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Understanding the Money Market: Demand, Supply, and Interest Rates

The money market is where the Federal Reserve interacts with money users to determine nominal interest rates. Money demand originates from households, firms, governments, and the foreign sector, with two components: transaction demand, which is independent of interest rates, and asset demand, which depends on them. The money supply is solely managed by the Federal Reserve. Changes in money demand and supply significantly impact interest rates, with equilibrium between them dictating i%. This overview addresses how variations in real GDP and monetary policy affect the money market.

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Understanding the Money Market: Demand, Supply, and Interest Rates

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  1. Mr. GerdesAP Macroeconomics The Money Market

  2. The Money Market • The market where the Fed and the users of money interact thus determining the nominal interest rate (i%). • Money Demand (MD) comes from households, firms, government and the foreign sector. • The Money Supply (MS) is determined only by the Federal Reserve.

  3. Money Demand • Transaction Demand – demand for money as a medium of exchange (independent of the interest rate). • Asset Demand – demand for money as a store of value (dependent on the interest rate). • Total Money Demand – (MD) is downward sloping because at high interest rates people are less inclined to hold money and more inclined to hold stocks & bonds. At lower interest rates people sacrifice less when they hold money.

  4. Money Supply • The money supply is determined by the Federal Reserve because the Fed has monopoly control over the supply of money.

  5. The Money Market i% MS i MD Q QM The equilibrium of MS & MD determines the nominal interest rate (i%). MD is downward sloping because the nominal interest rate is the opportunity cost of holding money. MS is vertical because it is independent of the interest rate.

  6. Changes in Money Demand • Money Demand is dependent on both the Price Level and Real GDP which together comprise the Nominal GDP • Nominal GDP↑ .: MD .: i%↑ • Nominal GDP↓ .: MD .: i%↓

  7. Increase in Money Demand i% MS  i1  MD1  i MD Q QM MD .: i%↑

  8. Decrease in Money Demand i% MS  i  MD  i1 MD1 Q QM MD .: i%↓

  9. Changes in the Money Supply • Only the Fed determines the money supply • Expansionary Monetary Policy • MS .: i%↓ • Contractionary Monetary Policy • MS .: i%↑

  10. Increase in Money Supply i% MS MS1  i   i1 MD Q Q1 QM MS .: i%↓

  11. Decrease in Money Supply i% MS1 MS  i1   i MD Q1 Q QM MS .: i%↑

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