AP® Macroeconomics review sheet from Aim for Five (aimforfive.com/macro/units/4/4-5)
Unit 4 · Topic 4.5
4.5 The Money Market
The money market shows how the demand for money and the supply of money set the nominal interest rate. Money demand slopes down because the interest rate is the cost of holding money, and money supply is vertical because the central bank sets it. A shift in either curve changes the equilibrium interest rate.
Key terms
- money demand (MD)
- money supply (MS)
- nominal interest rate
- transaction demand for money
- equilibrium interest rate
Drawing the money market
Label it exactly this way. Writing 'real interest rate' or just 'price' on the vertical axis makes the graph incorrectly labeled.
- Vertical axis: nominal interest rate.
- Horizontal axis: quantity of money.
- Money demand (MD): a curve sloping downward from left to right.
- Money supply (MS): a vertical line at the quantity the central bank sets.
- Equilibrium: where MS crosses MD. Label the interest rate i1 on the vertical axis and the quantity Q1 on the horizontal axis.
Why money demand slopes down, and what shifts it
People hold money mainly to buy things; this is the transaction demand for money. Holding money has a cost: the interest you could earn on bonds instead (4.1). When the nominal interest rate rises, that cost rises, so people hold less money and more bonds. That's a movement along MD, not a shift.
MD shifts when people need more or less money for buying things at every interest rate.
- The price level rises: each purchase takes more dollars, so MD shifts right.
- Real GDP (income) rises: people buy more, so MD shifts right.
- The price level or real GDP falls: MD shifts left.
- New payment technology that lets people get by with less money on hand shifts MD left.
Why money supply is vertical, and what shifts it
The central bank determines the monetary base and, with it, the money supply. That amount doesn't depend on the interest rate, so MS is a vertical line. In an economy with limited reserves, the central bank shifts MS with its policy tools (4.6).
- Buying government bonds (an open market purchase), lowering the required reserve ratio or lowering the discount rate shifts MS right and lowers the nominal interest rate.
- Selling bonds, raising the reserve ratio or raising the discount rate shifts MS left and raises the nominal interest rate.
Ample reserves and the money market
In an economy with ample reserves, like the U.S. today, changing the quantity of money doesn't really move the interest rate. The central bank uses administered rates instead, such as interest on reserves, and you show that on the reserve market graph (4.6). Exam questions say which kind of banking system an economy has. Use the money market with a shifting MS for limited reserves.
Getting back to equilibrium
Suppose the interest rate is above equilibrium. Then the quantity of money supplied is greater than the quantity demanded: a surplus of money. People holding more money than they want use the extra to buy bonds. Bond prices rise, so interest rates fall until the surplus is gone.
If the interest rate is below equilibrium, there's a shortage of money. People sell bonds to get money, bond prices fall, and interest rates rise back to equilibrium.
Worked examples
Try each one yourself first, then open the solution.
- Example 1
The price level rises
In an economy with limited reserves, the price level rises while the central bank holds the money supply constant. Using the money market, explain what happens to the nominal interest rate.
Show the solutionHide the solution
- Step 1: Start with the graph: nominal interest rate on the vertical axis, quantity of money on the horizontal axis, a vertical MS and a downward-sloping MD1 crossing at i1.
- Step 2: A higher price level means each purchase takes more dollars, so people want to hold more money at every interest rate. MD shifts right from MD1 to MD2.
- Step 3: At the old rate i1 there's now a shortage of money. People sell bonds to get money, bond prices fall and interest rates rise.
- Step 4: The new equilibrium is where MD2 crosses the unchanged MS, at a higher rate i2. The quantity of money stays the same, because MS is vertical.
Answer: MD shifts right and the nominal interest rate rises from i1 to i2; the quantity of money doesn't change.
- Example 2
An open market purchase
The central bank of a country with limited reserves buys government bonds. Show the effect in the money market, and say what happens to the price of previously issued bonds.
Show the solutionHide the solution
- Step 1: Buying bonds pays banks with new reserves. Banks lend out the excess reserves, and the money supply grows.
- Step 2: In the money market, MS shifts right from MS1 to MS2. MD doesn't move.
- Step 3: The new equilibrium has a lower nominal interest rate (i2 below i1) and a larger quantity of money (Q2 to the right of Q1).
- Step 4: Interest rates and the prices of existing bonds move in opposite directions, so existing bond prices rise.
Answer: MS shifts right, the nominal interest rate falls, and the prices of previously issued bonds rise.
- Example 3
A rate above equilibrium (classic trap)
In a money market, the current nominal interest rate is 6%, but the equilibrium rate is 4%. Is there a surplus or a shortage of money, and how does the market get back to 4%?
Show the solutionHide the solution
- Step 1: At 6%, holding money is expensive, so the quantity of money demanded is low. The money supply is fixed, so quantity supplied is greater than quantity demanded: a surplus.
- Step 2: People with more money than they want buy bonds.
- Step 3: Bond prices rise, which means interest rates fall. This continues until the rate reaches 4%.
- Step 4: The trap is saying 'people sell bonds' or 'bond prices fall'. A surplus of money means people buy bonds, which raises their prices and lowers interest rates.
Answer: There's a surplus of money; people buy bonds, bond prices rise and the interest rate falls to 4%.
Common mistakes
- Drawing money supply as upward-sloping. With the monetary base set by the central bank, MS is vertical.
- Shifting MD when the interest rate changes. A change in the interest rate is a movement along MD; changes in the price level or real GDP shift it.
- Labeling the vertical axis 'real interest rate'. The money market sets the nominal interest rate.
- Saying that an increase in money demand lowers the interest rate. When MD shifts right and MS stays put, the equilibrium nominal interest rate rises.
On the exam
- Free-response questions often ask for a correctly labeled money market graph showing the effect of a policy action or a change in the price level or income. Label both axes, both curves and the old and new equilibrium interest rates.
- A common chain: the nominal interest rate changes in the money market, so investment and interest-sensitive consumption change, so AD shifts. Write every link.
Connected topics
Videos
Check yourself
4 questions on 4.5 The Money Market. Pick an answer to see if you got it, and why.
During a recession, real GDP falls. If the central bank keeps the money supply constant, what happens in the money market?
The money demand curve slopes downward because
If the nominal interest rate rises, what happens to the opportunity cost of holding money and to the quantity of money demanded?
In a banking system with limited reserves, which of the following would shift the vertical money supply curve to the left on a money market graph?
0 of 4 answered