Demand, Supply, and Equilibrium in the Money Market

We have discussed the role of supply and demand in the money market, and we have seen how it has an effect on interest rates as well. Here, you will learn how transfer costs and expectations can affect demand. What is Keynes' theory with regard to the relationship between investment in bonds and money?

Introduction

Learning Objectives

  1. Explain the motives for holding money and relate them to the interest rate that could be earned from holding alternative assets, such as bonds.
  2. Draw a money demand curve and explain how changes in other variables may lead to shifts in the money demand curve.
  3. Illustrate and explain the notion of equilibrium in the money market.
  4. Use graphs to explain how changes in money demand or money supply are related to changes in the bond market, in interest rates, in aggregate demand, and in real GDP and the price level.

In this section we will explore the link between money markets, bond markets, and interest rates. We first look at the demand for money. The demand curve for money is derived like any other demand curve, by examining the relationship between the "price" of money (which, we will see, is the interest rate) and the quantity demanded, holding all other determinants unchanged. We then link the demand for money to the concept of money supply developed in the last chapter, to determine the equilibrium rate of interest. In turn, we show how changes in interest rates affect the macroeconomy.


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