The money market is no exception. The only difference between the markets we saw in Unit 1 and the money market is:

The price is the nominal interest rateThe supply curve is vertical

The central bank controls the money supply, so it can take actions to increase the money supply and decrease the money supply. Changes in the money supply lead to changes in the interest rate.

But what about the demand for money, can it change? Absolutely! There are a few reasons why the demand for money might change:

• Changes in national income
  • when real GDP increases, there are more goods and services to be bought. More money will be needed to purchase them. On the other hand, a decrease in real GDP will cause the money demand curve to decrease.
• Changes in the price level (inflation or deflation)
  • if the price of everything increases by $20\mathrm{\%}$‍, you need $20\mathrm{\%}$‍ more money in order to buy things. When there is an increase in the price level, the demand for money increases. Conversely, when there is a decrease in the price level, the demand for money decreases.
• Changes in money technology
  • the demand for money is driven by the transactions motive (we want money so we can buy things). When new technologies make it easier to convert wealth into money, we keep less of it on hand.

The money market illustrates how the demand for money and the supply of money interact to determine nominal interest rates. Note that the demand for money ($D_M$‍) is downward sloping and the supply of money is vertical ($S_M$‍ and $S_{M2}$‍).

In this graph, the money supply has increased. As a result of the increase in the money supply, the quantity of money demanded at the old rate of interest ($i_1$‍) is less than the money supply.

• Some students get confused about what interest rate is represented in the money market:real or nominal? It’s the nominal rate. Think of the nominal interest rate as the interest rate on the sign outside of a bank. A sign that says, “Now paying higher interest rates!” is advertising a higher nominal interest rate. The real interest rate is that nominal interest minus the rate of inflation.
• It might seem odd that the money supply curve is always perfectly vertical. Keep in mind what the vertical money supply curve is saying: the central bank determines the monetary base, and therefore the money supply. This money creation might change interest rates, but it is not being done in response to interest rates, so the supply of money is perfectly vertical.

• In a correctly labeled graph of the money market, show the impact of selling bonds on the interest rate.

• If the money supply increases, will bond prices increase, decrease, or stay the same? Explain.

• Show the impact of inflation on interest rates using the money market. Explain why the change that you showed occurs.