Money & the Money Market

You’ll be able to

Identify the three functions of money and the measures of the money supply
Explain why money demand slopes downward against the interest rate
Determine the nominal interest rate from money supply and money demand

What money does

Money is defined by what it does, not what it is. It serves three functions: a medium of exchange (accepted in trade, avoiding barter), a unit of account (a common measuring stick for prices), and a store of value (it holds purchasing power over time, though inflation erodes this). Economists track the money supply in tiers: M1 is the most liquid — currency in circulation plus checkable deposits — while M2 adds less-liquid "near money" such as savings deposits and small time deposits. Liquidity means how easily an asset converts to a medium of exchange without loss of value.

The demand for money

People hold money instead of interest-bearing assets like bonds. The money demand curve slopes downward against the nominal interest rate, which is the opportunity cost of holding money: when interest rates are high, holding cash means forgoing more interest, so people hold less money; when rates are low, the cost of holding money is small, so they hold more. Money demand shifts with the price level and real GDP — more transactions require more money at every interest rate — but a change in the interest rate is a movement along the curve, not a shift.

Equilibrium in the money market

The money supply is set by the central bank and is drawn vertical (it does not depend on the interest rate). The nominal interest rate is determined where money supply meets money demand. If the central bank increases the money supply, the vertical supply curve shifts right and the equilibrium interest rate falls; if it decreases the money supply, the rate rises. This interest rate is the crucial link to the real economy: a lower rate encourages borrowing and investment, boosting aggregate demand.

Real vs. nominal interest rate (Fisher)

Real interest rate ≈ Nominal interest rate − Expected inflation rate

The money market sets the nominal rate; borrowers and lenders care about the real rate. Rearranged: nominal rate = real rate + expected inflation.

Worked example

The money market is in equilibrium at a nominal interest rate of 5%. The central bank buys bonds, increasing the money supply. Trace the effect on the interest rate, investment, and aggregate demand.

1.A bond purchase increases the money supply, shifting the vertical money-supply curve to the right.
2.At the old 5% rate there is now a surplus of money; the interest rate falls until money demand again equals supply — say to 3%.
3.A lower interest rate reduces the cost of borrowing, so business investment (I) rises.
4.Higher investment is a component of AD, so aggregate demand shifts right, raising real GDP and the price level.

Answer: The larger money supply lowers the equilibrium nominal interest rate (5% → lower), which raises investment spending and shifts AD right — the transmission mechanism from money to the real economy.

Checkpoint

In the money market, the nominal interest rate is best described as:

Watch out

Distinguish a movement along money demand from a shift. A change in the interest rate moves you along the curve. A change in the price level or real GDP shifts the whole money-demand curve. Mixing these up leads to the wrong equilibrium rate.

Checkpoint

Holding the money supply constant, an increase in the price level will:

On the exam

Draw the money market with a vertical money supply and a downward-sloping money demand, and label the axes "nominal interest rate" and "quantity of money." A common exam task is to link a money-supply change to the interest rate and then to investment and AD.

Answer the 2 checkpoints as you read.