Recall that, in the goods market, the price of a product is determined by the demand for the product and the supply of the product. The equilibrium price is shown graphically by the intersection of the demand and supply curves. Similarly, in the money market, the interest rate is determined by the supply of money and the demand for money. We will examine this in the following section.
Supply and Demand in the Money Market
Earlier in this lecture, we saw that money holdings vary inversely with the interest rate. The question that arises next is, what determines the interest rate? As we will see, the supply of money, coupled with money demand, determines the interest rate.
Recall that the Fed influences the supply of money in the economy by conducting open market operations and by making changes in the discount rate or the reserve requirement. At any point in time, the supply of money is fixed. As we showed in the last lecture, the money supply curve is a vertical line.
We can couple the supply of money and money demand on the same graph in the following figure:
The equilibrium interest rate is the point at which the quantity of money supplied equals the quantity of money demanded. This is shown in the graph as r*. This means that r* is the interest rate that will prevail under the money supply and money demand conditions for the economy illustrated in the graph.
At the equilibrium interest rate, the quantity of money demanded equals the quantity of money supplied. At any other interest rate, this condition does not hold and, in the money market, it will force the interest rate to the equilibrium level.
For example, if the interest rate is temporarily above the equilibrium level, there will be an excess supply of money. Recall that at high interest rates, people are more likely to hold financial assets in interest-bearing securities. When the interest rate is above the equilibrium level, there will be more money available than people wish to hold. Interest rates must fall to encourage people to hold more money and fewer bonds. One way to look at this is an excess supply of money means there is that an excess demand for bonds. This causes the price of bonds to rise, which drives down the interest rate.
If the interest rate is below the equilibrium rate, there will be an excess demand for money. Because people want to hold more money than there is available, people will try to sell bonds in order to increase their money holdings. This drives down bond prices and causes interest rates to rise.
For more practice in understanding the adjustment to money market equilibrium, try the following Active Graph exercise: