What determines the interest rate in the economy? Why are the interest rates going up? How does the Fed control the interest rate in the economy? This article on the equilibrium in the money market will help you learn everything you need to know to answer these questions. Ready? Then keep going!
Meaning of equilibrium in the money market
To understand the meaning of equilibrium in the money market, let’s start by considering some of the characteristics of the money market.
A money market refers to the type of market where short-term debt obligations are traded between various financial institutions. It is where banks, businesses, and other financial institutions can find short-term loans and other types of financing instruments.
The money market refers to the type of market where short-term debt obligations are traded
To learn more about this type of market check our explanation - The Money Market.
Therefore, the money market consists of the money demand, which refers to the aggregate demand for money, and the money supply, which is the overall supply of money in the economy.
The interest rate influences the interaction between money supply and money demand in the economy and the quantity of money demanded by individuals and institutions.
Equilibrium in the money market occurs when the money demand equals the money supply. At that point, the equilibrium interest rate is formed.
For the equilibrium interest rate to change, either the money supply curve or the money demand curve should shift. A change in the interest rate out of equilibrium comes from a movement along the curves rather than a shift in the curves.
Money market equilibrium graph
The money market equilibrium graph is based on the liquidity preference model of the interest rate. The liquidity preference model is based on the idea that the equilibrium interest rate occurs at the point where the quantity demanded and supplied of money are equal.
Fig 1. - Equilibrium in the money market
Figure 1 above is the money market equilibrium graph. Note that on the vertical axis, it is the nominal interest rate rather than the real interest rate. The reason for that is that the nominal interest rate captures the real return you receive from investing in a financial asset as well as the loss in purchasing power that results from inflation.
Equilibrium in the money market provides the equilibrium rate in an economy. Equilibrium in the money market can change only when there is a shift in either the money demand or the money supply.
The liquidity preference model is based on the idea that the equilibrium interest rate is at the point where the quantity demanded and supplied of money are equalized
The interest rate in the economy provides the opportunity cost of holding money for individuals. That means that the interest rate is the loss an individual incurs when they choose to keep cash instead of investing it in an asset that generates a return. Usually, as the interest rate increases, so does the opportunity cost of holding money. You could be generating higher returns from having your money invested rather than kept as cash. Therefore, you are better of reducing the quantity of demanded money. Thus, there is an inverse relationship between the quantity of money demanded and the interest rate in the economy.
The money supply in an economy is perfectly inelastic. Regardless of the interest rate, the money supply in an economy will be static and won’t change. Remember that the money supply represents all the money circulating in an economy. The reason why the money supply curve is perfectly inelastic is that the Federal Reserve controls it. That means that the Fed makes decisions about the amount of money that will be flowing into an economy. The money supply curve changes only when there is a change in the Federal Reserve’s policy. They control the money supply to ensure more stability in the economy and to prevent economic disasters such as hyperinflation.
The point where the money demand equals the money supply provides the equilibrium interest rate. For the equilibrium interest rate to change, either the money supply or the money demand curves should experience a shift.
Fig 2. - Changes in the interest rate in the money market
Figure 2 shows what happens when there is a change in the interest rate out of equilibrium. The money supply in an economy is at Q1. When the interest rate decreases to r3, there is a movement along the money demand curve, causing the quantity of money demanded to move from Q1 to Q3. At r3, as the interest rate is low, individuals demand more cash than interest-bearing assets. As the money demand is higher than the money supply, it causes the interest rate to go back to r1, the initial equilibrium point. On the other hand, when the interest rate is at r2, the quantity of money demanded drops from Q1 to Q2. There is more money supply than demand for money, causing the interest rate to eventually go back to initial equilibrium r1.
Causes of equilibrium in the money market
The equilibrium in the money market happens through the interactions of money demand and money supply. Whenever the two are equal, the equilibrium occurs. But what happens if the money demand or the money supply changes for some external reason? That would cause a change in the equilibrium in the money market. To better understand what causes the equilibrium in the money market to change, we need to understand what causes shifts in money supply and money demand.
Shifts in the Money Supply
The Fed determines the money supply in the economy.
There are three main tools through which the Fed can influence the money supply:
- required reserve ratio
- open-market operations
- discount rate
Fig 3. - Shifts in the money supply
Figure 3 above shows shifts in the money supply. When the money supply curve shifts to the right, this results in a lower equilibrium interest rate (r3 compared to r1) and a higher quantity of money demanded (Q3 compared to Q1). On the other hand, when the money supply curve shifts to the left, the equilibrium in the money market results in a higher interest rate (r2 compared to r1) and a lower quantity of money demanded (Q2 compared to Q1).
To learn more check our explanation on - Money Supply
Equilibrium in Money Market: Required Reserve Ratio
Commercial banks in the United States can use only a fraction of their deposits to generate loans while keeping the rest in reserves as cash. The reason for that is to cover any potential withdrawal requests by the clients. The amount banks are required to keep in their reserves is known as the reserve ratio.
The Fed sets the required reserve ratio, and it is a tool used to control the money supply in the economy. When the required reserve ratio is high, banks need to keep a more considerable portion of their deposits in reserves, which leads to fewer loans generated. This then leads to less money circulating in the economy, which shifts the money supply curve to the left, resulting in a higher interest rate.
Equilibrium in Money Market: Open market operations
Open market operations are the practice of the Federal Reserve, which refers to the buying and selling of securities in the market to influence the money supply in the economy. One of the main securities targeted by the open market operations is the U.S. treasury securities.
Whenever the Fed buys securities from the market, it injects more money into the economy, increasing the overall money supply. This then shifts the money supply curve to the right resulting in lower interest rates. On the other hand, when the Fed wants to reduce the money supply in the economy, they sell these securities back to the market and collect the cash from the public in return. This causes the money supply curve to shift to the left, resulting in an overall increase in the interest rate in the economy.
Equilibrium in Money Market: Discount rate
When it comes to borrowing money for their short-term operational requirements, commercial banks in the United States have two basic options. Their interbank rate, which is determined by the market, allows them to borrow and lend money to other banks without requiring collateral.
They may also borrow money from the Federal Reserve Bank to cover their short-term operational needs. The rate at which commercial banks are allowed to borrow from the Federal Reserve Bank is called the discount rate. The Fed uses this rate to influence the money supply in the economy.
How does it work? Well, when there is a high discount rate, the cost of borrowing money is high for commercial banks, which means that they aren't going to borrow as much money from the Federal Reserve Bank. As commercial banks borrow less from the Federal Bank, they will generate fewer loans. This then translates into an overall fall in the money supply in the economy, shifting the money supply curve to the left.
In general, whenever the Fed increases the discount rate, the money supply curve would shift to the left, increasing the overall interest rate. On the other hand, when the Fed lowers the discount rate, the money supply curve will shift to the right, and there will be a decrease in the overall interest rate in the economy.
Shifts in the Money Demand
Factors that shift the money demand include:
- price level
- real GDP
- technology
- changes in institutions
Fig 4. - Shifts in the money demand
Figure 4 above shows shifts in the money demand. When the money demand curve shifts to the right, the interest rate increases. On the other hand, when the money demand shifts to the left, the interest rate in an economy decreases. Note that the quantity of money supplied doesn't change. The reason for that is that the quantity of money supplied can change only when there is a change as determined by the Federal Reserve.
To learn more check our explanation on - The Money Demand Curve
Equilibrium in Money Market: Price level
The price level reflects the rate of inflation in the economy. Whenever there is an increase in the overall price level, the money demand curve will shift to the right. People need more money to cover the additional expenses resulting from inflation.
Equilibrium in Money Market: Real GDP
Real GDP refers to the overall goods and services produced in the economy. Whenever there is an increase in the real GDP, more goods and services are produced in the economy. This will cause households to increase their consumption, which shifts the money demand curve to the right, resulting in a higher interest rate.
Equilibrium in Money Market: Technology
Technology refers to how easy new inventions make it for individuals to access cash. The money demand curve will be influenced whenever new technologies make it easier for individuals to change between money and savings.
Equilibrium in Money Market: Changes in Institutions
Whenever there is a change in government legislation that impacts the preference of individuals for cash, it will cause the demand curve to shift to the left or the right.
In summary, all these factors combined are the causes of the equilibrium in the money market. If any of these factors change, affecting either the money supply or demand, a new equilibrium in the money market will occur.
Examples of equilibrium in the money market
There are many examples of equilibrium in the money market. Let's consider some of them.
Recent Inflation in the U.S. and the Equilibrium in the Money Market
Consider the following scenario to better understand the equilibrium in the money market:
You have probably heard in the news that inflation has increased in the U.S. The Fed is concerned with how events are unfolding and are thinking of controlling inflation by increasing the interest rate in the economy. From what you’ve just learned, how do you think they will do it? In our imaginary scenario, we will assume that the Fed will increase the discount rate, making it more expensive for commercial banks to borrow from the Federal Bank.
This scenario is illustrated in Figure 5 below. As it becomes more expensive for banks to borrow from the Federal Bank, they will generate fewer loans to clients. This will cause the money supply curve to shift to the left. As a result, the equilibrium interest rate will rise in the economy.
Fig 5. A shift in supply in the money market example
Money Market Equilibrium Equation
Let's look at a calculation that involves a money market equilibrium equation:
Assume that the total money supply in an imaginary economy is $10,000.
The money demand equation is given as:
where r is the interest rate.
What is the equilibrium interest rate?
The equilibrium interest rate occurs at the point where
Therefore:
Equilibrium in Money Market - Key takeaways
- Equilibrium in the money market occurs when the money demand equals the money supply. At that point, the equilibrium interest rate is formed. For the equilibrium interest rate to change, either the money supply curve or the money demanded curve should shift.
- The liquidity preference model is based on the idea that the equilibrium interest rate occurs at the point where the quantity demanded and supplied of money are equal.
- The Fed determines the money supply, and there are three main tools through which it does so: the required reserve ratio, open-market operations, and discount rate. Subsequently, if any of these change, the money supply curve would shift.
- Factors that shift the money demand curve include: price level, real GDP, technology, and changes in institutions.
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