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Lesson summary: the money market

AP.MACRO:
MKT‑3 (EU)
,
MKT‑3.A (LO)
,
MKT‑3.A.1 (EK)
,
MKT‑3.A.2 (EK)
,
MKT‑3.B (LO)
,
MKT‑3.B.1 (EK)
,
MKT‑3.C (LO)
,
MKT‑3.C.1 (EK)
,
MKT‑3.D (LO)
,
MKT‑3.D.1 (EK)
In this lesson summary review and remind yourself of the key terms and graphs related to the money market.

Lesson Summary

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 (M, 1) 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.

Key Terms

Key termDefinition
money marketa graphical model showing the interaction of the demand for money and the money supply
money supplya curve that shows the relationship between the amount of money supplied and the interest rate; because the central bank controls the stock of money, it does not vary based on the interest rate, and the money supply curve is vertical.
money demanda curve showing the relationship between the quantity of money demanded and the interest rate; the money demand curve is downward sloping
liquidity preferencethe amount of wealth that people want to keep in the form of cash in order to use it as a medium of exchange
transactions motiveThe desire to hold money in order to buy things

Key Takeaways

The demand for money is downward sloping

Suppose you live in a world where you can only store your wealth in bonds or cash, and you have dollar sign, 1000 in cash. You can earn a 10, percent 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, percent, then holding onto these bonds doesn’t make as much sense as it did at 10, percent. This inverse relationship between liquidity preference and the interest rate means that the demand for money is downward sloping.

The money supply is vertical

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.

The nominal interest rate adjusts until the money market is in equilibrium

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 rate The supply curve is vertical
In the money market, the nominal interest rate adjusts until the quantity of money that people want to hold is the same as the quantity of money that exists. If the nominal interest rate is above equilibrium high, people reduce their holdings of cash. If the nominal interest rate is below equilibrium, they increase their holdings of cash.

Changes in the supply and demand for money

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, percent, you need 20, percent 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.

Key Graphical Models

Money market

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, start subscript, M, end subscript) is downward sloping and the supply of money is vertical (S, start subscript, M, end subscript and S, start subscript, M, 2, end subscript).
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, start subscript, 1, end subscript) is less than the money supply.

Common misperceptions

  • 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.

Discussion questions

Want to join the conversation?

  • blobby green style avatar for user rayamato610
    Does an improvement in payment technology increase money demand?
    (4 votes)
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    • piceratops ultimate style avatar for user thuhuongle0802
      To me, the relationship is not entirely clear. I think it should decrease the money demand instead. Payment technology makes it easier for people to hold money securely. It's easier for people to take their saving money out, so they do not need to hold much money on hand knowing that they can take it out when they need to.
      (3 votes)
  • hopper cool style avatar for user gosoccerboy5
    So.. why can't you use the market for loanable funds to model this? Wouldn't it be a lot more efficient, not to mention the opportunity costs incurred while learning this model? (Wow, I am already thinking like an economist!)
    (2 votes)
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  • blobby green style avatar for user cabeard21
    if the price level increases does the curve for money demand shift or does it just move downward on the same curve?
    (2 votes)
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  • blobby green style avatar for user M.J.G.
    An increase in the money supply leads to an increase in consumer spending, and thus an increase in aggregate demand. An increase in aggregate demand leads to an increase in output and thus an increase in money demand. Does this mean raising the supply of money raises demand for money at the same time, and vice versa?
    (1 vote)
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    • hopper cool style avatar for user gosoccerboy5
      Well, the money market tends to mainly focus on the short run. Of course, as inflation rises, the nominal interest rate will eventually increase to compensate. But before prices can catch up (and also the other effects you mentioned), increasing the money supply will lower rates.

      In other words, yes, money demand catches up, but it takes time.
      (2 votes)
  • mr pants teal style avatar for user arpneh.23
    does a decrease in money demand increase aggregate supply?
    (1 vote)
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    • blobby green style avatar for user wuzehua2015
      No it does not. Factors that increase the aggregate supply are either increases in the quantity or quality of the factors of production (increase both the long run AS and the short run AS), or decreasing production costs and lower corporate taxes (increase the short run AS only). A decrease in money demand results in a lower equilibrium interest rate, and the interest rate is a shifter of the aggregate demand. In this case, a lower interest rate leads to an increase in interest-sensitive expenditures, including consumption (C) and investment (I). Therefore, the aggregate demand will increase as a result.
      (1 vote)
  • blobby green style avatar for user Ant Cacchione
    Can someone help explain to me the third discussion question? I do not understand
    (1 vote)
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    • blobby green style avatar for user wuzehua2015
      Inflation means an increase in the price level within a country. When the price level increases, households demand more money for their consumption. This translates into a higher money demand curve (a rightward shift), resulting in a higher equilibrium interest rate.
      (1 vote)
  • starky ultimate style avatar for user lqiming2
    If we make the money supply smaller, the n.i.r will decrease. However, which direction will the curve of the money supply shift?
    (0 votes)
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    • blobby green style avatar for user Davoid Coinners
      You're wrong. Making the money supply smaller would increase interest rates, shifting the money supply curve to the left.
      A smaller money supply would stifle competition between banks and an overall amount of money being held within banks. This increases the interest rate, and discourages lending as a result.
      (2 votes)