No Such Thing as a Free Lunch: Principles of Economics (Part 127)

Here's how I think of my money - as soldiers - I send them out to war everyday. I want them to take prisoners and come home, so there's more of them.

Kevin O'Leary

Money Demand, the Equilibrium Interest Rate, and Monetary Policy

(Part C)

by

Charles Lamson

The Equilibrium Interest Rate

We are now in a position to consider one of the key questions in macroeconomics: How is the interest rate determined in the economy?

Financial markets (what we call the money market) work very well in the United States. Almost all the financial markets clear---that is, almost all reach an equilibrium where quantity demanded equals quantity supplied. In the money market:

The point at which the quantity of money demanded equals the quantity of money supplied determines the equilibrium interest rate in the economy.

This explanation sounds simple, but it requires elaboration.

Supply and Demand in the Money Market

We saw in earlier posts that the Fed controls the money supply through its manipulation of the amount of reserves in the economy. Because we are assuming that the Fed's money supply behavior does not depend on the interest rate, the money supply curve is a vertical line. (Review Figure 5 from last post.) In other words, we are assuming that the Fed uses its three tools (the required reserve ratio, the discount rate, and open market operations) to achieve its fixed target for the money supply.

Figure 6 superimposes the vertical money supply curve from Figure 5 on the downward sloping money demand curve. Only at interest rate r* is the quantity of money in circulation (the money supply) equal to the quantity of money demanded. To understand why r* is in equilibrium, we need to ask what adjustments would take place if the interest rate were not r*.

To understand the adjustment mechanism, keep in mind that borrowing and lending is a continuous process. The treasury sells U.S. government securities (bonds) more or less continuously to finance the deficit. When it does, it is borrowing, and must pay interest to attract bond buyers. Buyers of government bonds are, in essence, lending money to the government, just as buyers of corporate bonds are lending money to corporations that wish to finance investment projects.

If the interest rate is initially high enough to create an excess supply of money, the interest rate will immediately fall, discouraging people from moving out of money and into bonds.

If the interest rate is initially low enough to create an excess demand for money, the interest rate will immediately rise, discouraging people from moving out of bonds and into money.

Changing the Money Supply to Affect the Interest Rate

Increases in Y and Shifts in the Money Demand Curve

Changes in the supply of money are not the only factors that influence the equilibrium interest rate. Shifts in money demand can do the same thing.

Recall that the demand for money depends on both the interest rate and the volume of transactions. As a rough measure of the volume of transactions, we use Y, the level of aggregate output (income). Remember that the relationship between money demand and Y is positive---increases in Y mean a higher level of real economic activity. More is being produced, income is higher, and there are more transactions in the economy. Demand for money on the part of firms and households in aggregate is higher.

An increase in Y why shifts the money demand curve to the right.

The money demand curve also shifts when the price level changes. If the price level rises, the money demand curve shifts to the right, because people need more money to engage in their day-to-day transactions. With the quantity of money supplied unchanged, however, the interest rate must rise to reduce the quantity of money demanded to the unchanged quantity of money supplied---a movement along the money demand curve.

An increase in the price level is like an increase in Y in that both events increase the demand for money. The result is an increase in the equilibrium interest rate.

If the price level falls, the money demand curve shifts to the left, because people need less money for their transactions. However, with the quantity of money supply unchanged, the interest rate must fall to increase the quantity of money demanded to the unchanged quantity of money supplied.

A decrease in the price level leads to a decrease in the equilibrium interest rate.

We explore this relationship in more detail in upcoming posts. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 506-509*

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