Unit 4 · Topic 4.5

The Money Market

The money market sets the nominal interest rate.

Practice 1: Principles and ModelsPractice 2: InterpretationPractice 3: ManipulationPractice 4: Graphing and Visuals

Part 1 · Hook

Why this matters

You could keep your savings as cash in your wallet or in a bond that pays 5% a year. Cash lets you buy lunch on the spot; the bond pays you to wait. When rates jump to 8%, you would rather hold less cash. That trade-off, the convenience of money against the interest it gives up, is the demand for money, and it sets the interest rate.

Part 2 · Before you start

What this builds on

Part 3 · Prerequisite check

Quick check before you start

1. Market interest rates rise. What happens to the prices of existing bonds?

  1. They fall
  2. They rise
  3. They stay the same
  4. They double
Show the answer

Bond prices move opposite to interest rates.

  • Correct: They fall:
  • They rise:
  • They stay the same:
  • They double:

2. Which interest rate is the rate stated in dollars, before adjusting for inflation?

  1. The nominal interest rate
  2. The real interest rate
  3. The inflation rate
  4. The growth rate
Show the answer

The nominal rate is the stated rate; the real rate subtracts the expected inflation rate.

  • Correct: The nominal interest rate:
  • The real interest rate:
  • The inflation rate:
  • The growth rate:

3. Who controls the size of the money supply most directly?

  1. The central bank, with the banking system
  2. Each household
  3. The stock market
  4. Exporters
Show the answer

The central bank and bank lending determine the money supply.

  • Correct: The central bank, with the banking system:
  • Each household:
  • The stock market:
  • Exporters:

Part 4 · See it

See it first

A money market graph. The vertical axis is the nominal interest rate and the horizontal axis is the quantity of money. The money supply curve MS is vertical. Money demand shifts right from MD1 to MD2, so the equilibrium nominal interest rate rises from i1 to i2 while the quantity of money stays the same.
A rise in money demand, along a vertical money supply, raises the nominal interest rate. LevlPrep original diagram.

Part 5 · Step by step

How it works, step by step

  1. The price level or real GDP risespeople need more money for transactions, so money demand shifts right
  2. Money demand shifts right while the money supply is fixedpeople sell bonds to get money, so bond prices fall
  3. Bond prices fallthe nominal interest rate rises until people want to hold the money that exists

Part 6 · Key ideas

Key ideas

  • The money market graph: nominal interest rate on the vertical axis, quantity of money on the horizontal; money demand (MD) slopes down and the money supply (MS) is vertical.
  • MD slopes down because the nominal interest rate is the opportunity cost of holding money (asset demand).
  • MD shifts right when the price level or real GDP rises (transaction demand); MS shifts when the central bank changes the money supply.
  • Rate above equilibrium: people buy bonds, bond prices rise, the rate falls. Below: they sell bonds and the rate rises.

Part 7 · Misconception

A common mistake

The wrong idea: A change in the interest rate shifts money demand.

What actually happens: The nominal interest rate is on the axis, so a change in it moves along MD. Money demand shifts with the price level, real GDP and payment technology.

Part 8 · Check yourself

Check yourself

Exam-style questions. Anything you miss goes into your review queue.

1. Label the axes and the curves of the money market graph.

???1?2

Work on the graph (it needs JavaScript), then check.

Show the answer

The money market has the nominal interest rate on the vertical axis and the quantity of money on the horizontal axis, with downward-sloping money demand (MD) and vertical money supply (MS).

  • Key: see the explanation

2. With limited reserves, the central bank increases the money supply. Shift the right curve and mark the new equilibrium.

Quantity of moneyNominal interest rateMDMSMi

Work on the graph (it needs JavaScript), then check.

Show the answer

More money shifts the vertical money supply right; people hold the extra money only at a lower nominal interest rate.

  • Key: money supply shifts right

3. Why does the money demand curve slope down?

  1. A higher price level means people need less money
  2. Banks lend more when interest rates rise
  3. The central bank supplies less money at high rates
  4. The nominal interest rate is the opportunity cost of holding money
Show the answer

Money pays little or no interest, so the interest given up on bonds is the cost of holding it: higher rates, less money demanded.

  • A higher price level means people need less money: A higher price level shifts money demand right; it does not explain the slope.
  • Banks lend more when interest rates rise: That is about lending, not about how much money people choose to hold.
  • The central bank supplies less money at high rates: The money supply is vertical; the slope of demand comes from households' choices.
  • Correct: The nominal interest rate is the opportunity cost of holding money: Right: when bonds pay more, holding cash costs more, so people hold less of it.

Graph

A money market after a shift

Quantity of moneyNominal interest rateMD1MD2MSMi

4. The graph shows money demand shifting from MD1 to MD2. Which event could have caused this shift?

  1. A rise in the nominal interest rate
  2. A rise in the price level
  3. A rise in the money supply
  4. Wider use of payment cards and phone apps
Show the answer

Money demand shifts with the price level, real GDP and payment technology; the interest rate moves along it.

  • A rise in the nominal interest rate: A change in the interest rate moves along money demand; it does not shift it.
  • Correct: A rise in the price level: Right: higher prices mean people need more money for the same purchases, so MD shifts right.
  • A rise in the money supply: That would shift the vertical MS curve, not MD.
  • Wider use of payment cards and phone apps: Easier payments let people hold less money, which shifts MD left.

5. In the graph, what happens to the equilibrium nominal interest rate?

  1. It falls, because more money is demanded
  2. It stays the same, because the money supply is fixed
  3. It rises, from i1 to i2
  4. It rises at first, then returns to i1
Show the answer

With a vertical money supply, a rightward shift of money demand raises the nominal interest rate and leaves the quantity of money unchanged.

  • It falls, because more money is demanded: More money demanded with a fixed supply pushes the rate up, not down.
  • It stays the same, because the money supply is fixed: The fixed supply is why the rate must rise to balance the larger demand.
  • Correct: It rises, from i1 to i2: Right: MD2 crosses the vertical MS at a higher nominal interest rate.
  • It rises at first, then returns to i1: With MS unchanged, the new equilibrium stays at the higher rate.

6. As the economy moves to the new equilibrium in the graph, what happens to the prices of existing bonds?

  1. They fall, as people sell bonds to get money
  2. They rise, as people buy bonds
  3. They do not change, since bonds are not money
  4. They rise, because interest rates rise
Show the answer

Bond prices and interest rates move in opposite directions; selling bonds to raise money pushes bond prices down.

  • Correct: They fall, as people sell bonds to get money: Right: to hold more money, people sell bonds, which lowers bond prices and raises interest rates.
  • They rise, as people buy bonds: People want more money, so they sell bonds rather than buy them.
  • They do not change, since bonds are not money: Bonds are how people adjust their money holdings, so their prices move.
  • They rise, because interest rates rise: Bond prices move opposite to interest rates: the rate rises, so bond prices fall.

7. Make it specific: explain how a rise in the price level affects the nominal interest rate when the money supply does not change.

Build the answer part by part, then write it in your own words.

Show the answer

A higher price level raises money demand; with a fixed money supply the nominal interest rate rises (and bond prices fall).

  • An answer that earns the point: The price level rises, so people need more money for the same purchases and money demand shifts right; because the money supply is fixed, the nominal interest rate increases and the prices of existing bonds decrease.

Part 9 · Summary

Summary

The money market sets the nominal interest rate. Money demand slopes down because the nominal interest rate is the opportunity cost of holding money, and it shifts right when the price level or real GDP rises. The money supply is vertical, set by the central bank. A rise in money demand, or a fall in money supply, raises the nominal interest rate and lowers bond prices; a rise in money supply lowers the rate and raises bond prices.

Part 10 · Up next

What comes next

Part 11 · Connections

Connections

Question set for this topic