The money market is where the demand for money meets the supply of money set by the central bank, and together they determine the nominal interest rate. Shift money demand with the price level, real GDP, and payment technology, shift money supply with central bank policy, and watch the interest rate and bond prices respond. Then push the rate away from equilibrium and see how bond buying and selling pulls it back.
The market starts in equilibrium at a 5.0% nominal interest rate and $500 billion of money. Dashed grey lines show the starting position once something moves.
A bond's payment is fixed. When the interest rate rises, buyers will pay less today for that same $1,000, so the bond's price falls. Interest rates and bond prices always move in opposite directions.
Money demand (MD) and money supply (MS) meet at the equilibrium nominal interest rate. The vertical axis is the nominal interest rate because the cost of holding money is the interest you give up, and that is a nominal amount.
People and firms hold money to buy things. When the price level rises, each purchase takes more dollars. When real GDP rises, there are more purchases. Either change raises money demand at every interest rate, so MD shifts right.
People can hold wealth as money, which earns little or no interest, or as bonds, which pay interest. A higher nominal interest rate makes bonds more attractive, so people hold less money as an asset.
The nominal interest rate is the opportunity cost of holding money. When the rate rises, holding money costs more, so the quantity of money demanded falls. A change in the interest rate is a movement along MD, not a shift.
MS is vertical because the quantity of money does not depend on the interest rate. In the limited-reserves model, buying bonds (open market purchases), lowering the discount rate, or lowering the reserve requirement shifts MS right. Topic 4.6 adds the ample-reserves tools, where the central bank steers rates with administered rates such as interest on reserves.
Bond prices and interest rates move in opposite directions. Above equilibrium, people hold more money than they want and buy bonds, so bond prices rise and the rate falls. Below equilibrium, they sell bonds for cash, so bond prices fall and the rate rises.
Each row is one shift. Memorize the curve that moves, then the rest follows from the graph.
| Event | Curve that shifts | Nominal interest rate | Quantity of money | Bond prices |
|---|---|---|---|---|
| Price level rises | MD right | ↑ | No change | ↓ |
| Real GDP rises (expansion) | MD right | ↑ | No change | ↓ |
| Real GDP falls (recession) | MD left | ↓ | No change | ↑ |
| More use of digital payments, ATMs, or fast transfers | MD left | ↓ | No change | ↑ |
| Central bank buys bonds, lowers the discount rate, or lowers the reserve requirement | MS right | ↓ | ↑ | ↑ |
| Central bank sells bonds, raises the discount rate, or raises the reserve requirement | MS left | ↑ | ↓ | ↓ |
| MD right and MS right at the same time | Both | Indeterminate | ↑ | Indeterminate |
| Interest rate rises for any reason | None (move along MD) | ↑ | Quantity demanded ↓ | ↓ |
AP-style multiple choice. Pick an answer to see the explanation.
The vocabulary for topic 4.5. Read the list, flip through flashcards, or quiz yourself. For every term in the unit, see the Unit 4 terminology guide.