Topic 4.5 The Money Market: draw the money market, explain money demand and the vertical money supply, and show how shifts determine the equilibrium nominal interest rate.

What this topic is asking

Topic 4.5 introduces the money market, the diagram that determines the nominal interest rate. The College Board wants you to draw money demand and the vertical money supply, find equilibrium, and show how shifts change the interest rate. This is the engine of monetary policy.

Money demand

When the interest rate rises, that opportunity cost rises, so people economise on money and hold more interest-bearing assets; the quantity of money demanded falls. When the rate falls, holding money is cheaper, so people hold more.

Money supply

Equilibrium and shifts

Equilibrium is where money demand crosses money supply, setting the equilibrium nominal interest rate. At that rate, the quantity of money people want to hold equals the quantity the central bank has supplied.

• Increase the money supply (MS shifts right): there is now more money than people want at the old rate, so the interest rate falls until people are willing to hold the extra money.
• Decrease the money supply (MS shifts left): the interest rate rises.
• Increase money demand (MD shifts right, for example a higher price level): the interest rate rises.

A lower interest rate then raises interest-sensitive spending, shifting aggregate demand right (and vice versa), which is how the money market drives the real economy.

Try this

Q1. Why is the money supply curve vertical? [1 point]

• Cue. The central bank sets the money supply independently of the interest rate, so it does not vary with the rate.

Q2. The money supply falls. What happens to the nominal interest rate? [1 point]

• Cue. It rises (less money available, so the opportunity cost of holding it goes up).