The Money Market
Key Concepts
 People hold (demand) money (think M1) primarily to
make transactions
 The other alternative is to save the money in
interest-bearing assets.
 When money is held as M1, earned interest is
forgone, thus the short-term (or nominal) interest
rate is the opportunity cost of holding money.
Key Concepts (cont.)
 As the nominal interest rate rises, the opportunity
cost of holding money rises, so the quantity of money
held (demanded) falls.
 Thus the money demand curve is downward sloping
with the nominal interest rate plotted on the vertical
axis.
 Money demand will shift to the right if:
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The aggregate price level rises
Real GDP rises
Technology is slow to improve
If banking institutions become less reliable
Key Concepts (cont.)
 The liquidity preference model of the interest rate
says that the nominal interest rate is determined by
the intersection of supply and demand for money in
the market for money.
 The model assumes that the supply of money is
vertical and chosen by the Fed and that the demand
for money is downward sloping.
The key graph of this model is below:
Things to remember:
 In the case of the money market, money demand in
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particular has a short-term horizon
The model assumes that there is no inflation, so the
nominal interest rate is used on the vertical axis.
The desirable quantity of money demand in not
infinite
Even the wealthiest of persons don’t walk around
with all of his/her money in a pocket or checking
account
There is an opportunity cost of holding money and
most people understand that
The Demand for Money
 When most people are asked why they would like to have
money in their pocket, they respond by say “to spend it”.
 What would cause one to have more money in their
pocket today than they had yesterday?
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To buy more things today
Or, things today are more expensive then they were yesterday
 Indeed, people hold money so that they can buy things
 What else can you do with your money?
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You can SAVE it!
 What would make one interested in saving it?
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A higher interest rate
The Opportunity Cost of Holding Money
 Holding money in your pocket is convenient because
it allows you to conveniently make purchases
 The price of that convenience is that money in your
pocket earns no interest.
 Suppose you could put $100 in a 12-month CD that
would earn 5%
 A CD is not very liquid because if you withdraw the
money before 12 months, you forfeit most of the
interest.
The Opportunity Cost of Holding Money
 $100 in your pocket or in your checking account
(M1) will come at an opportunity cost of 5% or $5.
 Maybe it is easy to pass up $5 to have the
convenience of $100 in your pocket
 What if the interest rate was 50%?
 Would you still hold $100 in your pocket when the
cost is now $50?
The Opportunity Cost of Holding Money
 Intuitively, is reflects a general result:
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The higher the short-term interest rate, the higher the opportunity
cost of holding money
The lower the short-term interest rate, the lower the opportunity cost
of holding money.
 Why don’t we consider long-term interest rate like 10-
year CD’s as the opportunity cost of holding money?
 Because we hold money to make transactions in the short
term.
 Therefore, we must consider the opportunity cost in the
short-term, not the long-run
The Money Demand Curve
 Since we demand money to make purchases in the short
term, the opportunity cost of holding money is the shortterm interest rate.
 We assume that in a short period of time, there will be
virtually no inflation, so the nominal interest rate is
equal to the real interest rate.
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Note: It is this assumption that allows us to put the nominal interest
rate on the vertical axis of graph of the money market. (you may lost
points on the AP exam if you label this axis as the real interest rate)
 As discussed above, when the interest rate rises, the
opportunity cost of holding money rises, so the quantity
of money demanded will fall.
An increase in the nominal interest rate will cause a
movement upward along the money demand curve
Shifts of the Money Demand Curve
 Just like there are external factors that shift the
demand curve for oranges, there are external factors
that shift the demand curve for money
 NOTE: If an external change makes holding money
in your pocket more desirable at any interest rate,
the demand curve for money will shift rightward.
 The most important factors causing the money
demand curve to shift are
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Changes in the aggregate price level
Changes in real GDP
Changes in banking technology
Changes in banking institutions
Changes in the Aggregate Price Level
 All else equal, higher prices increase the demand
for money (a rightward shift of the MD curve).
 And, lower prices reduce the demand for money (a
leftward shift of the MD curve).
Changes in the Aggregate Price Level
Think of there being only two places to put your money. You can put
money in CDs that provide interest, or you can hold cash that earns no
interest.
Changes in the Aggregate Price Level
 Let’s discuss equilibrium by discussing interest rates
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above and below i* (interest rate at equilibrium)
If i1 > i*, the quantity of money supplied exceeds the
quantity of money demanded.
Why? Because of high interest rates, CDs are very
attractive saving options.
In fact, banks find that they can lower the interest rate on
CDs and still have plenty of customers ready to buy a CD
As interest rates fall, the quantity of money demanded
gets closer and closer to M* (quantity of money at
equilibrium)
Question
 What would happen to interest rates and the quantity of
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money demanded if there was some interest rate i2 that
was less than i*?
If i2 < i*, the quantity of money demand exceeds the
quantity of money supplied.
Why? Because of low interest rates
CDs are not very attractive saving options.
In fact, banks find that they must raise the interest rate
on CDs to get more customers ready to buy a CD
As interest rates rise, the quantity of money demanded
gets closer and closer to M*.
Two Models of the Interest Rate
 The model of liquidity preference describes
equilibrium in the money market
 This model is a good foundation for learning a
similar market in loanable funds that is also useful in
describing how interest rates are determined and the
impact of money policy and other more advanced
topics.