Interest Rate Determination

The equilibrium interest rate is determined at the level that will equalize real money supply with real money demand. We can depict the equilibrium by graphing the money supply and demand functions on the following diagram.

Figure 18.1 The Money Market

The functions are drawn in Figure 18.1 "The Money Market" with real money, both supply and demand, plotted along the horizontal axis and the interest rate plotted along the vertical axis.

Real money supply, $\frac{M_{\$}^{S}}{P_{\$}}$, is drawn as a vertical line at the level of money balances, measured best by $M_{1}$. It is vertical because changes in the interest rate will not affect the money supply in the economy.

Real money demand - that is, the liquidity function $L\left(i_{\$}, Y_{\$}\right)$ - is a downward sloping line in i_$ reflecting the speculative demand for money. In other words, there is a negative relationship presumed to prevail between the interest rate and real money demand.

Where the two lines cross determines the equilibrium interest rate in the economy $\left(i_{\$}\right)$ since this is the only interest rate that will equalize real money supply with real money demand.